Intermediate accounting 19th by stice stice chapter 11

Depreciation Formula SymbolsThe examples that follow assume the acquisition of a polyurethane plastic-molding machine at the beginning of 2013 by Schuss Boom Ski Manufacturing, Inc., a

Intermediate

Accounting

James D Stice Earl K Stice

Investments in Noncurrent Operating Assets—Utilization

and Retirement

Chapter 11

19 th

Edition

What is depreciation?

• Depreciation is not a process through which

a company accumulates a cash fund to

replace its long-lived fixed assets

• Depreciation is not a way to compute the

current value of long-lived assets

• Depreciation is the systematic allocation of the cost of an asset over the different

periods benefited by the use of the asset

Factors Affecting the Periodic

Four factors are taken into consideration in

determining the appropriate amount of annual depreciation expense

• Useful life is the expected life of the asset

in years, hours of service, or per unit of

output

(continued)

Useful Life

The physical factors that limit the service life

of an asset are—

1) wear and tear,

2) deterioration and decay, and

3) damage or destruction

The primary functional factor limiting the useful life of assets is obsolescence.

Depreciation Formula Symbols

The examples that follow assume the acquisition

of a polyurethane plastic-molding machine at the beginning of 2013 by Schuss Boom Ski

Manufacturing, Inc., at a cost of $100,000 with

an estimated residual value of $5,000.

C = Asset cost

R = Estimated residual value

n = Estimated life in years, hours of service, or

units of output

r = Depreciation rate per period, per hour of

service, or per unit of output

D = Periodic depreciation charge

Time-Factor Methods

Straight-Line

Straight-Line

• Of the time-factor methods , straight-line

depreciation is by far the most popular

• Straight-line depreciation relates to the passage of time and recognizes equal

depreciation in each year of the life of the asset

• This method assumes the asset is equally useful during each time period

Straight-Line Depreciation

Using data for the machine acquired by

Schuss Boom Ski Manufacturing and

assuming a 5-year life, annual depreciation is computed as follows:

Sum-of-the-Years’

Digits Method

SYD = [n (n + 1)]

2 SYD = [5 (5 + 1)]

2 SYD = 15

The sum-of-the-years’-digits depreciation

method yields decreasing depreciation in

each successive year To determine the

denominator, use the following formula

(assuming 5 years):

Or, simple add

1 + 2 + 3 + 4 + 5

Now that we know the denominator, we can

determine the depreciation for the year using the following formula, where “t” equals years

remaining at the beginning of the period.

Sum-of-the-Years’

Digits Method

(continued)

For the second year, we reduce the numerator

Declining-Balance Method

• The declining-balance depreciation

method provides decreasing charges by

applying a constant percentage rate to a

declining asset book value First, the

constant percentage must be calculated

• The most popular rate is two times the

straight-line rate, and this method is called

double-declining balance depreciation

• Thus, the molding machine would have a straight-line rate of 20% (1/5) This number

is doubled to arrive at the double-declining percentage of 40%

Declining-Balance Method

• Or you can use the following formula to get

the straight-line rate: 1/n

Factors Suggesting the Use of an

Accelerated Method

1) The anticipation of a significant

contribution in early periods with the

extent of the contribution to be realized

in later periods being less definite.

2) The possibility that inadequacy or

obsolescence may result in premature retirement of the asset.

Use-Factor Methods

Use-factor depreciation methods

view asset exhaustion as related

primarily to asset use or output and

provide periodic charges varying with

the degree of such services.

(continued)

• The first use-factor method we will

examine is service-hours

depreciation

• This method is based on the theory that the purchase of an asset represents the purchase of a number of hours of direct service.

(continued)

Service-Hours Depreciation

The Schuss Boom Ski Manufacturing

machine costs $100,000 and had a

residual value of $5,000 It is estimated that the machine will perform for an

estimated service life of 20,000 hours

Now we can determine the rate to be

applied to each service hour

(continued)

Service-Hours Depreciation

Service-Hours Depreciation

D = C – R

n

$100,000 – $5,000 20,000 hours

=

D = $4.75 per hour

Equals the projected

Productive-Output Depreciation

• Productive-output depreciation is based

on the theory that an asset is acquired for the service it can provide in the form of

production output

• The Schuss Boom asset is estimated to

have a productive life of 25,000 units

• Assume the company produced 3,200

units in 2013 and 5,400 units in 2014

(continued)

r = $3.80 per unit

Productive-Output Depreciation

Group and Composite Depreciation

• Group depreciation groups similar assets into depreciation accounts (e.g., all of a

company’s delivery vans)

