Chapter Eleven

Chapter Eleven - Intermediate Accounting Chapter 11...

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Unformatted text preview: Intermediate Accounting Chapter 11 Depreciation, Impairments, and Depletion Learning Objectives Learning Describe the concept of depreciation Identify the factors involved in the depreciation process Compare activity, straight­line, and decreasing­charge methods of depreciation Explain special depreciation methods Explain the accounting issues related to asset impairment Explain the accounting procedures for depletion of natural resources Explain how to report property, plant, equipment and natural resources 2 Depreciation – Method of Cost Allocation Depreciation Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic rational manner to those periods expected to benefit from the use of the asset. Allocating costs of long­term assets: 3 Fixed assets = Depreciation expense Intangibles = Amortization expense Natural resources = Depletion expense LO 1: Explain the concept of depreciation. Depreciation – Method of Cost Allocation Depreciation Factors Involved in the Depreciation Process Three basic questions: (1) What depreciable base is to be used? (2) What is the asset’s useful life? (3) What method of cost allocation is best? 4 LO 2: Identify the factors involved in the depreciation process. Depreciation – Method of Cost Allocation Depreciation Factors Involved in the Depreciation Process Depreciable Base Original Cost Less: Salvage Value Depreciable Base 5 $ 10,000 1,000 9,000 LO 2: Identify the factors involved in the depreciation process. Depreciation – Method of Cost Allocation Depreciation Factors Involved in the Depreciation Process Estimation of Service Lives 6 Service life of an asset often differs from its physical life. Companies retire assets for two reasons: (1) physical factors (such as casualty or expiration physical life) and (2) economic factors (obsolescence). LO 2: Identify the factors involved in the depreciation process. of Depreciation – Method of Cost Allocation Depreciation Methods of Depreciation The profession requires the method employed be “systematic and rational.” Examples include: (1) Activity method (units of use or production). (2) Straight­line method. (3) Sum­of­the­years’­digits. Accelerated methods (4) Declining­balance method. (5) Group and composite methods. Special methods (6) Hybrid or combination methods } 7 } LO 3: Compare activity, straight­line, and decreasing­charge methods of depreciation. Depreciation – Method of Cost Allocation Depreciation Special Depreciation Methods The choice of method depends on the nature of the assets involved: 8 Group method used when the assets are similar in nature and have approximately the same useful lives. Composite approach used when the assets are dissimilar and have different lives. Companies are also free to develop tailor­made depreciation methods, provided the method results in the allocation of an asset’s cost in a systematic and rational manner (Hybrid or Combination Methods). LO 4: Explain special depreciation methods. Depreciation – Method of Cost Allocation Depreciation Special Depreciation Issues (1) How should companies compute depreciation for partial periods? • Companies normally compute depreciation on the basis of the nearest full month. (2) Does depreciation provide for the replacement of assets? NO • Funds for the replacement of the assets come from the revenues (3) How should companies handle revisions in depreciation rates? 9 LO 4: Explain special depreciation methods. Depreciation – Method of Cost Allocation Depreciation Changes in Depreciation Rate 10 Accounted for in the period of change and future periods (Change in Estimate) Not handled retrospectively Not considered errors or extraordinary items LO 4: Explain special depreciation methods. Change in Estimate Example Change Arcadia HS, purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a salvage value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight­line basis. In 2010 (year 8), it is determined that the total estimated life should be 15 years with a salvage value of $5,000 at the end of that time. Questions: What is the journal entry to correct the prior years’ depreciation? 11 Calculate the depreciation expense for 2010. LO 4: Explain special depreciation methods. No Entry Required Change in Estimate Example (After 7 Years) (After Equipment cost Salvage value Depreciable base Useful Life (original) Annual depreciation $510,000 First, establish NBV at ­ 10,000 date of change in estimate. 