Annual SL Depreciation Acquisition cost - Residual value Estimated useful life in years = SL...

Annual SLDepreciation

Acquisition cost - Residual value Estimated useful life in years

=

SL

Straight-Line (SL)Straight-Line (SL)

On January 1, we purchase equipment for $50,000 cash. The equipment has an estimated useful life of 5 years and residual value of $5,000.

What is the annual straight-line depreciation?

SL

Straight-LineExample


Annual SLDepreciation =

Annual SLDepreciation

$50,000 - $5,000 5 years

=

Acquisition cost - Residual value Estimated useful life in years

Annual SLDepreciation = $9,000

SL



Depreciation Accumulated Accumulated UndepreciatedExpense Depreciation Depreciation Balance

Year (debit) (credit) Balance (book value)50,000$

1 9,000$ 9,000$ 9,000$ 41,000 2 9,000 9,000 18,000 32,000 3 9,000 9,000 27,000 23,000 4 9,000 9,000 36,000 14,000 5 9,000 9,000 45,000 5,000

45,000$ 45,000$ Residual Value

SL



• Depreciation may be based on measures of input or output like. . .

Service hours

Productive output (units-of-production)

• No depreciation is taken if the asset is idle.

Activity MethodActivity Method

Depreciation Expense =

Depreciation × Number of hours Per SH running time

Depreciation Per SH

= Acquisition cost - Residual value Estimated service life in hours

Service Hours (SH)Service Hours (SH)

Depreciation Expense =

Depreciation × Number of unitsrate per unit produced

Depreciation rateper unit of output

= Acquisition Cost - Residual Value Estimated Productive Output in Units

Productive Output (PO)Productive Output (PO)

On January 1, we purchased equipment for $50,000

cash. The equipment is expected to produce 100,000

units during its life and has an estimated residual

value of $5,000.

If 22,000 were produced this year, what is the amount

of depreciation expense?

Productive Output (PO) Example


Depreciation expense = × 22,000 units

Depreciation rateper unit of output

= $50,000 - $5,000 100,000 Units

= $.45 per unit

$.45 per unit

Depreciation expense = $9,900



In addition to the 22,000 units produced the first

year, we produced 28,000 units in year 2, zero

units in year 3, 32,000 units in year 4, and 18,000

units in the fifth and final year of the asset’s life.

Let’s look at a schedule of depreciation for the

five-year period.



Depreciation Accumulated UndepreciatedExpense Depreciation Balance

Units (debit) Balance (book value)50,000$

22,000 9,900$ 9,900$ 40,100 28,000 12,600 22,500 27,500

- - 22,500 27,500 32,000 14,400 36,900 13,100 18,000 8,100 45,000 5,000

100,000 45,000$

No depreciation expense if the equipment is idle.

Residual Value



Accelerated depreciation methods result in more

depreciation expense in the early years of an

asset’s useful life and less depreciation expense

in later years of an asset’s useful life.

Accelerated DepreciationAccelerated Depreciation

Accelerated depreciation methods . . .– Match higher depreciation expense with higher revenues in the

early years of an asset’s useful life when the asset is more efficient.

– Maintain a more uniform total use expense for an asset:

Depreciation RepairExpense Expense

Early Years High Low

Later Years Low High

Accelerated DepreciationAccelerated Depreciation

• Sum-of-the-Years Digits

• Double-Declining Balance

Accelerated Depreciation MethodsAccelerated Depreciation Methods

(Cost - Residual Value) ×

Remaining Yearsof Useful Life

Sum-of-the-Years’ Digits

Annual depreciation is calculated with the following formula:

Sum-of-Years’ Digits (SYD)Sum-of-Years’ Digits (SYD)

The sum-of-the-years’ digits may be computed as follows for an asset with a five-year life:

1 + 2 + 3 + 4 + 5 = 15

However, the following convenient formula is often more useful:

Where n = Total useful life in years.