• Composite depreciation refers to placing assets in the group that are related but

dissimilar (e.g., all of a company’s desks,

chairs, and computers)

• The group depreciation procedure treats a collection of assets as a single group

(continued)

The rate of 12.5%, applied to the cost of

existing assets, $20,000, results in annual

depreciation of $2,500

Group and Composite Depreciation

(continued)

Because the accumulated depreciation

account applies to the entire group of assets,

no book value can be calculated for any

specific asset If asset B were sold for $3,500 after two years, the following entry would be as follows:

Accumulated Depreciation 2,500

Equipment

6,000

Group and Composite Depreciation

No gain or loss is recognized.

Depreciation and IAS 16

The component approach is required under IASB standards The following requirement is contained in IAS 16:

“Each part of an item of property, plant

and equipment with a cost that is

significant in relation to the total cost

of the item shall be depreciated

separately.”

Depreciation and Accretion of an

Asset Retirement Obligation

• Bryan Beach Company purchases and

erects an oil platform at a total cost of

$750,000 Bryan Beach is legally

obligated to dismantle and remove the

platform after 10 years

• It is estimated that this will cost $100,000 Assuming an 8% interest rate, the present value of the obligation is $46,319 [46.319

(n = 10; i = 8%) × $100,000]

The journal entries to record the purchase

of the oil platform and the recognition of

the asset retirement obligation are as

Depreciation and Accretion of an

Asset Retirement Obligation

(continued)

The cost of the oil platform asset, including the estimated retirement obligation, is

depreciated just like any other long-term

asset.

Depreciation Expense 79,632* Accumulated Depreciation—

Oil Platform

79,632

*Assuming straight-line depreciation [($750,000 +

$46,319)/10]

Depreciation and Accretion of an

Asset Retirement Obligation

(continued)

Each year an entry must be made to

recognize the increase in the present

value of the asset retirement obligation.

Accretion Expense 3,706* Asset Retirement Obligation

3,706

* ($46,319 x 0.08) = $3,706

Depreciation and Accretion of an

Asset Retirement Obligation

• Natural resources (also called wasting

assets) are consumed as the physical units representing these resources are removed

and sold.

• The computation of depletion expense is an adaption of the productive-output method of depreciation.

• Perhaps the most difficult problem is

estimating the amount of resources available for economical removal from the land.

Depletion of Natural Resources

• Land containing mineral deposits is

tons, are calculated on Slide 11-51

Depletion of Natural Resources

charge per ton = $5.25

Depletion for 2013 = $5.25 × 80,000 tons

= $420,000

Depletion of Natural Resources

(continued)

Record the initial purchase as follows:

Depletion of Natural Resources

If only 60,000 tons are sold, $105,000 is

reported as part of ending inventory.

Change in Estimated Life

and estimated a 10-year life Using the

straight-line method with no residual value, the annual depreciation would be $5,000.

would amount to $20,000, and the remaining book value would be $30,000.

indicates only four more years of service can

be expected from the asset

Change in Estimated Units

of Production

A change in accounting for natural

resources occurs when the estimate of

the recoverable units changes as a result

of further discoveries, improved

extraction processes, or changes in sales prices that indicate changes in the

number of units that can be extracted

profitably.

(continued)

• Land is purchased at a cost of $5,500,000 with estimated net residual value of

$250,000 The original estimate of natural resources in the land was 1,000,000 tons

• In the second year of operations, 100,000 tons of ore are withdrawn At the end of

that year appraisers indicate a remaining tonnage of 950,000

Change in Estimated Units

of Production

(continued)

Cost assignable to recoverable tons

as of the beginning of second year:

Deduct: Depletion charge for first

Estimated recoverable tons as of the

beginning of second year:

Number of tons withdrawn in 2 nd year 100,000

Estimated recoverable tons as of

950,000

Total recoverable tons as of the

beginning of the second year

Cost assignable to recoverable tons as

of the beginning of second year:

Original costs applicable to depletable

Estimated recoverable tons as of the

beginning of second year

Change in Depreciation Method

• Another change in estimate occurs when

the actual pattern of consumption of an

asset doesn’t match the pattern of

consumption implicit in the depreciation

method

• Example: An asset is purchased for

$120,000 with a 12-year expected useful

life and zero salvage value After two years

of straight line depreciation, the asset has a remaining book value of $10,000

Change in Depreciation Method

• The company decides the balance method would yield a better

double-declining-estimate of periodic depreciation

• The straight-line depreciation rate is 10% (1/n = 1/10 = 10%) Double that rate is

20%

• Year 3 depreciation is $100,000 x 0.20, or

$20,000

Accounting for Asset Impairment

FASB Statement No 144 addresses four questions:

1. When should an asset be reviewed

for possible impairment?

