Documents
User Generated
Resources
Learning Center
Your Federal Quarterly Tax Payments are due April 15th

VIEWS: 2 PAGES: 32

• pg 1
```									                   Agenda

• Quiz #4 due Wednesday 3/4
• Ch. 10: wrap up
• Ch. 11: Depreciation, Impairments and
Depletion
Depreciation: Concept
• Depreciation is a means of cost allocation
• It is not a method of valuation
• What does this mean? It means that we will see
Book Value = Fair Value only by coincidence
(except for at the time when the asset is
purchased)
• Depreciation involves:
• allocating the cost of tangible assets to expense
in a systematic and rational manner to periods
expected to benefit from use of its depreciable
assets
•   à Matching
Factors in the Depreciation Process

•      What is the depreciable base of the asset?
•    Depreciable base is the dollar amount subject to
depreciation. It is determined as:
Original cost of the asset less
Estimated salvage or disposal value
·      (however note that for declining balance methods, we use
original cost (and ignore salvage value) in the calculation, and
only check that our deprecation does not cause the carrying
value of the asset to drop below salvage value)
•        What is the asset’s useful life?
•        What method of depreciation is best for the asset in
question?
Depreciation Methods: Overview

Depreciation
Methods

Financial Accounting                     Tax
Depreciation Methods                 Depreciation

Activity   Straight-   Decreasing     Special
line      Charge        methods

1. Declining Balance            1. Composite method
2. Sum-of-the-years’ digits     2. Hybrid methods
Depreciation Methods: Straight-Line

• S/L is a function of time rather than usage
• most commonly used method
• Results in an equal amount of depreciation
expense for a given period
• Depreciation Expense is computed as:
Cost – Salvage Value
Estimated Life
Example – Depreciation Methods

Jose Inc. bought a new printing press for
\$1,000,000 on June 30, 2005. The press has an
estimated useful life of 15 years, and a salvage
value of \$50,000. It is estimated that the
machine will provide 200,000 hours of use.
From its purchase to Jose’s year end of
December 31, 2005, the press ran for 7,000
hours. Calculate depreciation expense for the
machine for using the following methods:
straight-line, Activity, and Double Declining
Balance (2x SL rate).

6
Straight Line Method

Jose Inc.’s 2005 depreciation (S/L Method):
• Depreciable Base:
1,000,000 – 50,000 = 950,000

• Rate per year: 950,000 / 15 = \$63,333

• 6 months from July 1 to Dec 31: \$31,666
• Note: unless told otherwise, assume that firms using SL
depreciation; go by month for part-year problems

7
Depreciation Methods: Activity Based

• This method is a function of usage
rather than time
• requires more effort in recording asset use
or install hourly usage meters, etc.)
• Estimated life for this method is in
terms of total input/output of asset.
• Depreciation expense is computed as:
(Cost – Salvage Value) x Input or Output in period
Total Estimated Input or Output
Activity Based Method

Jose Inc.’s 2005 depreciation (Activity-
Based Method):
• Part-year? Doesn’t impact calculation

• \$950,000 / 200,000 hrs = \$4.75 / hr

• 7,000 x \$4.75 = \$33,250 Dep’n for 2005
9
Depreciation Methods: Decreasing
Charge (Accelerated)
These methods result in higher
depreciation expense in the earlier years
and lower charges in the later years.

Two accelerated methods are:
•    Declining balance
•    Sum-of-the-years’-digits
Depreciation Methods: Declining
Balance
•       Salvage value is not deducted when computing depreciable
base for declining balance
•       Often utilizes a depreciation rate (%) that is some multiple
of the SL rate
•       The depreciation rate is multiplied by the asset’s book
value at the beginning of the period to get the depreciation
expense for the period.
•       Since the book value decreases over time this results in a
decreasing amount of depreciation expense over time.
•       An asset’s book value can never be less than its estimated
salvage value.
•      You must check this “manually” after calculating the
depreciation expense for the year – and cut back on
depreciation that would drop carrying value below salvage
value
Double Declining Balance Method

Jose Inc.’s 2005 depreciation (DDB method):
• Ignores Salvage Value
• Calculate full- year depreciation:
• 1,000,000 x [2/15] = \$133,333
• Since only half-year:
133,333 x [6/12] = \$66,667
• What about next year in 2006?
• Take the NBV at the beginning of the period
(1,000,000 – 66,667) = 933,333 X [2/15] =
\$124,444

12
Depreciation Methods:
Sum-of-the-Years’ Digits
•       A fraction is multiplied by the depreciable base to
arrive at the depreciation expense per period.