SYD = n = 5 = 15n + 1

2[ ] 5 + 1 2[ ]

Sum-of-Years’ Digits (SYD)Sum-of-Years’ Digits (SYD)

On January 1, we purchase equipment for $50,000 cash. The equipment has a useful life of 5 years and an estimated residual value of $5,000.

What is depreciation expense for the first two years?

Sum-of-Years’ DigitsExample


SYD = n = 5 = 15 n + 1 2[ ] 5 + 1

2[ ]



1st year depreciation:

($50,000 - $5,000) ×5/15 = $15,000

SYD = n = 5 = 15 n + 1 2[ ] 5 + 1

2[ ]



2nd year depreciation:

($50,000 - $5,000) × 4/15 = $12,000

SYD = n = 5 = 15 n + 1 2[ ] 5 + 1

2[ ]


($50,000 - $5,000) ×5/15 = $15,000




Fraction (debit) Balance (book value)50,000$

5/15 15,000$ 15,000$ 35,000 4/15 12,000 27,000 23,000 3/15 9,000 36,000 14,000 2/15 6,000 42,000 8,000 1/15 3,000 45,000 5,000

45,000$

Residual Value



• Declining-balance depreciation is based on the straight-line rate multiplied by an acceleration factor. For example, when the acceleration factor is 200

percent, the method is referred to as double-declining-balance (DDB) depreciation.

• Declining-balance depreciation computations initially ignore residual value.

Declining-Balance MethodsDeclining-Balance Methods

Annual Depreciation is calculated with the following formula:

Book Value ×(2 × Straight-Line Rate)

( )Book Value × 2 × Useful Life in Years 100%

Double-Declining-Balance MethodDouble-Declining-Balance Method

On January 1, we purchase equipment for $50,000 cash. The equipment has a useful life of 5 years and an estimated residual value of $5,000.

What is depreciation expense for the first two years using double-declining-balance?

Double-Declining-BalanceExample


( )Book Value × 2 ×Useful Life in Years

100%





( ) $50,000 × 2 × 5 years 100%

= $20,000




( ) $50,000 × 2 × 5 years 100%

= $20,000


( )($50,000 - $20,000) × 2 × 5 years 100%

= $12,000





( ) $50,000 × 2 × 5 years 100%

= $20,000

( )($50,000 - $20,000) × 2 × 5 years 100%

= $12,000





Let’s calculate depreciation expense

for the life of the asset using DDB.



We usually have to force depreciation expense in thelatter years to an amount that brings BV to residual value.


Year (debit) Balance (book value)50,000$

1 20,000$ 20,000$ 30,000 2 12,000 32,000 18,000 3 7,200 39,200 10,800 4 4,320 43,520 6,480 5 1,480 45,000 5,000

45,000$



• The total amount of depreciation recorded over the useful life of an asset is the same regardless of the method used.

• Depreciation expense recorded in any one period will vary according to method used.

• The straight-line method isused by about 95 percent ofcompanies because it is easyto use and to explain.

Comparison of MethodsComparison of Methods

0

2000

4000

6000

8000

10000

1 2 3 4 5

Life in Years

De

pre

cia

tion

Comparison of Methods:Straight-Line Method

Comparison of Methods:Straight-Line Method

0

2000

4000

6000

8000

10000

12000

14000

16000

1 2 3 4 5

Life in Years

De

pre

cia

tion

Comparison of Methods:Productive Output Method

Comparison of Methods:Productive Output Method

0

2000

4000

6000

8000

10000

12000

14000

16000

1 2 3 4 5

Life in Years

De

pre

cia

tion

Comparison of Methods:Sum-of-the-Years’ Digits Method

Comparison of Methods:Sum-of-the-Years’ Digits Method

0

5000

10000

15000

20000

1 2 3 4 5

Life in Years

De

pre

cia

tion

Comparison of Methods:Double-Declining-Balance Method

Comparison of Methods:Double-Declining-Balance Method

Depreciation Expense

$

2006 2007 2008 2009 2010

During Year

Straight-Line

Sum-of-the-Years-Digits

Double-Declining-Balance

Conceptual Evaluation of Depreciation MethodsConceptual Evaluation of Depreciation Methods

Book Value

$

2006 2007 2008 2009 2010

At End of Year

Straight-Line

Sum-of-the-Years-Digits

Double-Declining-Balance


• For an asset purchased in 1987 and later, the Modified Accelerated Cost Recovery System (MACRS) is required for tax purposes.

