chapter 11

chapter 11 - Chapter 11 -- DEPRECIATION, IMPAIRMENTS,...

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Unformatted text preview: Chapter 11 -- DEPRECIATION, IMPAIRMENTS, Chapter 11 DEPRECIATION, IMPAIRMENTS, Chapter Chapter AND DEPLETION AND DEPLETION AND AND 1.. 1 Explain the concept of depreciation. 2. Identify the factors involved in the depreciation process. 3. Compare activity, straight­line, and decreasing­charge methods of depreciation. 4. Explain special depreciation methods. 5. Explain the accounting issues related to asset impairment. 6. Explain the accounting procedures for depletion of natural resources. 7. Explain how to report and analyze property, plant, equipment, and natural resources. Depreciation, Impairments, and Depletion Depreciation, Impairments, and Depletion Depreciation Depreciation Impairments Depletion Factors involved Methods of Methods depreciation depreciation Special methods Recognizing Recognizing impairments impairments Measuring Measuring Impairments Impairments Restoration of Restoration loss loss Assets to be Assets disposed of disposed Establishing a Establishing base base Write-off of Write-off resource cost resource Estimating Estimating reserves reserves Liquidating Liquidating dividends dividends Continuing Continuing controversy controversy Special issues Presentation and Presentation Analysis Analysis Presentation Analysis Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation 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. Allocating costs of long­term assets: Fixed assets = Depreciation expense Intangibles = Amortization expense Natural resources = Depletion expense Depreciation -- Method of Cost Allocation 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? Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Factors Involved in the Depreciation Process Depreciable Base Illustration 11-1 Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Factors Involved in the Depreciation Process Estimation of Service Lifes Service life of an asset often differs from its physical life. Companies retire assets for two reasons: physical factors (such as casualty or expiration of physical life) and economic factors (obsolescence). Depreciation -- Method of Cost Allocation 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. (4) Declining­balance method. (5) Group and composite methods. (6) Hybrid or combination methods. Accelerated methods Special methods Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Activity Method Illustration 11-2 Stanley Coal Stanley Mines Facts Mines Illustration: If Stanley uses the crane for 4,000 hours the first year, the depreciation charge is: Illustration 11-3 Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Straight-Line Method Illustration 11-2 Stanley Coal Stanley Mines Facts Mines Illustration: Stanley computes depreciation as follows: Illustration 11-4 Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Decreasing-Charge Methods Illustration 11-2 Stanley Coal Stanley Mines Facts Mines Sum-of-the-Years’-Digits. Each fraction uses the sum of the years as a denominator (5 + 4 + 3 + 2 + 1 =15). The numerator is the number of years of estimated life remaining as of the beginning of the year. Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Sum-of-the-Years’-Digits Illustration 11-6 Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Decreasing-Charge Methods Illustration 11-2 Stanley Coal Stanley Mines Facts Mines Declining-Balance Method. Utilizes a depreciation rate (percentage) that is some multiple of the straight­line method. Does not deduct the salvage value in computing the depreciation base. Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Declining-Balance Method Illustration 11-7 Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation E11-5 (Depreciation Computations—Four Methods): KC Corporation purchased a new machine for its assembly process on August 1, 2010. The cost of this machine was $150,000. The company estimated that the machine would have a salvage value of $24,000 at the end of its service life. Its life is estimated at 5 years and its working hours are estimated at 21,000 hours. Year­end is December 31. Instructions: Compute the depreciation expense under the following methods. (a) Straight­line depreciation. (c) Sum­of­the­years’­digits. (b) Activity method (d) Double­declining balance. Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Straight-line Method Year Depreciable Base Annual Expense 2010 $ 126, 000 / 5 = $ 25, 200 2 011 126, 000 / 5 = 2 012 126, 000 / 5 2 013 126, 000 / 2 014 126, 000 2 015 126, 000 Years Current Year Expense Part ial Year x 10, 500 $ 1 0, 500 25, 200 2 5, 200 3 5, 700 = 25, 200 2 5, 200 6 0, 900 5 = 25, 200 2 5, 200 8 6, 100 / 5 = 25, 200 2 5, 200 1 11, 300 / 5 = 25, 200 14, 700 1 26, 000 x 5/ 12 7/ 12 = = $ $ 1 26, 000 J our nal ent r y: 2010 Accum. Deprec. Depr eciat ion expense Accumult at ed depr eciat ion 10, 500 10, 500 Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Activity Method (Assume 800 hours used in 2010) ($ 126, 000 / 21, 000 hours = $ 6 per hour) Year (Given) Hours Used 2010 800 Rat e per Hours x $6 Annual Expense = 2 011 x x x x 4 , 800 $ 4 , 800 = 2014 $ = 2013 4, 800 = 2012 $ Part ial Year Current Year Expense = 800 J ournal ent ry: 2010 Depreciat ion expense Accumult at ed depreciat ion 4, 800 4, 800 Accum. Deprec. $ 4 , 800 Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation 5/12 = .416667 7/12 = .583333 Sum-of-the-Years’-Digits Method Current Year Depreciable Base 2010 $ 126, 000 x 2 011 126, 000 2 012 Annual Expense Years 5/ 15 = 42, 000 x 4. 