Chapter 11 Lecture Notes

DEPRECIATION AND DEPLETION


I. Depreciation-A Method of Cost Allocation

A. Depreciation is not a matter of valuation, rather it is a means of cost allocation.

B. Depreciation is defined as the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset.

C. Through the depreciation process the asset's cost is charged to depreciation expense over its estimated life, making no attempt to value the asset at fair market value between acquisition and disposition.

II. Factors Involved in the Depreciation Process

A. Before we can attempt to depreciate an asset, we must answer three basic questions:

1. What depreciable base is to be used for the asset?

2. What is the asset's useful life?

3. What method of cost apportionment is best for this asset?

B. Depreciable base for the asset

1. Historical cost

2. and salvage value

3. are the two factors taken into consideration when establishing the depreciable base.

C. Estimation of Service Lives

1. We are concerned with the service life, not the physical life of the asset.

2. Assets are retired due to

a. Physical factors

b. and economic factors

3. Physical factors include wear and tear.

4. Economic factors include

a. inadequacy

b. and obsolescence

III. Methods of Cost Apportionment

A. Depreciation methods fall into one of four classifications

1. Activity based methods

a. such as the units of use

b. or the units of production methods

2. The straight line method

3. Decreasing charge methods, including both

a. The sum of the year's digits method

b. and the declining balance method

4. and lastly special depreciation methods such as

a. The inventory method

b. The retirement and replacement methods

c. The group and composite methods

d. and the compound interest method.

B. The Activity Method

1. The activity method assumes that depreciation is a function of use or productivity instead of the passage of time.

2. The life of the asset is measured either

a. in units of inputs such as the number of hours worked

b. or in units of outputs such as the number of units it produces.

C. The Straight Line Method

1. Straight Line is a time based method

2. Straight line is the most popular of all depreciation methods because of its simplicity

3. The major objection to straight line is that it rests on two unrealistic assumptions

a. The asset's economic usefulness is the same each period.

b. The repair and maintenance expense is essentially the same each period.

D. Decreasing Charge Methods

1. These methods are often called accelerated depreciation methods.

2. Under these methods

a. Higher depreciation costs are recognized in the early years of asset ownership

b. And lower depreciation costs are recognized in the later years of asset ownership.

c. The justification for using these methods is that usually the greatest amount of service potential is used up in the earliest years of ownership of the asset.

3. Sum of the Year's Digits

a. is a decreasing charge method where the depreciation charge is based on a decreasing fraction of the depreciable cost.

b. The numerator of the fraction is the number of years of asset life remaining as of the beginning of the year.

c. The denominator is the sum of the years digits.

4. The Declining Balance Method

a. is a decreasing charge method

b. which utilizes a depreciation rate that is some multiple of the straight line rate.

c. Rather than multiplying this rate time the depreciable basis, this rate is multiplied times the book value of the asset.

(1)Since book value decreases each year

(2)Depreciation will decrease each year as well.

(3)The process continues until the book value of the asset equals its salvage value.

IV. Special Depreciation Methods

A. There are five groups of special depreciation methods

1.  The Inventory method

2. The retirement and replacement methods

3 .The group and composite methods

4. The Compound interest method

5. and the Hybrid or combination method.

B. The Inventory method

1. The inventory method is used to value small tangible assets such as hand tools or utensils.

2. Inventories would be taken at both the beginning and the end of the year

3. The beginning inventory cost, plus the cost of items purchased this year, less the ending inventory cost would give us the amount to charge to depreciation expense for the year.

C. Retirement and Replacement Methods

1. These methods are used by public utilities and railroads.

2. The retirement method charges the cost of the retired asset less salvage value to depreciation expense

3. The replacement method charges the cost of units purchased less salvage value from the units replaced to depreciation expense.

D. Group and Composite Methods

1. Sometimes multiple asset accounts are depreciated using one rate.

2. When dealing with a collection of assets that are similar in nature, the group method is used.

3. When dealing with a collection of assets that are dissimilar in nature, the composite method is used.

4. The method of computation for either the group method or the composite method is the same.

5. When using the group or composite methods, if an asset is retired the resulting gain or loss is buried in the Accumulated Depreciation account.

6. If a new type of asset is purchased, a new depreciation rate must be computed and applied in subsequent periods.

V. Compound Interest Methods

A. are not illustrated in the text.

B. In practice, they have found limited acceptance.

C. Presently only certain public utilities use this method.

D. These methods are increasing charge methods which change small amounts to depreciation in the early years and large amounts in the later years.

VI. Hybrid or Combination Methods

A. Some firms tailor make their own depreciation methods.

B. This is permissible because GAAP only requires that the depreciation method used result in the allocation of cost over the asset's life in a systematic and rational manner.

C.GAAP does not tell us how to accomplish this goal.