• A mandated tax life, which is usually shorter than the economic life.

• MACRS provides for rapid write-off of an asset’s cost in order to stimulate investment in modern facilities.

• MACRS ignores residual value.

• Depreciation is based upon percentages related to the “class life”of the asset.

Tax DepreciationTax Depreciation

Recovery PercentagesYear Three-Year Five-Year

1 33.33% 20.00%2 44.45% 32.00%3 14.81% 19.20%4 7.41% 11.52%5 11.52%6 5.76%

100.00% 100.00%

Percentages are based on the DDB method using the“half-year” convention--one-half year depreciation inthe first and last years of the asset’s class life.


• Three-year property includes special tools, horses and R&D activities.

• Five-year property includes machinery and equipment, automobiles and light trucks.

Recovery PercentagesYear Three-Year Five-Year

1 33.33% 20.00%2 44.45% 32.00%3 14.81% 19.20%4 7.41% 11.52%5 11.52%6 5.76%

100.00% 100.00%


On January 1, we purchase equipment for $50,000 cash. The equipment has a useful life of 4 years and an estimated residual value of $5,000. For tax purposes, the asset is classified as five-year property.

Determine proper depreciation expense for each year of the asset’s life.

Tax DepreciationExample



Rate (debit) Balance (book value)50,000$

20.00% 10,000$ 10,000$ 40,000 32.00% 16,000 26,000 24,000 19.20% 9,600 35,600 14,400 11.52% 5,760 41,360 8,640 11.52% 5,760 47,120 2,880 5.76% 2,880 50,000 -

50,000$

MACRS ignores residual value



• Depreciation expense.

• Balances of major classes of depreciable assets.

• Accumulated depreciation by asset or in total.

• General description ofdepreciation methods used.

Depreciation DisclosuresDepreciation Disclosures

If a company expects that repairs and maintenance costs and the total economic benefits of the asset will remain similar each period, a similar total cost each period can be achieved through straight-line depreciation and the similar repair and maintenance costs.

If a company expects that repairs and maintenance costs and the total economic benefits of the asset will remain similar each period, a similar total cost each period can be achieved through straight-line depreciation and the similar repair and maintenance costs.


If the company expects that benefits of having the asset will decline each year for the life of the asset, and repairs and maintenance costs are constant each period, a declining total cost will be achieved by using accelerated depreciation.

If the company expects that benefits of having the asset will decline each year for the life of the asset, and repairs and maintenance costs are constant each period, a declining total cost will be achieved by using accelerated depreciation.


Selection of Depreciation MethodSelection of Depreciation Method

• Depreciation expense, unlike most other expenses, does not require a cash outflow.

• Because depreciation is tax deductible, it reduces the cash outflow related to taxes.

Depreciation PolicyDepreciation Policy

May19

I bought an asset on May 19this year. Do I get a full yeardepreciation or a half-yeardepreciation?

Fractional-Year DepreciationFractional-Year Depreciation

May19

You have several choices. Consider the followingpolicies used by manycompanies.


On June 30, 19X1 we purchased equipment for

$100,000 cash. The equipment has a useful life of

5 years and estimated residual value of $20,000.

Calculate the straight-line depreciation for the

year ended December 31, 19X1.

June30

Fractional-Year DepreciationExample


Depr. = ($100,000 - $20,000) ÷5 = $16,000

Depr. = $16,000 ÷2 = $8,000

June30



On June 30, 19X1 we purchased equipment for

$100,000 cash. The equipment has a useful life of 5

years and estimated residual value of $20,000.

Calculate DDB depreciation for the year ended

December 31, 19X1.

