ACC 301 Ch. 11

What is a realistic assumption of the straight-line method of depreciation?

Depreciation is a function of time rather than a function of usage.

When depreciation is computed for partial periods under a decreasing charge depreciation method, it is necessary to...

Determine depreciation expense for the full year and then prorate the expense between the two periods involved.

Residual or Salvage Value

Estimated amount to be realized upon retirement. - Usually reduce by any expected dismantling and removal costs

Depreciation Policy

GAAP requires that the depreciation method allocate the asset's cost in a systematic and rational manner.

MACRS objective for tax depreciation

Help companies achieve a faster write-off of their capital assets

A principal objection to the straight-line method of depreciation is that it...

Ignores variations in the rate of asset use.

Classification -- Loss on Impairment

Income statement; other revenues & expenses

The activity method of depreciation...

Is a variable charge approach.

Depletion expense...

Is usually a part of COGS

The book value of a plant asset is...

The asset's acquisition cost less the total related depreciation recorded to date.

The term "depreciable base," or "depreciation base," as it is used in accounting refers to...

The total amount to be charged (debited) to expense over an asset's useful life.

Selecting a Depreciation Method

Three issues should be considered: 1. Pattern of use 2. Repair and maintenance costs 3. Technological changes

Depreciation

Related to plant assets

Reserve Recognition Accounting

Requires estimates of future production costs, the appropriate discount rate, and the expected selling price of oil and gas reserves.

What is not considered in determining depreciation for tax purposes?

Salvage value

What is the best conceptual rationale for the methods of matching depreciation expense with revenues?

Systematic and rational allocation

Depreciation, Depletion, and Amortization

- All are a process of cost allocation to periods benefited - They do not measure a market value decline, any physical change, or mean cash is being set aside for replacement

Activity (Units-of-Production) Method

- Assumes that depreciation is a function of use or productivity, instead of the passage of time - Advantages: - Depreciation charges follow the revenue curve - Suitable if the asset is primarily affected by use - Does the best to record expenses in the same period as associated revenues - Disadvantages: - Difficult to estimate a life in service hours or unit output - Service life may expire even when not in use - Fails to take into account increasing maintenance and repair costs - Fails to consider obsolescence and inadequacy

A change in estimate should...

Be handled in current and future periods.

Depreciation Revisions (multiple choice exam calculation)

- BV replaces cost when changing an asset's useful life and/or salvage value - Such changes in estimate are recognized in the current and future years (part of the normal accounting process) - Illustration 11-13 in book

Straight Line Method

- Considers depreciation as a function of time rather than a function of usage. - Most often used - When creeping obsolescence is the primary reason for a limited service life, the decline in usefulness may be constant from period to period. - Assumes benefits derived are constant each year - Disadvantages: - The asset's economic usefulness is the same each year - The maintenance and repair expense is essentially the same each period - Distortions in the rate of return analysis (income/assets)

Sum-of-the-Year Digits

- Decreasing depreciation charge based on a decreasing fraction of depreciable cost - Numerator is the number of remaining years of life at the beginning of the year and denominator is the sum of all the years - Numerator decreases year by year, denominator remains constant - At the end of the asset's useful life, the balance remaining should equal the salvage value

Double Declining Balance

- Depreciation rate is expressed as a percentage - Only method where you disregard salvage value when determining annual depreciation - The declining-balance rate is multiplied by the book value of the asset at the beginning of each period (BV x %; twice S/L rate) - The process continues until the book value of the asset equals its estimate salvage value - Only consider salvage in the final years since you do not want to over- depreciate

Impairment in Value

- If the total expected cash inflows from an asset are less than the BV, an impairment has occurred - You must recognize the write-down if the impairment is permanent and material by comparing FMV and BV - If the FMV subsequently increases, you are NOT permitted to write the asset back up, unless it is to be disposed.

