Chang, O.H. 1

ACCT373 Intermediate Accounting II

Chapter 11

Otto Chang

Professor of Accounting

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Depreciation

• Depreciation is NOT a matter of valuation, but cost allocation

• It is allocating the cost of tangible (c.f. wasting or intangible) assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the assets

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Factors Involved in the Depreciation Process

• Depreciable base: generally, it is original cost basis reduced by salvage value

• Estimation of service life: depends on physical factor as well as economic factors

• Methods of depreciation: any systematic and rational method

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Methods of Depreciation

• Activity method (units of inputs or output method): is a function of use or production

• Straight-line method: is a function of time (most appropriate for buildings)

• Decreasing charge methods: sum-of-years’-digits or declining balance method (150% or 200%, usually ignores salvage value)

• Group and composite methods

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Group and Composite Method

• Simplify calculation, avoid the likelihood of over- or under- depreciation

• No gain or loss recognized on disposition. Original Salvage Depreciable Economic DepreciationAsset Costs Value Base life per year A $145,000 $25,000 $120,000 3 $40,000 B 44,000 4,000 40,000 4 10,000 C 35,000 5,000 30,000 5 6,000 $224,000 $34,000 $190,000 $56,000Composite Depreciation rate = $56,000/$224,000 = 25%

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Depreciation and Partial Period

• Partial period depreciation can be based on:– Nearest fraction of a year– Nearest full month– Half year in period of acquisition & disposal– Full year in acquisition, none in disposition– None in acquisition, full year in disposition

• It’s a trade-off of simplicity and accuracy

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Revision of Depreciation Rates or Economic Life

• Treated as a change in accounting estimates

• Do not go back and change depreciation expenses in the previous periods

• Take the carrying value at the beginning of the period to compute revised depreciation expense per year based on new estimated economic life. Use the new depreciation rates for this year and the following years.

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Impairment of Long-lived Assets

• Type of assets applicable:– Long-lived assets to be held and used– Assets to be disposed of– Related goodwill

• Accounting and reporting:– Review required when circumstances change– impairment occurs if undiscounted future cash

is less than the carrying amount of the asset (recoverability test met)

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Changes in Circumstances

• Significant decrease in market value

• Significant change in manner in which asset is used

• Significant change in legal factors or business climate

• Significant excess of cost accumulation

• Projected continuing losses

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Measurement of Loss

• Amount of loss is the difference between the fair value and the carrying value of the assets if the entity expect to hold and use the asset.

• Except for assets covered by APB 30 (Discontinued Operation), assets to be disposed of should be reported at the lower of carrying amount or net realizable value.

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Measure of Fair Value and Journal Entry

• Measurement for fair value – Quoted market prices in active market– Estimate from prices of similar assets– Estimate from valuation techniques such as

discounted cash flow, option-pricing models

• Journal entry to record the loss:Loss on Impairment $75,000

Accumulated Depreciation $75,000

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Depreciation and Restoration of Impairment

• Assets held for use:– The reduced amount of asset becomes the new

cost for depreciation– Restoration of previous loss prohibited

• Assets to be disposed of:– No depreciation taken– Restoration of loss permitted– Gains or losses included in income from

continuing operations

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Depletion

• The depletion base include:– Acquisition costs of undeveloped property– Exploration costs: two methods are permitted

• Successful efforts approach: capitalize only the cost of successful exploration

• Full cost method: capitalize all costs, successful or not– Development costs:

• Intangible development costs• Tangible equipment subject to depreciation are

excluded from depletion base

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Write off of Resource Cost

• Computation of depletion rate = (Total cost - Salvage value) / Total estimated units available

• Journal entry:Inventory or Depletion Expense $250,000

Accumulated Depletion $250,000

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Special Problems in Depletion

• Difficulty of estimating recoverable reserves

• Should discovery value be recorded? ( Reserve Recognition accounting or not?)– pro: reflects economic reality– con: numbers not reliable

Currently, FAS#69 requires only current value to be disclosed

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Analysis of PPE

• Asset turnover ratio = Net sales / (Average total assets)

• Profit margin on sale = Net income / Net sales

• Rate of return on assets = Net income / Average total assets