June30



Depr. = ($100,000 - $0) ×(2 /5) = $40,000

Depr. = $40,000 ÷2 = $20,000

June30



1. A full month of depreciation for assets acquired before mid-month, none for assets acquired after mid-month.

Asset acquired Asset acquired

Mid-month

End ofmonth

1st ofmonth

Full month ofDepreciation

NoDepreciation


Asset acquired Asset acquired

Mid-year

End ofyear

1st ofyear

Full year ofDepreciation

NoDepreciation

2. A full year of depreciation for assets acquired before mid-year, and none for assets acquired after mid-year.


Asset acquired

Asset retired

Interveningyears

Lastyear

Firstyear

One-half yearof depreciation

3. One-half year of depreciation in the year of acquisition and retirement, without regard to the month of acquisition or retirement.

Full year ofdepreciation

One-half yearof depreciation


• Depreciation systems reduce accounting cost because fewer calculations are required.

• Accumulated depreciation records are not maintained for individual assets.

Depreciation SystemsDepreciation Systems

Inventory Appraisal DepreciationDepreciation expense is the result of appraisal of

numerous low-cost assets.

Group DepreciationHomogeneous assets are treated as a group.

Composite DepreciationHeterogeneous assets are treated as a group.

Additional Depreciation MethodsAdditional Depreciation Methods

• Plant assets are appraised at the end of each period.

• The decline in appraised value is recorded as depreciation expense with a corresponding credit to the plant asset account.

• Proceeds from disposal of tools reduces depreciation expense.

Inventory Appraisal DepreciationInventory Appraisal Depreciation

Assume this information on the hand tools

plant asset account of Miller Company, which

began operation in 2005:

Purchase of hand tools in 2005: $1,900

Appraisal value of tools at the end of 2005: $1,080

Proceeds from disposal of tools in 2005: $70

Inventory Appraisal DepreciationExample


During 2005:

Hand tools 1,900

Cash 1,900

Cash 70

Depreciation expense 70

December 31, 2005:

Depreciation expense 820

Hand tools ($1,900-$1,080) 820



• Assets are grouped by common characteristics.

• A “composite rate” is calculated.

• Annual depreciation is determined by multiplying the composite rate times the total group acquisition cost.

Group and Composite DepreciationGroup and Composite Depreciation

Compositerate

Annual group SL depreciationTotal group acquisition cost

=

Acquisition Residual Useful Annual SLGroup Cost Value Life Depreciation

A 250,000$ 25,000$ 5 45,000$ B 500,000 35,000 10 46,500 C 1,000,000 75,000 15 61,667 D 750,000 50,000 20 35,000

2,500,000$ 185,000$ 188,167$

Composite rate = ($188,167 ÷ $2,500,000) = 7.527%


• The composite rate (7.527%) is applied to the total cost of the assets.

• If assets in the group are sold or new assets added, the composite rate remains the same.

• When an asset in the group is sold or retired, the debit to Accumulated Depreciation is the difference between the asset’s cost and the proceeds from the sale or retirement.


• Impairment is the loss of a significant portion of the utility of an asset through . . . Casualty.

Obsolescence.

Lack of demand for the asset’s services.

• When plant assets suffer a permanent impairment in value, a loss should be recorded.

Plant Asset Impairment(SFAS 144)


An asset is impaired if . . .

Recoverable cost < Carrying value

Expected future total undiscounted net

cash inflows generated by use of the asset.



Reported aspart ofincome fromcontinuingoperations.

Impairmentloss

=Carrying _value

Fairvalue

•Market value, price of similar assets, or present value of future net cash inflows.•Fair value is less than recoverable value due to the time value of money.



$0 $250$125

Case 1:

$50 Carrying value

No loss recognized

Case 2:

$150 Carrying value

No loss recognized

Case 3:

$275 Carrying value

Loss = $275 - $125

FairValue

RecoverableCost



On January 1, 2004, the Hall Company purchased a factory for $1 million (20-year life) and machinery for $3 million (10-year life).