•       The fraction is:
•     Numerator: number of years remaining in the
asset’s life as of the beginning of the period.
•     Denominator: sum of the years in the life
•     For example, a 5 year life property would have
depreciation expense for the first year as:
•     (Cost – Salvage value) X 5 (years remaining)
15 (computed as
5+4+3+2+1)
SYD Method
Jose Inc.’s 2005 depreciation (SYD Method):
• Calculate full- year depreciation:
• (Cost – SV) X (# years remaining at beg of period/sum of years)
• 950,000 x [15/120] = \$118,750
• Since only half-year:
118,750 x [6/12] = \$59,375
• What about next year in 2006?
• The remaining \$59,375 is attributable to the first 6 months of
2006
• Then calculate depreciation for the next 12 months: 950,000 x
[14/120] = \$110,833
• Then allocate 6 months of the \$ 110,833 to the last six months of
2006:
\$ 110,833 X 6/12 = 55,417
• 2006 depreciation: 59,375 + 55,417 = 114,792

14
Depreciation Methods: Summary
•       Straight-Line
Cost – Salvage Value
Estimated Life

•     Activity Method
•    Depreciation expense is computed as:
(Cost – Salvage Value) x Input or Output in period
Total Estimated Input or Output
•       DDB:
•      Salvage value is not deducted when computing depreciable base.
•      The rate is double the SL rate
•      The depreciation rate is multiplied by the asset’s book value at the
beginning of the period to get the depreciation expense for the
period.

•       SYD:
(Cost – Salvage value) X     5 (years remaining)
15 (computed as 5+4+3+2+1)
Partial Year Depreciation

• When an asset is bought sometime during the year,
follow the company’s policy for treatment
• In some cases, a partial depreciation charge is required
• In other cases, the firm may choose to take a full year’s
depreciation in the year purchased, and none in the year
of disposal (or even ½ year when purchased and ½ year
when disposed)
• If the firm allocates proportionately based on
months owned, determine depreciation for a full
year, and allocate the amount between the two
periods affected
Revision of Depreciation Estimates

•   Determination of depreciation involves
initial estimates (e.g., life, salvage value)
•   When these estimates are revised,
depreciation must be re-computed:
Remaining B.V. – Est. Salvage Value
Remaining Est. Life
•   These revised depreciation expenses apply
prospectively to the remaining life of asset.
•   No Adjustment to prior periods
Revision Example
Kennedy Floatation Devices Inc. (KFD) bought a plastic
foam manufacturing machine on November 1, 2005. At
that time, KFD assumed the machine would last for 10
years, and would have a salvage value of \$1,000. The
machine cost \$50,000.

On July 1, 2007, KFD installed a new part on the machine
at a cost of \$15,000. The new part extended the life of
the machine for an additional 15 years, although at that
date it would have a salvage value of only \$500.

Calculate the depreciation expense for the machine for
the 2007 fiscal year (ended December 31).
18
Solution
Book value on July 1, 2007, before new part:

2005 depreciation = (50,000 – 1,000)/10 = 4,900 x 2/12 = 817
2006 depreciation = 4,900
2007 depreciation (up to July 1) = 4,900 x 6/12 = 2,450
Total Accum. Depn.: 817 + 4900 + 2450 = 8,167
Book Value before new part = 50,000 – 8,167 = 41,833
BV after new part: 41,833 + 15,000 = 56,833
Remaining Life: 15 years
New Depreciation per year = (56,833 – 500) / 15 = 3,756 per year

Total Depreciation for 2007: 2,450 + 3,756 X (6/12) = 4,328

19
Impairments

An impairment of a depreciable asset
occurs when:
• The carrying amount of the asset (or
asset group) is not recoverable, and
therefore a write-off is needed.
• The recoverability test determines if
an impairment has occurred.
Impairments

A Recoverability test should be performed
when circumstances change indicating a
carrying amount may not be recoverable:
• Significant decrease in market price
• Significant change in use or physical condition
• Significant change in legal factors or in business climate
that could affect asset’s value
• Accumulation of cost significantly greater than amount
originally expected to acquire or construct a long-lived
asset
• Expectation that entity will sell or otherwise dispose of
long-lived asset significantly before the end of its
previously estimated useful life
Impairments
Impairments: The Recoverability Test

Impairment?

Sum of expected              Sum of expected
future net cash flows         future net cash flows
(NO DISCOUNTING)           from use and disposal
from use and disposal                of asset is
of asset is less than      equal to or more than
the carrying amount           the carrying amount

Impairment has occurred             No impairment
Impairments: Measuring Loss
Impairment has occurred                Loss =
Carrying amount
Determine              Yes           less
impairment loss                Fair value of asset

Does an active market
Loss =
exist for the asset?
