CHAPTER 11
Depreciation and Depletion
Introduction: Chapter 11 presents a discussion of depreciation and depletion. Depreciation refers to the decline in value of tangible plant assets. Depletion is the term used to describe the decline in natural resources such as timber, oil, or coal. Amortization is the term used to describe the expiration of intangible assets which will be discussed in Chapter 12.
Part I. Depreciation
1. 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. Depreciation is not a valuation process. Matching principle Reliability of information
Justification of the cost allocation approach instead of valuation:
o o
Factors to be considered for computing depreciation: o The depreciable base (depreciable cost) to be used for the asset. The depreciable cost is the difference between an asset's cost and its salvage value. Salvage value is the estimated amount that will be received at the time the asset is sold or removed from service. o The asset's useful life. The useful life (service life) of a plant asset refers to the number of years that asset is capable of economically providing the service it was purchased to perform. The service life of an asset should not be confused with its physical life. o The depreciation method to be used. 2. Depreciation Methods The depreciation method selected for a particular asset should be systematic and rational. Commonly used depreciation methods include: o Activity method: Assumes that depreciation is a function of use. o Straight-line method: Assumes that an assets usefulness is the same each year. Its simple and widely used. o Sum-of-the-years'-digits (SYD): Assumes that the asset is more efficient in the earlier years, and therefore more depreciation should be charged in those years. It requires the multiplication of the depreciable cost by a fraction, which uses the sum of the years digits as denominator and the remaining life as of the beginning of the year as the numerator. o Declining-balance method (DB): Same assumption as SYD. The computation is based on the remaining book value (cost minus accumulated depreciation) instead of depreciable cost. Salvage value is ignored initially.
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3. Special Depreciation Methods
o Inventory method: Used to value small assets such as hand tools. Depreciation
expense is computed in a way similar to that of CGS.
o Retirement and Replacement methods: Used to depreciate numerous
interchangeable items that have small unit value, such as utility poles and railroad ties. o o o The retirement method charges the cost of the retired asset (less salvage value) to depreciation expense. The replacement method charges the cost of replacement units purchased (less salvage value) to depreciation expense. The retirement method is equivalent to a FIFO cost flow assumption; the replacement method is equivalent to a LIFO cost flow assumption.
o Group and Composite methods: Group methods are used for similar assets.
Composite methods are used for dissimilar assets. When an asset is retired, any resulting loss or gain is charged (or credited) to the accumulated depreciation account. That is, no gain or loss is recognized on disposition of any unit. The difference between the sales price and the unit's cost is recorded to Accumulated Depreciation.
4. Other Depreciation Related Issues 4.1. Fractional year depreciation o Compute depreciation expense based on the time the asset was actually used. o Depreciate for a full-year the first year, and no depreciation the year of disposal. o No depreciation for the first year, and depreciate a full year for the year of disposal. o Half-year convention: depreciate for half a year the first year, and for half a year the last year. 4.2. Changes in depreciation computation o Due to changes in depreciation methods discussed in a later chapter. o Due to changes in estimates and/or capital expenditures
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5. Disclosures The basis for valuing property, plant, equipment, and natural resources, which is normally historical cost, should be disclosed in the financial statements along with any pledges, liens, and other commitments related to these assets. Normally, assets not used in a productive capacity (held for future use or as an investment) should be segregated from assets used in operations and classified as "Other Assets." Financial statement disclosures related to depreciation include: a. b. c. d. Depreciation expense for the period. Balances of major classes of depreciable assets, by nature and function. Accumulated depreciation, either by major classes of depreciable assets or in total. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets.
6. Income Tax Depreciation oFor assets acquired before 1981, depreciation for income tax purposes is based on straight-line, sum-of-the-years'-digits, and declining-balance methods. oFor assets purchased in the years 1981 through 1986 the Accelerated Cost Recovery System (ACRS) of depreciation is used. oFor depreciable assets placed in service in 1987 and later, A Modified Accelerated Cost Recovery System, known as MACRS, which was enacted by Congress in the Tax Reform Act of 1986, is used. o Three major differences exist between the computation of depreciation under MACRS and GAAP: A mandated tax life, which is generally shorter than the economic life. MACRS assigns assets to property classes which indicate the depreciable tax life of the assets in each class. The depreciable tax lives range from 3-year property to 31.5-year property. Cost recovery on an accelerated basis, and An assigned salvage value of zero. 7. Impairments of Plant Assets The process to determine an impairment loss is o Review events for possible impairment, o If events suggest impairment, determine if the sum of the expected future net cash flows is less than the carrying amount, if so, then o The loss is the amount by which the carrying amount of the asset is greater than the fair value of the asset. o If an impaired asset is expected to be disposed of, it should be recorded at the lower of cost or net realizable value, and it is not depreciated. o If an asset is considered long-lived, the reduced carrying amount is now considered its new cost basis and no write-up is allowed. o If an impaired asset is held for disposal, it can be written up or down as long as the write-up is never greater than the carrying amount of asset at the time of the original impairment.
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Part II. Natural Resources and Depletion
1. Cost of natural resources o Cost of natural resources should include acquisition costs, exploration costs, and development costs. Tangible assets used in extracting natural resources are normally set up in a separate account and depreciated individually.
2. Depletion of natural resources
oCost to be depleted: the depletion base for natural resources includes acquisition
costs, exploration costs, development costs, and restoration costs reduced by any residual value related to the land. oDepletion method: Depletion is normally based on the number of units extracted during the period, which corresponds to the activity depreciation method discussed earlier. 11-4
3. Special issues related to natural resources
oAccounting for exploration costs for oil and gas companies: Successful efforts
approach v. full costing approach.
oDiscovery value accounting (and reserve recognition accounting): Discovery
value is generally not recognized in accounts.
oThe tax law has long provided a deduction for the greater of cost or percentage
depletion against income from oil, gas, and most minerals. The percentage or statutory depletion allows a write-off ranging from 5% to 22% (depending on the natural resource) of gross revenue received. As a result, the amount of depletion may exceed the investment cost that is assigned to a given natural resource.
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