Ch.11 Depreciation, Impairments, and Depletion

The cost of an asset less its salvage value is its depreciation base. True False

True

The declining-balance method does not deduct the salvage value in computing the depreciation base. True False

True

The profit margin on sales is a measure for analyzing the use of property, plant, and equipment. True False

True

Depletion Equation

Units extracted X Cost per unit

Normally, companies compute depletion (cost depletion) on a.....

Units-of-production method (Activity approach). Depletion is a FUNCTION of the NUMBER OF UNITS EXTRACTED during the period

impairment

a permanent decline in the fair value of an asset below its Book value

Composite or group depreciation is a depreciation system whereby - the years of useful life of the various assets in the group are added together and the total divided by the number of items. - the cost of individual units within an asset group is charged to expense in the year a unit is retired from service. - a straight-line rate is computed by dividing the total of the annual depreciation expense for all assets in the group by the total cost of the assets. - the original cost of all items in a given group or class of assets is retained in the asset account and the cost of replacements is charged to expense when they are acquired.

a straight-line rate is computed by dividing the total of the annual depreciation expense for all assets in the group by the total cost of the assets.

Use of the sum-of-the-years'-digits method - results in salvage value being ignored. - means the denominator is the years remaining at the beginning of the year. - means the book value should not be reduced below salvage value. - all of these answers are correct.

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

For income statement purposes, depreciation is a variable expense if the depreciation method used is - units-of-production. - straight-line. - sum-of-the-years'-digits. - declining-balance.

units-of-production.

Depreciation, depletion, and amortization all involve the allocation of the cost of a long-lived asset to expense. True False

True

Gains or losses on disposals of assets do not distort periodic income when the group or composite method is used to compute depreciation. True False

True

activity method of depreciation

(Cost LESS Salvage value) X Hours this year / Total Estimated Hours

straight line depreciation

(cost - salvage value) / useful life

depletion cost per unit

(total cost - salvage value) / total estimated units available

declining balance method

- Method that determines depreciation charge for the period by multiplying a depreciation rate (often twice the straight-line rate) by the asset's beginning-period book value. - DOES NOT DEDUCT the SALVAGE VALUE in computing the depreciation base.

Computation of the depletion base involves four factors:

1) Acquisition cost. - Mineral lease stuff 2) Exploration costs. - Determine any natural resources you want to recover/find 3) Development costs. - EX: Drilling a well 4) Restoration costs. - Restore what you destroyed

Methods of Depreciation

1. Activity method (units of use or production). 2. Straight-line method. 3. Decreasing-charge methods (accelerated) a. Sum-of-the-years'-digits. b. Declining-balance method. 4. Special depreciation methods: a. Group and composite methods. b. Hybrid or combination methods.

Measuring Impairments

1. Review events for possible impairment. 2. If the review indicates impairment, apply the recoverability test. If the sum of the expected future net cash flows from the long-lived asset is less than the carrying amount of the asset, an impairment has occurred. 3. Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market value or the present value of expected future net cash flows.

Double Declining Balance

2x straight line rate (100%/estimated life) =rate multiply (2x straight line rate) X book value

recoverability test

A test to determine whether an impairment of a long-lived asset has occurred. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, the asset is considered impaired. If the test indicates impairment has occurred, the company then computes the amount of the impairment loss to record, based on a fair value test.

Restoration of Impairment Loss

After recording an impairment loss: • Reduced carrying amount becomes its new cost basis • No change in new cost basis except for depreciation or amortization in future periods or for additional impairments • No restoration of impairment loss for an asset held for use as new cost basis puts impaired asset on an equal basis with other assets that are unimpaired

Which of the following is true of depreciation accounting? - It is not a matter of valuation. - It is part of the matching of revenues and expenses. - It is the process of cost allocation. - All of these answers are correct.

All of these answers are correct.

depletion

Allocation of the cost of a natural resource over its service life

Impairment of Assets to Be Disposed of

Assets held for disposal are like inventory; companies • Should report at lower-of-cost-or-net realizable value • Can write up or down an asset held for disposal in future periods, as long as carrying value after write-up never exceeds carrying amount of asset before impairment • Should report losses or gains related to impaired assets as part of income from continuing operations

Impaired assets held for disposal should be reported at the lower of cost or net realizable value. True False

True

McDonald Company acquired machinery on January 1, 2015 which it depreciated under the straight-line method with an estimated life of fifteen years and no salvage value. On January 1, 2020, McDonald estimated that the remaining life of this machinery was six years with no salvage value. How should this change be accounted for by McDonald? - As a prior period adjustment - As the cumulative effect of a change in accounting principle in 2020 - By setting future annual depreciation equal to one-sixth of the book value on January 1, 2020 - By continuing to depreciate the machinery over the original fifteen year life

