Chapter 11

DEPRECIATION

Depreciation is a systematic and rational way to

allocate the cost of long-lived tangible assets over
their useful lives. This satisfies the goal of matching
costs and revenues. Done because fair values
change and are difficult to measure.
Depreciationlong-lived tangible assets.
Depletionnatural resources.
Amortizationintangible assets.

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Information needed in order to calculate depreciation:

(1) depreciable base = original cost salvage value.
(2) estimated service (useful) life versus physical life.
(3) depreciation method:**
Activity basedunits of use or production.
Straight-linebased on calendar time.
AcceleratedSoYD or declining-balance.
Specialgroup & composite, retirement &
replacement, hybrid, combination, other.
** All take the same total depreciation over an
assets useful life.

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Activity-based methods
Big Steel uses an activity-based depreciation
method. They have equipment with a cost of
$250,000, salvage value of $10,000 and
estimated useful life of 20,000 hours. In 2003,
Big Steel used the equipment 3,000 hours. How
much depreciation on this equipment should
they recognize for 2003?
$240,000 * 3,000 hrs. = $36,000
20,000 hrs.

Why would some companies want to use this

approach?

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Straight-line method
Simple & widely used.
Depreciation is function of time only.
Big Steel uses straight-line depreciation. They
have equipment with a cost of $250,000, salvage
value of $10,000 and estimated useful life of 10
years. Equipment was purchased 1/1/2002. In
2003, Big Steel used the equipment 3,000 hours.
How much depreciation on this equipment
should they recognize for 2003?
$240,000 / 10 = $24,000 (each year for 10 years)

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Accelerated Depreciation Methods

(aka Decreasing-Charge methods)
These methods take more depreciation in the early
years of an assets life.
Two most used are: (1) Sum-of-years-digits and
(2) declining-balance [200% or 150%].
SoYD = n(n+1) / 2
Where n = useful life in years.
SoYD = 10(11) / 2 = 55
for a 10-year asset
or (10 + 9 + 8+ 2 + 1)
Big Steel uses Sum-of-years-digits depreciation
method. They have equipment with a cost of
$250,000, salvage value of $10,000 and
estimated useful life of 10 years. Equipment
was purchased on 1/1/2002. How much
depreciation on this equipment should they
recognize for 2003?
Year
2002
2003
2004
2005
..
..
2011

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Deprec. base
$240,000

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Remain life
10
9
8
7
.
.
1

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Depre. fraction
10/55
9/55
8/55
7/55
.
.
1/55

Depreciation
$43,636.34
39,272.12
34,904.08

4,363.63

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Declining-Balance Method
Apply some constant rate to the beginning of period
book-value of the asset. Rate is defined usually as
1.5 or 2 times the straight-line rate (e.g., 20% is
twice the straight-line rate for a 10-year asset).
Remember to not depreciate the asset to below its salvage value
therefore might have to take less than calculated depreciation
in years close to end of life (maybe 0). If low SV, might have to
take more depreciation in last year or switch to SL when greater
depreciation.

Big Steel uses double-declining-balance

depreciation method. They have equipment with
a cost of $250,000, salvage value of $10,000 and
estimated useful life of 10 years. Equipment
was purchased on 1/1/2002. How much
depreciation on this equipment should they
recognize for 2003?
* switch to straight-line
Year
BV begin of
period
2002
$250,000
2003
$200,000
2004
$160,000
2005
$128,000
2006
$102,400
2007
$81,920
2008
$65,536
2009
$51,652
2010
$37,768

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Rate
20%
20%
20%
20%
20%
20%
.25*
.25
.25

Depreciation
Expense
$50,000
$40,000
$32,000
$25,600
$20,480
$16,384
$13,884
$13,884
$13,884

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A/D balance
(EOP)
$50,000
$90,000
$122,000
$147,600
$168,080
$184,464
$198,348
$212,232
$226,116

BV EOP
$200,000
$160,000
$128,000
$102,400
$81,920
$65,536
$51,652
$37,768
$23,884

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2011

$23,884

.25

$13,884

$240,000

$10,000

Clarificationontheswitchtostraightlinewhenusing
decliningbalancemethodfordepreciation:
Companiesdolikethedistortioninthelateryearswhen
decliningmethodstakelittleornodepreciation(highsalvage
value)oralargeamountinthelastyear(lowsalvagevalue)so
theyswitchtostraightlinewhenstraightlinedepreciation
wouldbehigher.Totestifthestraightlineamountwouldbe
more,youdividetheremainingamounttobedepreciated
(balancesalvagevalue)bythenumberofremainingyears.
Toavoidatesteveryyear,theymighthaveapolicytoswitchat
themidpointoftheassetsusefullife.
ForGAAP,companiesdonothavetoswitchiftheydonotwant
to.
Fortax,theswitchisrequiredandalreadyinthetaxtablesfor
alltouse.So,thegovernmentallowsyoutopaylesstaxfor
yearofswitch!

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Other Depreciation Methods

GAAP allows companies to develop their own
custom methods. Only requirement is that the
assets cost be allocated in a systematic and rational
manner over its useful life.
Group & Composite Methods:
Groupsimilar assets
Compositedissimilar assets
Both use average depreciation and this
simplifies bookkeeping costs.
Hybrid/combination Methods: use more than one
method. E.g., depreciate part of cost using straightline and the remainder with activity.

