Ch. 11: Depreciation, Depletion, Impairment, and Disposal

Asset retirement obligation (ARO)

legal obligation related to the retirement of an asset

Composite depreciation rate

Annual Depreciation Expense ÷ Cost

Composite depreciation expense

Cost of Assets Remaining in Service x Composite Depreciation Rate

Straight-line method

o For fixed assets, a method of depreciation that allocates an equal amount of an asset's cost to depreciation expense for each period of the asset's service life. o For bonds or notes payable, a method of amortizing discounts and premiums where the amortized portion of the discount or premium is an equal amount each period during the life of the payable.

Additional depreciation methods

o Group depreciation o Composite depreciation o Recognize that depreciation expense is based on estimates of service lives and residual values and that gains or losses on disposals of single assets are often immaterial o The major disadvantages of the two methods are that faulty estimates might be concealed for long periods and gains and losses may be deferred beyond the period in which they actually occurred

Methods of cost allocation

o Time-based methods --- Straight-line --- Accelerated >>>>> Sum-of-the-years'-digits >>>>> Declining-balance o Activity (or use) methods o Group or composite methods *All acceptable under GAAP*

Asset cost

o all costs necessary to acquire the asset and prepare it for use in order to obtain the benefits from the asset o any expenditures necessary to obtain the asset and put it in operating condition, such as the contract price plus freight, assembly, installation, and testing costs

Straight-line method for fixed assets

o The straight-line method recognizes the same amount of depreciation expense ($20,000) each year. o The book value of the asset decreases linearly each year until it equals the estimated residual value at the end of the asset's service life. o Most widely used depreciation method with approximately 98% of public U.S. companies and 97% of international companies using it for some portion of property, plant, and equipment.

Depreciation base (depreciable cost)

Asset Cost - Estimated Residual Value

Average useful life

Average Depreciable Assets ÷ Depreciation Expense

Average age of property, plant, and equipment

Average Depreciable for specific year ÷ Depreciation Expense

If the fair value of property, plant, and equipment is less than its book value,

it could signal that a company's past earnings were overstated because it did not record sufficient depreciation expense in prior years.

How Do We Account for the Impairment of Property, Plant, and Equipment?

o

Depreciation methods - repair and maintenance costs

o A company often considers the selection of the depreciation method together with the expected repair and maintenance costs associated with the asset. o The use of the straight-line depreciation method and constant repairs and maintenance will result in a consistent total cost (depreciation expense plus repair and maintenance cost) each period. o The use of an accelerated depreciation method coupled with increasing repair and maintenance costs may produce a consistent total cost each period. --- However, repair and maintenance costs would have to increase significantly to offset the decreasing depreciation expense amounts.

Depreciation - correction of an error

o Accounted for as a prior period adjustment o The effect on the current period's financial statements involves a correction to the amount in the accumulated depreciation account and an adjustment to retained earnings (net of income taxes) for the amount of the error in previously reported net income o Previous financial statements are also corrected (restated)

Depreciation - changes in depreciation method

o Accounted for prospectively o Requires a justification as to why the new method is preferable o The book value of the asset at the beginning of the year of the change is allocated over the remaining life (considering the residual value) using the new depreciation method o This change is called a change in accounting estimate that is effected by a change in accounting principle

Depreciation methods - U.S. GAAP vs. IFRS

o Both allow the use of the same depreciation methods (straight-line; sum-of-the-years'-digits; declining-balance). o IFRS require that the estimated useful lives and residual values of the assets, and the depreciation method, be reviewed at least once a year. U.S. GAAP only requires this review when events or circumstances indicate that the estimate has changed. o When an operating asset is made up of individual components that are significant with respect to the total cost of the item (e.g., an airplane and its engines), IFRS require that the initial cost of the operating asset be allocated to the significant components and each component be depreciated separately (component depreciation). Permitted under GAAP. o When a company writes the value of its property, plant, and equipment up to fair value under the revaluation model, the revalued amount is used to compute subsequent depreciation expense. This issue does not exist under U.S. GAAP as it does not allow upward revaluations of property, plant, and equipment. o IFRS require that companies disclose the accumulated depreciation for each class of property, plant, and equipment, not just the total amount as allowed by U.S. GAAP.

Depreciation - changes and corrections

o Change in estimate --- Recalculation of depreciation expense, which is accounted for prospectively --- The remaining book value of the asset at the beginning of the year of the change is allocated over the new remaining life, considering the new residual value o Change in depreciation method --- Accounted for prospectively --- Requires a justification as to why the new method is preferable --- The book value of the asset at the beginning of the year of the change is allocated over the remaining life (considering the residual value) using the new depreciation method o Correction of an error --- Accounted for as a prior period adjustment --- Correction to the amount in the accumulated depreciation account --- Adjustment to retained earnings (net of income taxes) for the amount of the error in previously reported net income --- The previous financial statements are also corrected (restated)

