Straight-Line (SL) = Annual SL Acquisition cost - Residual value Depreciation Acquisition cost - Residual value Estimated useful life in years = SL

Straight-Line Example 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-Line Example Annual SL Depreciation Acquisition cost - Residual value Estimated useful life in years = Annual SL Depreciation $50,000 - $5,000 5 years = Annual SL Depreciation = $9,000 SL

Straight-Line Example Residual Value SL

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

Service Hours (SH) Depreciation Per SH = Acquisition cost - Residual value Estimated service life in hours Depreciation Expense Depreciation × Number of hours Per SH running time =

Productive Output (PO) Depreciation rate per unit of output = Acquisition Cost - Residual Value Estimated Productive Output in Units Depreciation Expense Depreciation × Number of units rate per unit produced =

Productive Output (PO) Example 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 rate per unit of output = $50,000 - $5,000 100,000 Units = $.45 per unit Depreciation expense = $.45 per unit × 22,000 units Depreciation expense = $9,900

Productive Output (PO) Example 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.

Productive Output (PO) Example Residual Value No depreciation expense if the equipment is idle.

Accelerated Depreciation 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 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:

Sum-of-the-Years Digits Double-Declining Balance Accelerated Depreciation Methods Sum-of-the-Years Digits Double-Declining Balance

Sum-of-Years’ Digits (SYD) Annual depreciation is calculated with the following formula: Remaining Years of Useful Life (Cost - Residual Value) × Sum-of-the-Years’ Digits

[ ] [ ] 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: [ ] [ ] n + 1 5 + 1 SYD = n = 5 = 15 2 2 Where n = Total useful life in years.

Sum-of-Years’ Digits Example 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’ Digits Example SYD = n = 5 = 15 n + 1 2 [ ] 5 + 1

[ ] Sum-of-Years’ Digits Example SYD = n = 5 = 15 n + 1 2 5 + 1 1st year depreciation: ($50,000 - $5,000) ×5/15 = $15,000

[ ] [ ] Sum-of-Years’ Digits Example n + 1 2 5 + 1 SYD = n = 5 = 15 2 1st year depreciation: ($50,000 - $5,000) ×5/15 = $15,000 2nd year depreciation: ($50,000 - $5,000) × 4/15 = $12,000

Sum-of-Years’ Digits Example Residual Value

Declining-Balance Methods 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.

( ) Double-Declining-Balance Method 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 Example 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-Balance Example 100% Book Value × 2 × Useful Life in Years 100%

( ) ( ) Double-Declining-Balance Example Book Value × 2 × Useful Life in Years 100% 1st year depreciation: ( ) $50,000 × 2 × 5 years 100% = $20,000

( ) ( ) ( ) Double-Declining-Balance Example Book Value × 2 × Useful Life in Years 100% 1st year depreciation: ( ) $50,000 × 2 × 5 years 100% = $20,000 2nd year depreciation: 100% ( ) ($50,000 - $20,000) × 2 × = $12,000 5 years

( ) ( ) ( ) Double-Declining-Balance Example Book Value × 2 × Useful Life in Years 100% 1st year depreciation: ( ) $50,000 × 2 × 5 years 100% = $20,000 2nd year depreciation: 100% ( ) ($50,000 - $20,000) × 2 × = $12,000 5 years

Double-Declining-Balance Example Let’s calculate depreciation expense for the life of the asset using DDB.

Double-Declining-Balance Example We usually have to force depreciation expense in the latter years to an amount that brings BV to residual value.

Comparison of Methods 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 is used by about 95 percent of companies because it is easy to use and to explain.

Comparison of Methods: Straight-Line Method Depreciation Life in Years

Comparison of Methods: Productive Output Method Depreciation Life in Years

Comparison of Methods: Sum-of-the-Years’ Digits Method Depreciation Life in Years

Comparison of Methods: Double-Declining-Balance Method Depreciation Life in Years

Conceptual Evaluation of Depreciation Methods $ Sum-of-the-Years-Digits Depreciation Expense Straight-Line Double-Declining-Balance 2006 2007 2008 2009 2010 During Year

Conceptual Evaluation of Depreciation Methods $ Sum-of-the-Years-Digits Book Value Straight-Line Double-Declining-Balance 2006 2007 2008 2009 2010 At End of Year

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

Tax Depreciation Three-year property includes special tools, horses and R&D activities. Five-year property includes machinery and equipment, automobiles and light trucks.

Tax Depreciation Example 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 Depreciation Example MACRS ignores residual value

Balances of major classes of depreciable assets. Depreciation Disclosures Depreciation expense. Balances of major classes of depreciable assets. Accumulated depreciation by asset or in total. General description of depreciation methods used.

Conceptual Evaluation of Depreciation Methods 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.

Conceptual Evaluation of Depreciation Methods 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 Method

Depreciation Policy 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.