Wasting Assets or Natural Resources

- Listed under PP&E - Three types of costs are incurred for natural resources 1. Acquisition Cost 2. Exploration Costs - Full Costs - Successful Efforts 3. Development Costs - Tangible Equipment - Intangible Cost

Use of the double-declining balance method

- Means the book value should not be reduced below salvage value - Results in a decreasing charge to depreciation expense - Mean salvage value is not deducted in computing the depreciation base

Inventory Method or Appraisal System

- Most applicable to tools - Beginning Inventory Value + Purchases - Ending Inventory Value = Depreciation expense

Depreciation Accounting

- Part of the matching of revenues and expenses - Not a matter of valuation - Retains funds by reducing income taxes and dividends

Group and Composite Methods

- Similar or Dissimilar Assets are combined and depreciated - A single accumulated depreciation account is kept for the group - No gain or loss can be recognized as retirements occur because BV for a specific asset is unknown

Disclosure of PP&E (exam multiple choice)

- The composition of PP&E can be disclosed in the notes 1. Depreciation expense for the period 2. Balances of major classes of depreciable assets, by nature and function 3. Accumulated depreciation, either by major classes or in total 4. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets

Retirement and Replacement Methods

- The cost less salvage of retirements or the replacement amount less salvage of retirement is charge to depreciation expense - Most often used by utility companies

Depletion

- Use the activity method - Depletion is classified under: 1. Inventory if unsold Inventory Accumulated Depletion 2. Inventory if sold COGS Inventory - Some companies use "percentage depletion" instead of "cost depletion" for tax purposes. Under percentage depletion, companies can write off more than the depletable cost for taxes. - Purely political, those companies who contribute to campaigns get a bigger tax break.

Many companies use S/L for financial reporting and an accelerated method for taxes because...

1. Tax advantages -- lower taxes 2. Higher reported income for financial reporting - For taxes, companies use MACRS depreciation which is DDB with a half years depreciation in the year of purchase.

Methods of Depreciation

1. Activity Method (Units-of-Production) 2. Straight Line Method 3. Decreasing Charge or Accelerated Methods 4. Special Depreciation Methods

Exploration Costs (Multiple Choice)

1. Full Costs (small companies) - Capitalize ALL exploration costs 2. Successful Efforts (big companies) - Capitalize only successful exploration costs - Both are acceptable

Special Depreciation Methods

1. Inventory Method or Appraisal System 2. Retirement and Replacement Methods 3. Group and Composite Methods

Decreasing Charge or Accelerated Methods

1. Sum-of-the-Year Digits 2. Double Declining Balance - Provide for a higher depreciation cost in the earlier years and lower charges in later periods - Companies should charge more depreciation in earlier years because the asset is most productive in its earlier years - Also provide a constant cost because the depreciation charge is lower in the later periods, at the time when the repair/maintenance expenses are higher - Recognize the greatest loss of services in the early years - Suitable if technological changes cause the asset to become obsolete before the end of its useful life

Development Costs

1. Tangible Equipment - if it can be removed, use it's useful life. If not, use life of resource if shorter 2. Intangible Cost - Drilling, tunneling, etc. - Write off over life of resource

The most common method of recording depletion for accounting purposes is the...

Activity, or units-of-production, method

What is not a similarity between depreciation and cost depletion?

Both are based on time.

For the composite method, the composite...

Life is the total depreciable cost divided by the total annual depreciation

Useful Life

Limited by: 1. Physical factors - Wear and tear - Deterioration and damage 2. Economic or functional factors - Involves inadequacy, supersession (replacing with more efficient one) and obsolescence

Acquisition Cost (Initial Cost)

May have negative salvage because of restoration of reclamation costs

Use of the sum-of-the-years'-digits method

Means the book value should not be reduced below salvage value.

Rate of Return on Total Assets

Net income/average total assets

Asset Turnover Ratio

Net sales/average total assets

Amortization

Related to intangible assets

Depletion

Related to natural resources

A general description of the depreciation methods applicable to major classes of depreciable assets...

Should be include in corporate financial statements or notes.

For income statement purposes, depreciation is a variable expense if the depreciation method used is....

Units-of-production (Activity Method)