Conceptual evaluation of depreciation methods

o Depreciation (as well as depletion and amortization) is a process of cost allocation, not asset valuation. o The asset's book value should represent fair value both at the time the asset is acquired (acquisition cost should reflect fair value) and at the end of the asset's life, when residual value represents the disposal value. o Financial statements effect --- Yearly depreciation expense --- Book value of assets --- Rate of return o Other factors --- Repair and maintenance costs --- The risk associated with the cash flows from the asset

Composite depreciation

o Depreciation method applied to heterogeneous assets that are related but have differing service lives and residual values (e.g., all the different equipment in a company's office) o Combines the assets in one asset account and depreciates them accordingly. o Uses one accumulated depreciation account. o Does not recognize a gain or loss on each item retired. o Recognizes a net gain or loss when it retires the final asset. o

Group depreciation

o Depreciation method applied to homogeneous assets that are expected to have similar service lives and residual values (e.g., laptop computers) o Capitalizes the total cost of the assets into one account which is treated as one "asset" for purposes of depreciation o Bases the group depreciation rate on the average life of the assets in the group o Calculates the depreciation expense each period by multiplying this rate by the balance in the asset account o Accumulates the depreciation expense in a single contra-asset account o When an item in the group is retired, the company records the retirement of an item in the group by a credit to the asset account for the original cost and a debit to the Accumulated Depreciation account for the difference between the cost and the proceeds received. o When the final unit in the group is retired, a net gain or loss on the group as a whole is recognized.

Component depreciation

o Depreciation method used when an operating asset is made up of individual components that are significant with respect to the total cost of the item (e.g., an airplane and its engines) o Each component is depreciated separately. o Permitted under U.S. GAAP o Required under IFRS

One-half year convention

o Depreciation policy in which all assets purchased or sold during the fiscal year are considered to have been purchased or sold at the midpoint of the year. o One-half year's depreciation is recorded in the year of acquisition. o One-half year's depreciation is recorded in the year of disposal.

Nearest whole year convention

o Depreciation policy in which any assets purchased during the first 6 months of the year are considered to be owned for the entire year. o Assets purchased during the second 6 months are not depreciated for that year. o Assets disposed of during the first 6 months of a year are not depreciated for that year. o Assets disposed of during the last 6 months of a year are depreciated for an entire year..

Nearest whole month convention

o Depreciation policy in which assets purchased on or before the 15th of the month are considered owned for the whole month o Assets purchased after the 15th are considered not to be owned during the month. o Assets sold on or before the 15th are considered not to be owned for the month o Assets sold after the 15th are considered owned for the whole month. o Depreciation expense is then based on the fraction of the year (in whole months) the asset is used.

Depreciation methods - risk associated with the cash flows from the asset

o In periods of rapid technological change, an asset may become obsolete before the end of its originally estimated useful life. o There is a greater risk associated with the estimated cash flows produced by the asset near the end of its life than for those at the beginning. o Use of an accelerated depreciation method may be appropriate in such situations because the lower depreciation expense recorded late in the asset's life would be consistent with the greater risk that the estimated cash flows will not be realized. o The age of a company's assets affects its competitive position because old assets tend to be less efficient than newer assets. o The age of assets provides an indication of a company's capital replacement policy and assists analysts in estimating future capital expenditures. o All things being equal, a company's return on assets will increase as the company's assets get older, which may affect the company's perceived profitability.

Depreciation and accretion related to asset retirement obligations

o Initially: The fair value is recognized as a liability with an offsetting increase in the carrying value of the related asset. o Subsequent periods: --- The asset is depreciated over its service life. --- The company recognizes accretion expense and increases the asset retirement obligation each year it uses the asset.

Double-declining-balance method

o Method of depreciation that recognizes a declining depreciation expense amount each period by applying a constant rate of 2 to the book value of the asset at the beginning of each period o The periodic depreciation expense declines because the book value decreases each year as the asset depreciates. o Because the residual value is ignored in the calculation of depreciation expense, the application of the declining-balance method can cause an asset's book value to be different from its residual value at the end of the asset's service life. --- Depreciation expense is adjusted toward the end of the asset's service life so that the book value will equal the residual value. o 2 x Straight-Line Rate o Depreciation Expense = Declining-Balance Rate x Net Book Value at Beginning of Period

Declining-balance methods

o Method of depreciation that recognizes a declining depreciation expense amount each period by applying a constant rate to the book value of the asset at the beginning of each period. o The declining balance depreciation rate is some multiple of the straight-line rate. o Multiple x Straight-Line Rate

Sum-of-the-years'-digits method

o Method of depreciation that recognizes a declining depreciation expense each period by applying a decreasing fraction each year to the depreciable base of the asset. o The denominator of the fraction is the sum of the years of the asset's service life. o The numerator of the fraction is the number of years remaining in the asset's life as of the beginning of the year. o The depreciation base remains constant, while the fraction decreases each year.