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Partial Period Depreciation

Firms seldom purchase depreciable assets on the
first day of the period. There are several ways to
handle the depreciation for the first and last period in
this situation.
Prorate using nearest full month or fraction of year.
Half year in year of purchase, and half year in year
of disposal (called half-year convention, used for
tax purposes).
Full years depreciation in year of purchase, none in
year of disposal.
No depreciation in year of purchase, full years in
year of disposal.

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Revisions (changes) in depreciation estimates.

Salvage value and/or useful life estimates can
change anytime. This is not handled as an error.
Change will be made in the current and future
periods. Simply calculate a new rate based on the
remaining life and total depreciable amount
remaining after the change.
For straight-line:
New rate = remaining amount to be depreciated
remaining useful life

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ImpairmentsSFAS # 144
ConservatismPPE that is held for use is never
written up, but will be written down in the case of an
impairment.
Events lead to possibility of an impairment.
Recoverability test:
If the sum of future net undiscounted cash flows is
less than the carrying amount of the asset, than an
impairment has occurred.
If an impairment, how much?
Impairment loss = CV FairV of asset
If no FairV, then use discounted future cash flows.
Use the risk-free rate of interest as the discount rate.

Loss on impairment
A/D

xxx
xxx

Other gains and losses section of IS.

Assets held for disposal: valued at the lower of cost or net
realizable value. Written up or down each period, but has to be
no more than the CV prior to impairment.
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Depletion of natural resources (wasting assets)

Oil & gas, minerals, timber, coal..

Accounting is similar to PPE.

Depletion base: includes acquisition cost of resource
(not land) + exploration cost + intangible
development cost + restoration cost.
If exploration efforts are successful then capitalize,
otherwise expense.
Depletion expense is calculated similar to how
depreciation based on units-of-production is done.
Entry to record the depletion for the period is
Inventory
XXX
Accum. Depletion

XXX

Depletion expense is included in CoGS for the

period.

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It is often very difficult to estimate the amount of

recoverable resources and changes in estimates are
common (handled exactly like change in useful life
for depreciation).
Interesting tax law issues with oil & gas and most
minerals (including gravel). Tax law allows for
deduction of cost or percentage-depletion based on
gross revenue, whichever is greater! % varies from
5-22%. This means that depletion can exceed the
cost of some natural resources!

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Very interesting history of an accounting controversy

on pages 539-541 of the text, re: successful-efforts
versus full-cost for the oil and gas industry. The
story underscores the political nature of accounting
rules.
1977SFAS #19, must use successful efforts.
1978outrage by small O&G companies, SEC
wants Reserve Recognition Accounting which is a
current value vs. cost approach.
1979FASB issues #25suspends #19.
1981SEC drops RRA, FASB issues #69 (requires
current value disclosure).
Currently, back to pre-1977 GAAP, either full or
successful-efforts is allowed. Full cost has a ceiling
(PV of company reserves).

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Income Tax Depreciation

1981ACRS, assets placed in service 1981-1986
1986MACRS, for assets placed in service 1987
and later.
(1) all depreciable assets are placed into property
classes. This determines the tax life, which is
generally shorter than the useful life.
(2) depreciation rate depends on class, most are
declining-balance.
(3) salvage value = 0. Depreciate for tax to zero
value.
(4) half-year convention.
(5) switch to SL when it gives more depreciation.
Optional approach is allowed for taxStraight-line.
Only point (2) above would change.

Because companies use a different method for

financial reporting and tax, a difference exists in tax
expense and tax payable. This will be dealt with in
Acctg. 303.
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Analysis of PPE and Natural Resources

RATE OF RETURN ON TOTAL ASSETS (ROA)
Rate of Return on
Total Assets

= Profit Margin on sales x Asset turnover

= Net Income
Net Sales
=

Net Sales
Average Total Assets

Net Income
Average Total Assets

Example (in million of $):

Net sales
Total Assets (1/1)
Total Assets (12/31)
Net Income

$1,500
1,200
1,400
150

ROA = $150 x
$1,500
$1,500
(1,200 + 1,400) / 2
= 0.10 x 1.15
= 11.5%

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OIL AND GAS ACCOUNTING

Two generally accepted methods to account for oil

and gas exploration costs are:
*

The successful efforts method requires that exploration

costs that are known not to have resulted in the
discovery of oil or gas (sometimes referred to as dry
holes) be included as expenses in the period the
expenditures are made.

The full-cost method allows costs incurred in searching

for oil and gas within a large geographical area to be
capitalized as assets and expensed in the future as oil
and gas from the successful wells are removed from
that area.

The Shannon Oil Company incurred $2,000,000 in exploration

costs for each of 10 oil wells drilled in 2000 in West Texas. Eight
of the 10 wells were dry holes.
The accounting treatment of the $20 million in total
exploration costs will vary significantly depending on the
accounting method used. The summary journal entries using
each of the alternative methods are as follows:
Successful Efforts

Full Cost

Oil deposit
4,000,000
Exploration expense 16,000,000

Oil deposit 20,000,000

Cash
20,000,000

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Cash

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20,000,000

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