By setting future annual depreciation equal to one-sixth of the book value on January 1, 2020

Fixed assets = Intangibles = Natural resources =

Depreciation Expense Amortization expense Depletion expense

decreasing-charge methods

Depreciation methods that allow for higher depreciation charges in the early years and lower charges in later periods. Also called accelerated depreciation methods. Generally, companies use one of two decreasing-charge methods: sum-of-the-years'-digits or declining-balance.

composite depreciation rate

Depreciation per year divided by the total original cost of the assets.

sum-of-the-years'-digits method

Each fraction uses the sum of the years as a DENOMINATOR (5 + 4 + 3 + 2 + 1 = 15). The NUMERATOR is the number of years of estimated life remaining as of the beginning of the year. (Depreciation Fraction) Alternate Equation (Denominator) = n(n+1)/2

Yes Impairment

Expected future net cash flows < Carrying amount

No Impairment

Expected future net cash flows > Carrying amount

An impairment loss is the amount by which the carrying amount of the asset exceeds the sum of the expected future net cash flows from the use of that asset. True False

False

Depreciation is based on the decline in the fair market value of the asset. True False

False

The three factors involved in the depreciation process are the depreciation base, the useful life, and the risk of obsolescence. True False

False

Return on Assets (ROA)

Net Income/Average Total Assets - Firm's performance in using assets to generate income

successful-efforts concept

Related to the accounting for exploration costs in the oil and gas industry, this view holds that companies should capitalize only the costs of successful projects. Companies should report any remaining costs as period charges.

full-cost concept

Related to the accounting for the oil and gas company, this view holds that the cost of drilling a dry hole is a cost needed to find the commercially profitable wells.

Composite Life

The length of time it takes a company to depreciate its assets on a composite basis - Total depreciable base / Total Depreciation per year

Worley Truck Rental uses the group depreciation method for its fleet of trucks. When it retires one of its trucks and receives cash from a salvage company, the carrying value of property, plant, and equipment will be decreased by the - original cost of the truck. - original cost of the truck less the cash proceeds. - cash proceeds received. - cash proceeds received and original cost of the truck.

cash proceeds received.

Book Value

cost - accumulated depreciation

When depreciation is computed for partial periods under a decreasing charge depreciation method, it is necessary to - charge a full year's depreciation to the year of acquisition. - determine depreciation expense for the full year and then prorate the expense between the two periods involved. - use the straight-line method for the year in which the asset is sold or otherwise disposed of. - use a salvage value equal to the first year's partial depreciation charge.

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

Depreciation is normally computed on the basis of the nearest - full month and to the nearest cent. - full month and to the nearest dollar. - day and to the nearest cent. - day and to the nearest dollar.

full month and to the nearest dollar.

The activity method of depreciation - is a variable charge approach. - assumes that depreciation is a function of the passage of time. - conceptually associates cost in terms of input measures. - all of these answers are correct.

is a variable charge approach.

For the composite method, the composite - rate is the total cost divided by the total annual depreciation. - rate is the total annual depreciation divided by the total depreciable cost. - life is the total cost divided by the total annual depreciation. - life is the total depreciable cost divided by the total annual depreciation.

life is the total depreciable cost divided by the total annual depreciation.

Profit Margin on Sales

net income/net sales - Measure of the ability to generate operating income from a particular level of sales.

Asset Turnover Ratio

net sales/average total assets - Measure of a firm's ability to generate sales from a particular investment in assets.

Depreciable base =

original cost - salvage value

Return on Assets

profit margin on sales x asset turnover - Measures a firm's success in using assets to generate earnings.

The major difference between the service life of an asset and its physical life is that - service life refers to the time an asset will be used by a company and physical life refers to how long the asset will last. - physical life is the life of an asset without consideration of salvage value and service life requires the use of salvage value. - physical life is always longer than service life. - service life refers to the length of time an asset is of use to its original owner, while physical life refers to how long the asset will be used by all owners.

service life refers to the time an asset will be used by a company and physical life refers to how long the asset will last.

Depreciation is...

the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset.

Special Depreciation Methods

• Group method used when the assets are similar in nature and have approximately the same useful lives. • Composite method used when the assets are dissimilar and have different lives. Choice of method depends on the nature of the assets involved. The Computation for group or composite methods is ESSENTIALLY THE SAME: find an average and depreciate on that basis.