Carrying amount
less
No     present value of
expected net cash
Use company’s market               flows
rate of interest
Impairment: Accounting
Impairment has occurred

Assets are held         Assets are held
for use             for disposal
1. Loss = Carrying value         1. Loss = Carrying value
less Fair value                  less Fair Value less
2. Depreciate new cost basis
• i.e., this is a change in      cost of disposal
estimate                    2. No depreciation is taken
3. Restoration of impairment     3. Restoration of impairment
loss is NOT permitted            loss is permitted
Graphic of Accounting for
Impairments

Not
Discounted
Impairment Example

Rocky Inc. manufactured a pet rock making machine. Raw materials and
direct labor costs totaled \$100,000, plus another \$5,000 of allocated
overhead and \$3,000 of capitalized interest. On January 1, 2003, the
machine was put into use. On that date, Rocky estimated that it would
have a useful life of 10 years and no scrap value. In 2004, another
\$3,000 was spent on overhauling the machine. This did not extend the
life or output of the machine, and was part of its regular maintenance.

After sales declined in early 2006, Rocky’s controller assessed whether
the machine’s value was impaired. He estimated that the machine
would generate net cash flows of \$14,000 per year for the next 4 years
(including 2006), but would not generate any future cash flows after
that. No market existed for the machine. Rocky’s discount rate is 10%.
Rocky intends to continue to use the machine to make pet rocks.

Show any journal entries that might be required for 2006 with respect to
the machine.

27
Solution
We need the Book Value as of January 1, 2006:
108,000 / 10 = 10,800 x 3 years (2003 to 2005) = 32,400
BV: 108,000 – 32,400 = 75,600
(note: the \$3000 expenditure in 2004 is regular maintenance, and was
charged to expense in 2003)

Total future net cash flows: 14,000 x 4 = 56,000

Because 56,000 < 75,600, there is an impairment (move to stage 2)

No market exists for the machine, so use PV à i=10%, n=4, pmt=14,000
à PV = \$44,378

Dr. Impairment Loss (75,600 – 44,378)      31,222

Dr. Depreciation Expense (44,378 / 4)      11,095

28
What if…
• What if the market improved in 2007, and expected future
cash flows increased?
• We would do nothing, unless the expected useful life of the
machine also increased. In that case, we would revise our
depreciation rate from 3 years remaining to some new number
• What if a market existed for the machine in 2006, and its fair
value was \$50,000?
• We would have written the machine down to 50,000 instead of
\$44,378
• What if Rocky had decided to sell the machine instead of
continue to use it?
• We would write the machine down to its present value less any
estimated disposal costs (e.g., fees paid to an auction)
• No more depreciation!
• If a market existed, and its market value increased in the future,
we could recognize a recovery of the loss we recognized in 2006
(but we could not increase its book value above the original
\$75,600)

29
IFRS vs. US GAAP
Step 1: Recoverability test
•US GAAP compares carrying value to future undiscounted cashflows
•IFRS compares carrying value to the recoverable amount.
• The recoverable amount is the greater of:
• Net selling price (market value of the asset less disposal costs)
• Value in use (Discounted future cashflows)
Step 2: Measurement of loss
•US GAAP: Carrying value less:
• Fair value (if there is a market for assets) – or – if not market:
• Future discounted cashflows
•IFRS: Carrying value less the recoverable amount

Write-ups for subsequent recoveries:
•Under US GAAP, allowed only if asset is held for disposal, up to carrying
value at time of original write-down
•Under IFRS, allowed
• If using cost model, up to carrying value at time of original write-down
• If using the revaluation model, no ceiling

30
Depletion: Terminology

Depletion refers to the cost basis write-off
of natural resources (e.g., coal, oil, timber)
• Note that cost here includes (future)
restoration costs (e.g., replanting logged areas)
Depletion expense per unit is calculated:
Cost – Estimated Salvage Value
Total Estimated Units Available
The per unit cost is multiplied by the units
extracted during a period to derive the depletion for
the period.
Oil and Gas – A Special Case

• How to you treat “dry” well costs?
• There are no future benefits from dry wells – so
you could write off all related expenses
(successful efforts method)
• However, there will always be dry wells dug in
the process of finding good wells
• So perhaps the cost of dry wells could be capitalized
and added to the depletion base of good wells (full cost
method)
• Currently, both methods are acceptable

32

```
To top
;