On January 1, 2004, the Hall Company purchased a factory for $1 million (20-year life) and machinery for $3 million (10-year life).

Late in 2007, the company believes that its asset(s) may be impaired and the remaining useful life is 5 years. The company estimates that the asset will produce cash inflows of $700,000 and incur cash outflow of $300,000 each year for the next 5 years.

Late in 2007, the company believes that its asset(s) may be impaired and the remaining useful life is 5 years. The company estimates that the asset will produce cash inflows of $700,000 and incur cash outflow of $300,000 each year for the next 5 years.

Impairment of a Noncurrent AssetImpairment of a Noncurrent Asset

December 31, 2007Factory cost $1,000,000 Less: Accumulated depreciation(4 x $50,000) (200,000)Book value $ 800,000Machinery cost $3,000,000 Less: Accumulated depreciation(4 x $300,000) (1,200,000)Book value 1,800,000Total Book Value $2,600,000

Impairment TestImpairment Test


= 5 x $400,000

= $2,000,000

Impairment TestImpairment TestUndiscounted expected net cash flows = 5 x ($700,000 - $300,000)

Years Years Cash Inflows

Cash Inflows

Cash Outflows

Cash Outflows

Because $2,000,000 is less than $2,600,000 (the book value), an impairment loss must be recognized.

Because $2,000,000 is less than $2,600,000 (the book value), an impairment loss must be recognized.


Measurement of the LossMeasurement of the Loss

Undiscounted annual cash flowsPresent value of the expectedcash flows (fair value)

= $400,000 x 3.274294

= $1,309,718 (rounded)

n= 5, i = 0.16 from Table 4 in Appendix

n= 5, i = 0.16 from Table 4 in Appendix

Book value $2,600,000 Fair value (1,309,718)Impairment loss $1,290,282


FASB Statement No. 121 does not specify how to record the write-down. It does indicate that the reduced book value is to be accounted for as the new cost.

FASB Statement No. 121 does not specify how to record the write-down. It does indicate that the reduced book value is to be accounted for as the new cost.

Although FASB Statement No. 121 has been replaced by FASB Statement No. 144, the principles it established have only changed slightly.

Although FASB Statement No. 121 has been replaced by FASB Statement No. 144, the principles it established have only changed slightly.


Loss on Impairment 150 Accumulated Depreciation 150



Loss from Impairment 1,290,282Accumulated Depreciation: Factory 200,000Accumulated Depreciation: Machinery 1,200,000Factory (new cost) 327,429Machinery (new cost) 982,289 Factory (old cost) 1,000,000 Machinery (old cost) 3,000,000

$1,309,718 x [$1,000,000 ÷ ($3,000,000 + $1,000,000)]$1,309,718 x [$1,000,000 ÷ ($3,000,000 + $1,000,000)]

$1,309,718 x [$3,000,000 ÷ ($3,000,000 + $1,000,000)]$1,309,718 x [$3,000,000 ÷ ($3,000,000 + $1,000,000)]


Is this boat impairedor fully depreciated?

• Sometimes referred to as wasting assets.

• Supplied by nature and extracted from natural environment. Gold, oil, timber, coal, and other minerals.

• Presented on the balance sheet as noncurrent assets.

Natural ResourcesNatural Resources

• SFAS No. 19 identifies total costs as including acquisition costs

exploration costs

development costs

production costs

support equipment and facilities cost.

• Total cost is allocated over periods benefited by means of depletion.

Natural ResourcesNatural Resources

Depletion is calculated using theunits-of-production method.

Unit depletion rate is calculated as follows:

Estimated Recoverable Units

Capitalized Cost of Residual Natural Resource Value-

The numerator, cost -residual value, is called the depletion base.

The numerator, cost -residual value, is called the depletion base.

DepletionDepletion

Total depletion cost for a period is:

The unit depletion rate . . .• is inventoried with each extracted unit. • is expensed as a part of cost of goods sold for

each unit sold.• remains in inventory with each unsold unit.