Activity method (units of production method)

o Method of depreciation that recognizes the service life of an asset is affected primarily by the amount the asset is used and not by the passage of time. o Activity, or usage, is usually measured in terms of an input measure such as the number of hours worked or an output measure such as miles driven or units produced. o An adjustment to depreciation expense is necessary toward the end of the asset's service life so that the book value of the asset will equal its estimated residual value. o Method used for depletion o Disadvantages --- Difficulty estimating the lifetime units of activity --- Cost o Depreciation Rate = (Cost - Residual Value) ÷ Estimated Usage of the Asset o Depreciation Expense = Depreciation Rate x Actual Usage of the Asset

Depreciation for partial periods

o Nearest whole month convention o Nearest whole year convention o One-half year convention

Depreciation - changes in estimate

o Recalculation of depreciation expense, which is accounted for prospectively o The remaining book value of the asset at the beginning of the year of the change is allocated over the new remaining life, considering the new residual value

Recording depreciation

o Recorded each period --- Debit: Depreciation Expense --- Credit: Accumulated Depreciation (or Allowance for Depreciation) o A company maintains a separate contra-asset account for each class of asset and should deduct this amount on its balance sheet directly from the cost of that asset class. o A manufacturing company includes depreciation on manufacturing assets as a cost of inventory by allocating depreciation to each unit of production during the year by increasing the Work-in-Process Inventory account. --- The portion of the total depreciation allocated to the units sold appears in the company's income statement as part of the cost of goods sold (and not separately as depreciation expense). --- Any depreciation included in the cost of the units produced but not sold remains in the inventory accounts (Work-in-Process or Finished Goods) on the company's balance sheet.

Accretion expense

o The increase of the asset retirement obligation due to the passage of time, computed by multiplying the book value of the asset retirement obligation by the appropriate discount rate o Classified as an operating expense o Results from the increase in the carrying value of the liability associated with the ARO o Computed by multiplying the book value of the liability by the discount rate used to compute the original present value of the ARO

Residual value (salvage value)

o The net amount that a company expects to obtain from disposing of an asset at the end of its service life o the expected value of the asset at the end of its service life minus disposal costs, such as dismantling, removing, and selling the asset o If a company plans to hold an asset until it is physically exhausted or functionally obsolete, the expected residual value is probably very low and perhaps zero o If a company plans to dispose of the asset when it still has considerable economic usefulness to others (e.g., a building), the expected residual value is the estimated net market value of the asset (the selling price minus disposal costs) at the time of the disposal, which may be relatively high o Due to future uncertainties, many companies assume a residual value of zero (acceptable if they do not have a material effect on the measurement of income and the book value of the asset)

Time-based methods

o The straight-line method is appropriate when a company estimates that the service potential of the asset will decline by an approximately constant amount each period of its useful life. o The accelerated methods are appropriate when a company estimates that the service potential of the asset will decline more quickly in the early periods of the asset's useful life than in the later periods.

Depreciation methods - effects on financial statements

o The yearly amounts of depreciation expense are different. o In the early years of an asset's life, the use of the straight-line method results in a higher book value of assets relative to the accelerated methods. o The depreciation of property, plant, and equipment may make comparisons of the rate of return on assets more difficult. --- Recording depreciation causes the rate of return on total assets (income before financing charges divided by average assets) to increase over time. --- The increase in the rate of return over the life of the asset would be more dramatic if an accelerated depreciation method were used instead of the straight-line method. o The straight-line method tends to produce higher income and shareholders' equity amounts compared with the accelerated methods.

What are the factors involved in depreciation?

o asset cost o service life (or useful life) o residual value (or salvage value) o methods of cost allocation

Depreciable asset disclosures - GAAP

o depreciation expense for the period o balances of major classes of depreciable assets, by nature or function, at the balance sheet date o accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date o a general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets

Depreciation methods - additional issues

o depreciation for partial periods o changes and corrections of depreciation o depreciation and accretion of asset retirement obligations

Service life (useful life)

o the amount of service or use that a company expects from an asset before its disposal. May be measured in units of time, such as years and months, or units of activity or output, such as hours of operation of a machine, tons produced for a steel mill, or miles driven for a truck o Limitations --- Physical causes: wear and tear because of operational use, deterioration and decay that is a function of time (e.g., rust), and damage and destruction --- Functional causes: obsolescence and inadequacy, even though the physical life is not exhausted

Amortization

the allocation of the cost of intangible assets, such as patents and copyrights, as an expense to each period in which the asset is used and economic resources are consumed. Also used as a general term to describe the periodic allocation of costs

Depletion

the allocation of the cost of natural resources, such as oil, gas, minerals, and timber, as an expense to each period in which the asset is used and economic resources are consumed (the period in which benefits are received)

Rational

the amount of the depreciation expense each period should relate to the decline in the asset's service potential each period

Systematic

the calculation should follow a formula and not be determined in an arbitrary manner

Depreciation

the rational allocation of the cost of tangible assets, such as property, plant, and equipment, as an expense to each period in which the asset is used and economic resources are consumed

Impairment

when the future economic benefit or service potential of an asset decreases below its book value