AF310- Intermediate Accounting I
Chapter 11
Depreciation, Impairments, and
Depletion
Kun Yu, Intermediate Accounting I 11-1
Cost Allocation
The goal is to provide a reasonable and consistent matching of
revenue and expense over the asset’s estimated useful life.
PPE: Depreciation
Depreciation is 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.
Natural Resources: Depletion
Intangible assets: Amortization
Balance Sheet Income Statement
Cost
Acquisition
Expense
Cost Allocation
(Unused) (Used)
Kun Yu, Intermediate Accounting I 11-2
How to Determine Depreciation
Expense?
Determine depreciation base
Depreciable cost = Acquisition cost - Residual
value
Residual value: is the estimated amount to be
recovered at the end of the estimated useful life
of the asset (also called terminal value, disposal
value, salvage value or scrap value).
Determine useful life
Determine the cost allocation method
Kun Yu, Intermediate Accounting I 11-3
Cost Allocation – Journal Entry
Recording depreciation expense (impacts the I/S):
Dr. Cr.
Depreciation Expense (+E, -SE) XX
Accumulated Depreciation (+XA, -A) XX
The total amount of depreciation expense for an asset reduces the
carrying value of the asset in the B/S
Asset Cost
- Accumulated Depreciation
Book Value of Asset
BV Assets ≠ Market Value Assets. E.g. Chrysler building.
Accumulated Depreciation – it is a contra-asset account.
This is done regardless of the method used for depreciation expense.
Kun Yu, Intermediate Accounting I 11-4
Allocation Methods
Straight-line depreciation
Constant decline in dollar amounts with time
Units-of-production depreciation
Proportional to annual production and usage
Accelerated depreciation
Sum of the years’ digits
Declining balance depreciation
Constant % decline with time
Usually double-declining-balance (DDB).
Modified accelerated cost recovery system
(Tax purposes)
Kun Yu, Intermediate Accounting I 11-5
2007 Survey of 600 major U.S.
Companies
Straight-line 592
Units of production 23
Sum of the years’ digits 5
Declining balance 16
Accelerated-unspecified 27
Kun Yu, Intermediate Accounting I 11-6
Example
Delta Airlines
Acquisition cost of repair truck :$62,500
(purchased on Jan. 1, 1996)
Est. Useful life (years) : 3
Est. residual value :$2,500
Est. life in units (miles) :100,000 miles
Actual miles driven in:
first year: 30,000 miles
second year: 50,000 miles
third year: 20,000 miles
Kun Yu, Intermediate Accounting I 11-7
Straight-Line Depreciation
Annual Depreciation Expense =
(acquisition cost-residual value)/useful life
Depreciation expense for 1996:
($62,500-2,500)/3=$20,000
Journal Entry:
Dr. Cr. .
Depreciation expense (+E,-SE) $20,000
Accumulated depreciation (+XA, -A) $20,000
Kun Yu, Intermediate Accounting I 11-8
Straight-Line Depreciation
End of Period End of Period
Year Bal. of Truck Annual Accumulated Book Value
asset account Depreciation Depreciation of Asset
Exp
1
$62,500 $20,000 $20,000 $42,500
2 $40,000 $22,500
$62,500 $20,000
3
$62,500 $20,000 $60,000 $2,500
Kun Yu, Intermediate Accounting I 11-9
Units-of-Production
Annual Depreciation Expense =
Annual units of production (or usage)*
Depreciation rate per unit
Depreciation rate per unit =
(Acquisition cost – Salvage value) / Estimated
total units of production (or usage)
Depreciation rate per unit in the
example is:
($62,500-2,500)/100,000=$0.60
Kun Yu, Intermediate Accounting I 11-10
Units-of-Production
Depreciation expense:
1st yr—30,000*$0.6 =$18,000
2nd yr—50,000*$0.6=$30,000
3rd yr—20,000* $0.6=$12,000
End of Period End of Period
Year Bal. of Truck Annual Accumulated Book Value
asset account Depreciation Depreciation of Asset
Exp
1 $62,500 $18,000 $18,000 $44,500
2
$62,500 $30,000 $48,000 $14,500
3
$62,500 $12,000 $60,000 $2,500
Kun Yu, Intermediate Accounting I 11-11
Sum of the Years’ Digits
Depreciation Expense
=Depreciation Base* Number of Years
Remaining/Sum of Years
Depreciation Base
= Acquisition Cost – Residual Value
Kun Yu, Intermediate Accounting I 11-12
Sum of the Years’ Digits
Depreciation expense:
1st yr—60,000*3/6 =$30,000
2nd yr—60,000*2/6=$20,000
3rd yr—60,000* 1/6=$10,000
End of Period End of Period
Year Bal. of Truck Annual Accumulated Book Value
asset account Depreciation Depreciation of Asset
Exp
1 $62,500 $30,000 $30,000 $32,500
2
$62,500 $20,000 $50,000 $12,500
3
$62,500 $10,000 $60,000 $2,500
Kun Yu, Intermediate Accounting I 11-13
Declining Balance
Declining balance rate of 2 is
double-declining-balance (DDB) rate.