500,000 10 years $ 50,000 x 7 years = $350,000 Balance Sheet (Dec. 31, 2009) Fixed Assets: Equipment $510,000 Accumulated depreciation 350,000 Net book value (NBV) $160,000 12 LO 4: Explain how to report irregular items. Change in Estimate Example (After 7 Years) (After Net book value Salvage value (new) Depreciable base Useful life remaining Annual depreciation $160,000 5,000 155,000 8 years $ 19,375 Depreciation Expense calculation for 2010 Journal entry for 2010 Depreciation expense 19,375 Accumulated depreciation 19,375 13 LO 4: Explain how to report irregular items. Impairments Impairments When the carrying amount of an asset is not recoverable, a company records a write­off referred to as an impairment. Events leading to an impairment: a. Decrease in the market value of an asset. b. Change in the manner in which an asset is used. c. Adverse change in legal factors or in the business climate d. An accumulation of costs in excess of the amount originally expected to acquire or construct an asset. e. A projection or forecast that demonstrates continuing losses associated with an asset. 14 LO 5: Explain the accounting issues related to asset impairment. Impairments Impairments Measuring Impairments 1. Review events for possible impairment. 2. If the review indicates impairment, apply the recoverability test. If the sum of the expected future net cash flows from the long­lived asset is less than the carrying amount of the asset, an impairment has occurred. 3. Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market value or the present value of expected future net cash flows. See Illustration 11-16 15 LO 5: Explain the accounting issues related to asset impairment. Depletion Depletion Natural resources, often called wasting assets, include petroleum, minerals, and timber. They have two main features: 1. complete removal (consumption) of the asset, and 2. replacement of the asset only by an act of nature. Depletion is the process of allocating the cost of natural Depletion is the process of allocating the cost of natural resources. 16 LO 6: Explain the accounting procedures for depletion of natural resources. Depletion Depletion Establishing a Depletion Base Computation of the depletion base involves four factors: (1) Acquisition cost of the deposit, (2) Exploration costs, (3) Development costs, and (4) Restoration costs. 17 LO 6: Explain the accounting procedures for depletion of natural resources. Depletion Depletion Write-off of Resource Cost Normally, companies compute depletion on a units-of-production units-of-production method (an activity approach). Thus, depletion is a function of the method number of units extracted during the period. Calculation: Total cost – Salvage value = Depletion cost per unit Total estimated units available Units extracted x Depletion cost per unit= Depletion 18 LO 6: Explain the accounting procedures for depletion of natural resources. Depletion Depletion Estimating Recoverable Reserves Same as accounting for changes in estimates Revise the depletion rate on a prospective basis Divide the remaining cost by the new estimate of the recoverable reserves 19 LO 6: Explain the accounting procedures for depletion of natural resources. Liquidating Dividends Liquidating Liquidating Dividends – Dividends greater than the Liquidating Dividends greater than the amount of accumulated net income. Illustration: Callahan Mining had a retained earnings balance of Illustration: Callahan Mining had a retained earnings balance of $1,650,000 and paid­in capital in excess of par of $5,435,493. Callahan’s board declared a dividend of $3 a share on the 1,000,000 shares outstanding. It records the $3,000,000 cash dividend as follows. Retained Earnings Paid­in Capital in Excess of Par Cash 20 1,650,000 1,350,000 3,000,000 LO 6: Explain the accounting procedures for depletion of natural resources. Depletion Depletion Continuing Controversy • Oil and gas Industry: • Full cost concept • Successful efforts concept 21 LO 6: Explain the accounting procedures for depletion of natural resources. Presentation and Analysis Presentation Presentation of Property, Plant, Equipment, and Presentation Natural Resources Natural Depreciating assets, use Accumulated Depreciation. Depleting assets may include use of Accumulated Depletion account, or the direct reduction of asset. • Basis of valuation (cost) • Pledges, liens, and other commitments Disclosures = • Depreciation expense for the period • Balances of major classes of depreciable assets. • Accumulated depreciation • A description of the depreciation methods used 22 LO 7: Explain how to report and analyze property, plant, equipment, and natural resources. Appendix 11A Appendix Income Tax Depreciation Modified Accelerated Cost Recovery System MACRS differs from GAAP in three respects: 1. a mandated tax life, which is generally shorter than the economic life; 2. cost recovery on an accelerated basis; and 3. an assigned salvage value of zero. 23 LO 8: Describe income tax methods of depreciation. ...
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