Fractional-Year Depreciation I bought an asset on May 19 this year. Do I get a full year depreciation or a half-year depreciation? May 19

Fractional-Year Depreciation You have several choices. Consider the following policies used by many companies. May 19

Fractional-Year Depreciation Example 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. June 30

Depr. = ($100,000 - $20,000) ÷5 = $16,000 Depr. = $16,000 ÷2 = $8,000 Fractional-Year Depreciation Example Depr. = ($100,000 - $20,000) ÷5 = $16,000 Depr. = $16,000 ÷2 = $8,000 June 30

Fractional-Year Depreciation Example 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. June 30

Depr. = ($100,000 - $0) ×(2 /5) = $40,000 Depr. = $40,000 ÷2 = $20,000 Fractional-Year Depreciation Example Depr. = ($100,000 - $0) ×(2 /5) = $40,000 Depr. = $40,000 ÷2 = $20,000 June 30

Fractional-Year Depreciation 1. A full month of depreciation for assets acquired before mid-month, none for assets acquired after mid-month. Asset acquired Asset acquired Full month of Depreciation No Depreciation 1st of month Mid- month End of month

Fractional-Year Depreciation 2. A full year of depreciation for assets acquired before mid-year, and none for assets acquired after mid-year. Asset acquired Asset acquired Full year of Depreciation No Depreciation 1st of year Mid- year End of year

Fractional-Year Depreciation 3. One-half year of depreciation in the year of acquisition and retirement, without regard to the month of acquisition or retirement. First year Intervening years Last year Asset acquired Asset retired One-half year of depreciation Full year of depreciation One-half year of depreciation

Depreciation Systems Depreciation systems reduce accounting cost because fewer calculations are required. Accumulated depreciation records are not maintained for individual assets.

Inventory Appraisal Depreciation Additional Depreciation Methods Inventory Appraisal Depreciation Depreciation expense is the result of appraisal of numerous low-cost assets. Group Depreciation Homogeneous assets are treated as a group. Composite Depreciation Heterogeneous assets are treated as a group.

Plant assets are appraised at the end of each period. Inventory Appraisal Depreciation 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.

Assume this information on the hand tools Inventory Appraisal Depreciation Example 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 Depreciation Example 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. Group and Composite Depreciation 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 Depreciation rate Annual group SL depreciation Total group acquisition cost = Composite rate = ($188,167 ÷ $2,500,000) = 7.527%

Group and Composite Depreciation 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.

Plant Asset Impairment (SFAS 144) 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.

Recoverable cost < Carrying value 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.

Impairment loss = Carrying _ value Fair value Plant Asset Impairment (SFAS 144) Impairment loss = Carrying _ value Fair value Reported as part of income from continuing operations. 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.

Plant Asset Impairment (SFAS 144) Fair Value Recoverable Cost $0 $125 $250 Case 1: $50 Carrying value No loss recognized Case 3: $275 Carrying value Loss = $275 - $125 Case 2: $150 Carrying value No loss recognized

Impairment of a Noncurrent Asset 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.

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

Impairment of a Noncurrent Asset Impairment Test Undiscounted expected net cash flows = 5 x ($700,000 - $300,000) Cash Inflows Cash Outflows Years = 5 x $400,000 = $2,000,000 Because $2,000,000 is less than $2,600,000 (the book value), an impairment loss must be recognized.

Impairment of a Noncurrent Asset Measurement of the Loss Undiscounted annual cash flows Present value of the expected cash flows (fair value) = $400,000 x 3.274294 = $1,309,718 (rounded) 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

Impairment of a Noncurrent Asset 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.

Plant Asset Impairment (SFAS 144) Loss on Impairment 150 Accumulated Depreciation 150

Impairment of a Noncurrent Asset Loss from Impairment 1,290,282 Accumulated Depreciation: Factory 200,000 Machinery 1,200,000 Factory (new cost) 327,429 Machinery (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 [$3,000,000 ÷ ($3,000,000 + $1,000,000)]

Is this boat impaired or fully depreciated?

Sometimes referred to as wasting assets. Natural Resources 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.

SFAS No. 19 identifies total costs as including Natural 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.

- Depletion is calculated using the units-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.

x Total depletion cost for a period is: Depletion UNIT DEPLETION RATE NUMBER OF UNITS EXTRACTED IN PERIOD x 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.

Depletion - Example 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 - Example Unit Depletion Rate = Cost - Residual Value Units $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

The estimated cost of restoration increases the depletion base. Natural Resources Restoration Costs 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.

The unit depletion rate is based on estimated recoverable units. Natural Resources Change in Estimate 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.

The cost-based depletion method is for financial reporting purposes. Natural Resources Income Tax Reporting 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.

Exploration Costs Oil and Gas Industry 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 Costs Full-Cost Method 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.

The costs associated with unsuccessful wells are expensed as incurred. Exploration Costs Successful-Efforts 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 Costs Example 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 Costs Example Record the exploration costs for WOWOCO assuming they use the successful-efforts method.

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

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

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

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

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

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

I Need Some Help!

C 5 hapter The End Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.