Net
Annual Book 2
Depreciation =
expense
Value at
Year
Beginning
× ( Useful Life in Years )
Cost – Accumulated Depreciation
Annual
Annual computation
computation ignores
ignores residual
residual value.
value.
Kun Yu, Intermediate Accounting I 11-14
Double-Declining-Balance
End of Period End of Period
Year Bal. of Truck Annual Accumulated Book Value
asset account Depreciation Depreciation of Asset
Exp
1
$62,500 $41,667 $41,667 $20,833
2
$62,500 $13,889 $55,556 $6,944
3
$62,500 $4,444 $60,000 $2,500
Depr exp: 1st yr--- $62,500*(2/3)=$41,667
Depr exp: 2nd yr--- ($62,500 - $41,667)*(2/3)=$20,833*(2/3)=$13,889
Depr exp: 3rd yr--- $6,944*(2/3)=$4,629. But then the book value of asset
would have been $2,315 < salvage value. Need to set depreciation
expense to $4,444 to bring the net book value of the asset to $2,500.
Kun Yu, Intermediate Accounting I 11-15
How do Managers choose?
Method that best matches the use of the asset to
revenues it generates.
Accelerated Methods – Assets are more efficient
(produce more revenues) in early years (thus need to
match to more expenses).
Companies can use different depreciation methods for
different assets.
Note disclosure for depreciation methods used and
estimated useful lives selected is required.
When a depreciation method is chosen for an asset, it
should be consistently applied.
Kun Yu, Intermediate Accounting I 11-16
Modified Accelerated Cost
Recovery System (MACRS).
The method used for tax purposes. Different from GAAP
methods.
Tax laws mandate the lives and depreciation rates to be
used. MACRS delays the payment of income taxes, as it
allocates more of the depreciable cost in the early years
of an asset.
Theoretically, this delay will reverse in the later years of
an asset; however, as long as a company continues to
purchase new assets, the tax will continue to be
delayed.
Kun Yu, Intermediate Accounting I 11-17
Tax and Timing Effects
Companies generally must maintain two sets of
accounting records.
For financial reporting according to GAAP.
For Income tax purposes according to IRC.
Why? Income tax and Financial reporting serve different purposes.
Why would a firm prefer accelerated depreciation for
tax purposes? To save on taxes.
Why does the government allow this?
Driven by the government's focus to secure revenues. Taxpayers want to
pay the smallest amount of tax at the latest possible date.
Why not use the tax method for financial reporting?
Provide economic information about the business so that decision
makers can make future cash flows predictions.
Kun Yu, Intermediate Accounting I 11-18
Extra Problem on PPE
Haley Company has the following account balances for the year ended December 31, 2002.
12/31/02 12/31/01
Equipment $900,000 $650,000
Accumulated depreciation -equipment 360,000 306,000
Gain on sale of equipment 22,000
During 2002, Haley sold for $88,000 a piece of equipment that originally cost $140,000,
and purchased several pieces of equipment. Based on the above information, what is the
(i) depreciation expense for 2002?
(ii) amount of equipment purchased during 2002?
Kun Yu, Intermediate Accounting I 11-19
Extra Problem on PPE (cont.)
Solution :
Haley Company: Gain (Loss) on Sale = [Selling price – BV]
If Selling Price= $88 and Gain on Sale = $22 then BV= 66
Now, we know that BV = Cost of Equipment – A/D (accumulated depreciation)
If Cost of Equip. sold = $140 and BV = $66 then A/D on Equip. Sold = $74
PPE A/D (Acc. Depreciation)
BB 650 BB 306
Purchase of Equip 140
390 Sale of PPE 140 A/D on Equip. sold 74 Dep. Expense 128
EB 900 EB 360
Kun Yu, Intermediate Accounting I 11-20
Change of Estimates
Acquisition cost of an aircraft $60 million
Est. useful life 20 years
Est. residual value $3 million
SL depreciation method is used.
At the start of the 7th year, est. useful life
changed to 16 years, residual value changed
to $900,000.
What is the depreciation expense for years 1 thru 6?
Depreciation expense for years 1-6
($60-3)/20=$2.85 M
Kun Yu, Intermediate Accounting I 11-21
Change of Estimates
Depreciation expense for the 7th year onward:
Acquisition cost $60
Less: A/D end of year 6 17.1 = (60-3)/20*6
Undepreciated balance/BV 42.9
Less: New residual value 0.9
Dr. Cr
New depreciable amount 42.0
Depreciation exp $4.2
remaining useful life: 10 years
Accum. depreciation $4.2
New depr exp each year=$42/10=$4.2M
Changes are applied to current and future periods.
Changes in depreciation estimates can be caused by change in asset
life or residual value.