UNIT DEPLETION RATE

NUMBER OF UNITS

EXTRACTED IN PERIODx

DepletionDepletion

Reggio Company purchases land for $3,000,000

from which it expects to extract 1,000,000 tons

of coal, the estimated residual value is $200,000,

and it mines 80,000 tons of coal in the first year.

Depletion - ExampleDepletion - Example

Unit Depletion Rate =Cost - Residual Value

Units

Unit Depletion Rate =$3,000,000 - $200,000

1,000,000 tons

Unit Depletion Rate = $2.80 per ton

Depletion for Year = $2.80 x 80,000 = $224,000

Depletion - ExampleDepletion - Example

• In some cases, the extractor is required to restore the land to its original state subsequent to the resources being extracted.

• The estimated cost of restoration increases the depletion base.

Natural ResourcesRestoration Costs

Natural ResourcesRestoration Costs

• The unit depletion rate is based on estimated recoverable units.

• Those estimates may change over time.

• The revised unit depletion rate is computed for the remaining costs.

• Prior depletion costs are not revised.

Natural ResourcesChange in Estimate

Natural ResourcesChange in Estimate

• The cost-based depletion method is for financial reporting purposes.

• The Internal Revenue Code allows the use of statutory depletion (also called percentage depletion) for tax purposes.

• Use of different methods for tax and financial reporting purposes leads to different incomes.

Natural ResourcesIncome Tax Reporting

Natural ResourcesIncome Tax Reporting

• The costs of exploration for the oil and gas industry are very large.

• An accounting question arises as to how much of the exploration costs can be capitalized.

• Two basic methods are allowed when accounting for those costs:

Full-cost method

Successful-efforts method

Exploration CostsOil and Gas Industry

Exploration CostsOil and Gas Industry

• All exploration costs are capitalized as part of the cost of the natural resource.

• This method tends to be used by smaller firms primarily in the exploration business.

Exploration CostsFull-Cost Method

Exploration CostsFull-Cost Method

• Only the exploration costs associated with successful wells are capitalized in the cost of the natural resource.

• The costs associated with unsuccessful wells are expensed as incurred.

Exploration CostsSuccessful-Efforts Method

Exploration CostsSuccessful-Efforts Method

World-Wide Oil Company (WOWOCO) spent

$25,000,000 in 19X8 exploring for oil. Of all the

wells drilled, 90% were dry. As a result of the

remaining 10%, 20 million barrels of oil worth

$10 per barrel were discovered.

Exploration CostsExample


Record the exploration costs for WOWOCO assuming they use the successful-efforts method.



Record the exploration costs for WOWOCO assuming they use the successful-efforts method.

GENERAL JOURNAL

(All amounts shown are in thousands.)

Page: 15

Date Description PR Debit Credit

Cost of Oil Reserves 2,500 Exploration Expense 22,500 Cash, payables, etc. 25,000 to record exploration costsfor the period



What is WOWOCO’s unit depletion cost if they use the successful-efforts method?



What is WOWOCO’s unit depletion cost if they use the successful-efforts method?

Unit Cost EstimatedDepletion = of Oil ÷ Removable

Cost Reserves Units

= 2,500,000$ ÷ 20,000,000

= 0.125$ per barrel



Record the exploration costs for WOWOCO assuming they use the full-cost method.



Record the exploration costs for WOWOCO assuming they use the full-cost method.

GENERAL JOURNAL

(All amounts shown are in thousands.)

Page: 15

Date Description PR Debit Credit

Cost of Oil Reserves 25,000 Cash, payables, etc. 25,000

to record capitalization ofexploration costs for the period



What is WOWOCO’s unit depletion cost if they use the full-cost method?



What is WOWOCO’s unit depletion cost if they use the full-cost method?

Unit Cost EstimatedDepletion = of Oil ÷ Removable

Cost Reserves Units

= 25,000,000$ ÷ 20,000,000

= 1.250$ per barrel



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