Chapter 11: Depreciation, Impairments and Depletion

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Chapter 11 Depreciation, Impairments and
Depletion

• WE WILL COVER
• I. Depreciation
• 2. Impairments
• 3. Depletion
• 4. Presentation Analysis
• 5. Tax Depreciation (in general)--Appendix 11A

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Depreciation

• Depreciation is not a method of valuation but a
  method of cost allocation.
• Matches costs with revenues
• Acctg cannot measure FMV of these assets because
  valuation is subjective and subject to
  fluctuations
• Definition--Depreciation is an acctg process of
  allocating the cost of tangible assets to expense
  in a systematic rational manner over their
  estimated useful (service) lives

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Depreciation

• Depreciation Related Terms
• Depreciation is allocation of cost of long-term
  tangible assets.
• Depletion is allocation of cost of natural
  resources.
• Amortization is allocation of cost of
  intangible assets.
• Factors involved with depreciation
• Original cost .
• Salvage (residual) value--Must be estimated.
• Depreciation base (Cost less salvage value).
• Service life. Limited by
• Physical factors--wears out
• Economic. Factors--obsolescence

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Depreciation

• Methods of depreciation - should be systematic,
  rational appropriate for asset being consumed.
• Activity method
• Related to production, not time.
• Straight-line method
• Allocates cost pro-rata/equally over estimated
  useful life
• Declining charge methods (accelerated)greater
  depreciation in earlier years
• SYD
• Declining balance
• Group composite methods
• Applied to asset groups with composite or average
  rates

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Methods of Depreciation Crane Example

• Activity Method
• (Cost less Salvage) X Hours this year
  Depreciation Total estimated hours
  Charge
• (500,000 - 50,000) X 4,000 60,000
  30,000

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Methods of DepreciationStraight Line Method

• Cost less Salvage
  Depreciation Estimated Service life
  Charge
• 500,000 - 50,000 90,000
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Methods of Depreciation
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Methods of Depreciation
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Depreciation
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Depreciation

• Regardless of the method employed the adjusting
  journal entry for depreciation is

Depreciation expense (I/S) XX Accumulated
depreciation (B/S) XX

• Selection of Method
• Concern should be to properly matching expenses
  with revenues.
• Often use of one method for books and another
  for tax return--gives rise to deferred taxes--
  see Ch 20, Deferred Taxes.
• Depreciation misconception that is is a source of
  CASH
• It is only a book adjustment to arrive at accrual
  based N/I
• There is a tax impact source of C/F, however

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Impairments

• Impairments in value
• Per FASB Statement 121-- 1995, Accounting for
  the Impairment of Long-lived Assets
• Assets subject to a recoverability test to
  determine if an impairment has occurred.
• If NCF lt NBV
• ltNCF are undiscountedgt
• See Illustration
• See FASB 142 and Ch 12 regarding impairment of
  Intangible Assets

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Impairments
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Depletion

• Depletion of Natural Resources
• Establishment of depletion basis-- from 4
  sources
• 1. Acquisition costs of resource--purchase
  price--Capitalize
• 2. Exploration costs--to find resource--Expense.
• 3. Development costs
• Tangible equipment-- extracting--Capitalize as
  equipment
• Intangible development costs--drilling,
  wells,,etc. --Capitalize to depletion base
• 4. Restoration costs--estimate to bring property
  back to original condition after use--Capitalize
• See Illustration 11-17 text

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DepletionComputation of Depletion Rate

• Total Cost Salvage Value
  Depreciation Cost Total estimated units
  available per unit
• 1,000,000 10.00 per ounce
  100,000

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Presentation Analysis

• Disclose Basis of Valuation
• Historical cost, etc.
• Pledges, liens, etc.
• Disclose Depreciation Information
• Depreciation for the period
• Major classes of PPE
• Methods used
• Financial Ratios
• Asset turnover
• Rate of return on assets

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Presentation and Analysis

• Facts Sample Company
• in millions
• Net Sales 7,678
• Total Assets Eoy 6,632
• Total Assets Boy 6,315
• Net Income 802
• See Ilustrations

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Asset Ratios

• Net Sales Asset turnover
  Average
  total assets
  7,678
• 6.315 6,632 2
  1.19
• Profit Margin of Sales
  Net income
  Net Sales
  802 7,678
  10.4Rate of return on
  total assets Profit margin on sales X Asset
  turnover
  10.4 X 1.19
  12.4Rate of
  return on Assets Net
  income Average total assets
  802 6,315
  6,632 2
  12.4

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Tax Method Depreciation

• Tax depreciationMACRS,ACRS
• Uses accelerated depreciation methods.
• Mandated classes of property, recovery
  periods.(lives)
• Half-year convention generally applies.
• S/V generally ignored.
• Tax Depreciation usually gt GAAP depreciation
• See Illustrations

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MACRS Property Classes

• 3-year property includes small tools, horses,
  and assets used in research and development
  activities.
• 5-year property includes automobiles, trucks,
  computers, and peripheral equipment, and office
  machines.
• 7-year property includes office furniture and
  fixtures, agriculture equipment, oil exploration
  and development equipment, railroad track,
  manufacturing equipment, and any property not
  designated by law as being in any other class.
• 10-year property includes railroad tank cars,
  mobile homes, boilers, and certain public utility
  property.
• 15-year property - includes roads, shrubbery,
  and certain low-income housing.
• 20-year property includes waste-water treatment
  plants and sewer systems.
• 27.5-year property includes residential rental
  property.
• 39-year property - includes nonresidential real
  property.

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Depreciation Rates, by Property Class
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Tax versus Book Depreciation

• MACRS Depreciation1997 100,000 x .2
  20,0001998 100,000 x .32
  32,0001999 100,000 x .192 19,2002000
  100,000 x .1152 11,5202001 100,000 x
  .1152 11,5202002 100,000 x .0576
  5,760 Total Depreciation 100,000
• GAAP Depreciation
• (100,00 - 16,000) / 7 12,000 annual
  depreciation X 7 Years1/1/97
  1/2/2004 84,000 total depreciation