Waste Management overstated NI in the amount of $1.43 billion by
increasing salvage value of assets among other things…
Kun Yu, Intermediate Accounting I 11-22
Change of Estimates
New Depreciation Expense:
(Net Book Value – New residual value)
(Remaining Life of asset)
Kun Yu, Intermediate Accounting I 11-23
Change of Estimates (Cont.)
What if in the previous example, the firm
had spent 1 million in cash to maintain and
improve efficiency of the aircraft (major
replacement) at the end of year 6?
How do we account for the improvement?
Capitalize the cost.
Dr. Cr
PPE 1
Cash 1
New Depreciation Expense for year 7
New book value = 42.9 + 1 =43.9
Depreciation Expense = (43.9-0.9)/10
Kun Yu, Intermediate Accounting I 11-24
Depreciation and Partial Periods
Disposal of Assets
Cost of equipment acquired on Jan 1, Yr 2001 =$10 million
Straight line depreciation method used. Useful life is 3 years and
residual value is $1 million.
The firm sold the equipment for $2 million in cash on July 1, Yr 2003.
Calculate the gain or loss on the sale
Straight line depreciation/year = (10-1)/3=3
BV equipment at the time of sale = 10-(3+3+1.5) = 2.5
Price - BV equipment = 2 – 2.5 = loss = -0.5
Make the journal entry. Dr. Cr.
Cash (+A) 2
Acc. Depr. (Equipment) (-XA, +A) 7.5
Loss (-SE) 0.5
Equipment (-A) 10
Kun Yu, Intermediate Accounting I 11-25
Asset impairment
The value of tangible and intangible assets must be
reviewed for possible impairment.
Two-step test:
If estimated future cash flows < book value
Impairment loss = Market value (or fair value of assets) –
book value.
Example:
Asset (building) acquisition cost=$10 million
Accumulated depreciation=$4 million
Estimated future cash flows =$5 million
Fair value of asset=$4 million
Kun Yu, Intermediate Accounting I 11-26
Asset impairment
Previous example continued:
Is the asset impaired?
Yes. Future CF=$5 <BV =$6
If yes, what’s the impairment loss?
Impairment loss=Fair value - BV
=$4-$6=-$2
What should be the journal entry?
Account Dr. Cr.
Loss on Impairment $2
Accumulated Depr $2
Kun Yu, Intermediate Accounting I 11-27
Another Example: Asset
Impairment
E11-16 (Impairment): Presented below is information related to
equipment owned by Pujols Company at December 31, 2010. Assume
that Pujols will continue to use this asset in the future. As of
December 31, 2010, the equipment has a remaining useful life of 4
years. Cost $ 9,000,000
Accumulated depreciation to date 1,000,000
Expected future net cash flows 7,000,000
Fair value 4,400,000
Instructions:
(a) Prepare the journal entry (if any) to record the impairment of the
asset at December 31, 2010.
(b) Prepare the journal entry to record depreciation expense for 2011.
(c) The fair value of the equipment at December 31, 2011, is $5,100,000.
Prepare the journal entry (if any) necessary to record this increase in
fair value. Kun Yu, Intermediate Accounting I 11-28
(a).
Cost $9,000,000
Accumulated depreciation 1,000,000
Carrying amount 8,000,000
Fair value 4,400,000
Loss on impairment $3,600,000
12/31/10
Loss on impairment 3,600,000
Accumulated depreciation 3,600,000
Kun Yu, Intermediate Accounting I 11-29
(b).
Net carrying amount $4,400,000
Useful life 4 years
Depreciation per year $1,100,000
12/31/11
Depreciation expense 1,100,000
Accumulated depreciation 1,100,000
(c). Restoration of any impairment loss is not permitted.
Kun Yu, Intermediate Accounting I 11-30
Depletion of Natural Resources
Annual Depletion Expense =
Annual units of production* Depletion Cost
per unit
Depletion Cost per Unit =
(Total cost – Salvage value) / Estimated
total units Available
Kun Yu, Intermediate Accounting I 11-31
An Example: Depletion
Apex Mining acquired a tract of land
containing ore deposits. Total costs of
acquisition and development were
$1,000,000 and Apex estimates the land
contained 40,000 tons of ore. During the
first year of operations Apex extracted
and sold 13,000 tons of ore.
Kun Yu, Intermediate Accounting I 11-32
Depletion Expense
Step 1:
Depletion $1,000,000 - $0
= = $25 per ton
Per Unit 40,000 tons
Step 2:
Depletion =
Expense $25 per ton × 13,000 units = $325,000
Kun Yu, Intermediate Accounting I 11-33
8-33
Journal Entries to Record
Depletion
Record Depletion expense:
Dr. Depletion expense 325,000
Cr. Accumulated depletion 325,000
What if the company sold the 13,000 units next year?
Record Depletion:
Dr. Inventory 325,000
Cr. Accumulated Depletion 325,000
When they are sold in the next year
Dr. Depletion expense/Cogs 325,000
Cr. Inventory 325,000
Kun Yu, Intermediate Accounting I 11-34