VII. Selection of Depreciation Method

A. The depreciation method to select is the one which best matches revenues and expenses.

B. If you are uncertain as to how to best match revenues and expenses, then select straight line method.

C. If your objective is to minimize bookkeeping costs, then select whatever method you use for tax purposes.

D. In practice most companies

1. Use straight line for the accounting records

2. and an accelerated depreciation method for tax purposes.

3. This results in lower tax and higher net income.

VIII. Special Depreciation Issues

A. The text discusses four major issues

1. How should depreciation be computed for partial periods?

2. Does depreciation provide for the replacement of assets?

3. How are revisions in depreciation rates handled?

4. How is depreciation computed for income tax purposes?

B. Depreciation and Partial Periods

1. Plant assets are seldom purchased on the first day of the fiscal period or disposed of on the last day of the fiscal period.

2. This raises the question, how much depreciation should be charged for a partial period?

3. If we are using SL we have no problem

4. If we are using SYD we have a big problem

a. In computing depreciation expense for partial periods, it is necessary to determine the depreciation expense for the full year

b. and then to prorate this depreciation expense between the two periods involved.

5. With DDB, no problem

6. Companies are permitted to adopt their own policies on how to handle partial years depreciations.

C. Depreciation and Replacement of Fixed Assets

1. Depreciation does not provide funds for the replacement of fixed assets

2. Depreciation reduces net income just as any other expense will, but depreciation does not involve a current cash flow.

D. Revision of Depreciation Rates

1. Depreciation relies on estimates of the life of the asset and of salvage value. Estimates are just intelligent guesses and may prove to be wrong.

2. When new better information comes to our attention we should change our estimates.

3. Changes in estimates should be handled in the current and prospective period. We should never go back and retroactively change anything we did in the past as a result of a change in estimate.

IX. Income Tax Depreciation

A. For assets acquired before 1981, depreciation for income taxes is based on the SL, SYD,and declining balance methods.

B. For assets purchased between 1981 and 1986 the method used os called ACRS. ACRS has preestablished cost recovery periods for various classes of assets.

C. For assets placed into service in 1987 and later, MACRS is used.

D.MACRS differs from GAAP in three respects

1. Mandated tax life for a period shorter than economic life.

2. Cost recovery on an accelerated basis

3. and an assigned salvage value of zero.

E. Tax lives

1. Each item of depreciable property is assigned to a property class.

2. The recovery period of an asset depends on its property class.

F. Tax Depreciation Methods

1. The depreciation method depends on the life of the asset as mandated by the MACRS property class

2. The tax law is written by lawyers and

3. Since lawyers don't know how to add or subtract, this is all incorporated into tables

4. MACRS provides you with the option of using SL.

a. You must ignore all salvage values

b. and use the half year convention

X. Impairment in Value

A. Assets should not be carried on the books in amounts greatly in excess of their net realizable value.

B. In implementing this rule the impairment in value must be judged to be permanent before any writeoff can occur.

C. The FASB recently issued SFAS #121 to address this issue.

XI. Disclosures of PPE and Depreciation

A. In the presentation of depreciation, the four items on page 559 must be disclosed.

B. The notes to the Financial Statements dealing with PPE are illustrated on page 560.

XII. Depletion

A. Natural resources are called wasting assets.

B. These include assets such as:

1. petroleum

2. minerals

3. and timber

C. Wasting assets are characterized by two main features

1. The normal course of business brings about the complete removal or consumption of the asset,

2. and replacement of the asset can occur only by an act of nature.

D. There are two questions which must be answered to account for wasting assets

1. What is the cost basis for writeoff?

2. and what pattern of allocation would be employed?

E. Establishment of a Depletion Base

1. Cost of natural resources can be divided into three categories

a. Acquisition cost

b. exploration cost

c. and development cost

2. Acquisition cost is the cost of the property right to search and find an undiscovered natural resource.

3. Exploration cost includes all costs entailed in finding the resource.

a. Some firms only capitalize the exploration costs of successful searches. These firms charge to expense the cost of any unsuccessful searches. This is called the successful efforts approach.

b. Other firms capitalize all exploration costs whether successful or not. This is called the full-cost approach.

4. Development costs

a. are divided into two groups:

(1) Tangible equipment costs

(2) and intangible development costs

b. The tangible equipment costs are separately capitalized and depreciated over their useful lives.

c. The intangible development costs are considered as part of the depletion base.

F. Writeoff of resource cost

1. Once the depletion base has been established

2. the next problem is determining how the cost of that base should be allocated to the periods served.

3. Normally, depletion is calculated using the units of production method.

XIII. The chapter discusses the continuing controversy over the use of the full costing method versus the successful efforts method for accounting for oil and gas.

A. Read this section for amusement, you will not be held responsible for it.

B. What you do want to remember is that both successful efforts and full cost are GAAP.

 

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