 An impairment review should be

conducted whenever there has been

a material change in the way an asset

is used or in the business environment

2 When is an asset impaired?

 An asset is impaired when the

undiscounted sum of estimated future cash flows from an asset is less than the book value of the asset

Accounting for Asset Impairment

3 How should an impairment loss be

measured?

 The impairment loss is the difference

between the book value of the asset and the asset’s fair value

 The fair value can be approximated

using the present value of estimated

future cash flows from the asset

Accounting for Asset Impairment

4 What information should be disclosed

about an impairment?

 Disclosure should include a description

of the impaired asset, reasons for the impairment, a description of the

measurement assumptions, and the

business segment or segments

affected

Accounting for Asset Impairment

(continued)

International Accounting for Asset

Impairment: IAS 36

• IAS 36 requires that a company recognize an impairment loss whenever the “recoverable

amount” of an asset is less than its book value.

selling price of the asset or the discounted

future cash flows associated with the asset’s use.

• IAS 36 allows for the reversal of an impairment loss if events in subsequent years suggest the asset is no longer impaired.

• Intangible assets are to be amortized by the straight-line method unless there is strong

justification for using another method

• Because companies must disclose both the original cost and the accumulated

amortization for an amortizable intangible,

the credit should be to a separate

accumulated amortization account

Amortization and Impairment of Intangible

Assets Subject to Amortization

(continued)

Impairment of Intangibles Not

Subject to Amortization

The FASB describes the following examples of

intangibles with indefinite lives:

• Broadcast licenses often have a renewal

period of 10 years Because renewal is

virtually automatic, such licenses are

considered to have an indefinite life.

• A trademark right is granted for a limited

time, but can be renewed almost routinely

If economic factors suggest that the

trademark will continue to have value in the

foreseeable future, then its useful life is

indefinite.

Procedures in Testing Goodwill for Impairment

• The procedure in testing goodwill for

impairment is a four step test

• Buyer Company acquired Target Company

on January 1, 2013 As part of the

acquisition, $1,000 in goodwill was

recognized; this goodwill was assigned to Buyer’s Manufacturing unit For 2013,

earnings for the Manufacturing unit were

$350

(continued)

Procedures in Testing Goodwill for Impairment

• Separately traded companies with

operations similar to the manufacturing

reporting unit have market values

approximately equal to six times earning

(continued)

Procedures in Testing Goodwill for Impairment

As of December 31, 2013, book and fair

values of assets and liabilities of the

Manufacturing reporting units are as follow:

Book Values Fair Values

Procedures in Testing Goodwill for Impairment

1. Compute the fair value of each reporting

unit to which goodwill has been assigned

(continued)

 Using the earnings multiple, the

fair value of the Manufacturing reporting unit is estimated to be

$2,100 ($350 x 6)

Procedures in Testing Goodwill for Impairment

2 If the fair value of the reporting unit

exceeds the net book value of the assets and liabilities of the reporting unit, the

goodwill is assumed to not be impaired

and no impairment is recognized

(continued)

 The net book value of the assets and

liabilities of the Manufacturing reporting unit is $2,500 [($3,500 +$1,000) – $2,000] Since $2,100 (step 1) is less than $2,500, further computations are needed.

3. If the fair value of the reporting unit is less

than the net book value of the assets and liabilities of the reporting unit, then a new fair value of goodwill is computed

Goodwill value is always a residual value

 Implied fair value of goodwill is calculated as follows:

Procedures in Testing Goodwill for Impairment

Estimated fair value of Manufacturing $2,100

Fair value of identifiable assets – fair

value of liabilities ($4,000 – $2,000) 2,000

4 If the implied amount of goodwill computed in

(3) is less than the amount initially recorded, a goodwill impairment loss is recognized for the difference.

Procedures in Testing Goodwill for Impairment

 The implied fair value of goodwill is less than the recorded amount of goodwill

($100 < $1,000) The journal entry necessary

to recognize goodwill impairment loss is as

follows:

Goodwill Impairment Loss 900

Goodwill

900

Asset Retirement by Sale

On July 1, 2013, Landon Supply Co sells

machinery for $43,600 that is recorded on the books at a cost of $83,600 with accumulated

depreciation as of January 1, 2013, of $50,600 Assume a 10 percent straight-line rate.