58/ 15 = 126, 000 x 2 013 126, 000 2 014 2 015 Part ial Year 5/ 12 $ $ 1 7, 500 38, 500 3 8, 500 5 6, 000 3. 58/ 15 = 30, 100 3 0, 100 8 6, 100 x 2. 58/ 15 = 21, 700 2 1, 700 1 07, 800 126, 000 x 1. 58/ 15 = 13, 300 1 3, 300 1 21, 100 126, 000 x . 58/ 15 4, 900 4 , 900 1 26, 000 $ 1 26, 000 J our nal ent r y: 2010 Accum. Deprec. 17, 500 = x Year Expense Depr eciat ion expense Accumult at ed depr eciat ion 17, 500 17, 500 Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Double-Declining Balance Method Rat e per Year Annual Expense Current Year Expense Year Depreciable Base 2010 $ 150, 000 x 40% = 2 011 125, 000 x 40% = 50, 000 5 0, 000 2 012 75, 000 x 40% = 30, 000 3 0, 000 2 013 45, 000 x 40% = 18, 000 1 8, 000 2 014 27, 000 x 40% = 10, 800 $ 60, 000 x Part ial Year 5/ 12 Plug = $ 25, 000 3, 000 $ 1 26, 000 J our nal ent r y: 2010 Depr eciat ion expense Accumult at ed depr eciat ion 25, 000 25, 000 Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Depreciation Special Depreciation Methods The choice of method depends on the nature of the assets involved: 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). Depreciation -- Method of Cost Allocation 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. (1) Does depreciation provide for the replacement of assets? Funds for the replacement of the assets come from the revenues (1) How should companies handle revisions in depreciation rates? Depreciation -- Method of Cost Allocation Depreciation Method of Cost Allocation Changes in Depreciation Rate Accounted for in the period of change and future periods (Change in Estimate) Not handled retrospectively Not considered errors or extraordinary items Change in Estimate Example Change in Estimate Example Arcadia HS, purchased equipment for $510,000 which was estimated to 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? N No Calculate the depreciation expense for 2010.o Entry Required Required Change in Estimate Example Change in Estimate Example Equipment cost Salvage value Depreciable base Useful life (original) Annual depreciation Fixed Assets: After 7 years $510,000 First, establish NBV at First, establish NBV at ­ 10,000 date of change in estimate. date of change in estimate. 500,000 10 years $ 50,000 x 7 years = $350,000 Balance Sheet (Dec. 31, 2009) Equipment Equipment Accumulated depreciation $510,000 350,000 Net book value (NBV) $160,000 Change in Estimate Example Change in Estimate Example Change Net book value Salvage value (new) Depreciable base Useful life remaining Annual depreciation $160,000 5,000 155,000 8 years $ 19,375 After 7 years Depreciation Expense Depreciation Expense calculation for 2010. calculation for 2010. Journal entry for 2010 Depreciation expense Accumulated depreciation 19,375 19,375 Impairments 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. Impairments 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. Impairments Impairments Impairments Illustration 11-16 Accounting for Impairments Impairments Impairments Impairments E11-16 (Impairment): Presented below is information related to equipment owned by Pujols Company at December 31, 2010. Assume that Pujols will continue to use this asset in the future. As of December 31, 2010, the equipment has a remaining useful life of 4 years. Instructions: Cost A ccumulat ed depr eciat ion t o dat e Expect ed f ut ur e net cash f lows Fair value $ 9, 000, 000 1, 000, 000 7, 000, 000 4, 400, 000 (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010. (b) Prepare the journal entry to record depreciation expense for 2011. (c) The fair value of the equipment at December 31, 2011, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value. Impairments Impairments (a). (a). Cost $ 9, 000, 000 Accumulat ed depr eciat ion 1, 000, 000 Car r ying amount 8, 000, 000 Fair value 4, 400, 000 Loss on impair ment $ 3, 600, 000 12/31/10 Loss on impairment Accumulated depreciation 3,600,000 3,600,000 Impairments Impairments (b). (b). Net car r ying amount $ 4, 400, 000 Usef ul lif e Depr eciat ion per year 4 year s $ 1, 100, 000 12/31/11 Depreciation expense 1,100,000 Accumulated depreciation (c). Restoration of any impairment loss is not permitted. 1,100,000 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 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. Depletion Depletion Write-off of Resource Cost Normally, companies compute depletion on a units-of-production method (an activity approach). Thus, depletion is a function of the number of units extracted during the period. Calculation: Total cost – Salvage value Total estimated units available Units extracted x Cost per unit = Depletion cost per unit = Depletion Depletion Depletion E11-19 (Depletion Computations—Timber): Hernandez Timber Company owns 9,000 acres of timberland purchased in 1999 at a cost of $1,400 per acre. At the time of purchase the land without the timber was valued at $400 per acre. In 2000, Hernandez built fire lanes and roads, with a life of 30 years, at a cost of $87,000. Every year Hernandez sprays to prevent disease at a cost of $3,000 per year and spends $7,000 to maintain the fire lanes and roads. During 2001, Hernandez selectively logged and sold 700,000 board feet of timber, of the estimated 3,000,000 board feet. In 2002, Hernandez planted new seedlings to replace the trees cut at a cost of $100,000. Instructions: Determine the depreciation expense and the cost of timber sold related to depletion for 2001. Depletion Depletion E11-19 (Depletion Computations—Timber) De pr e c ia t io n Ex pe ns e : Fir e lane s and r o ad s Us e f ul lif e De p r e c iatio n e x p e ns e p e r ye ar $ 8 7 ,0 0 0 3 0 $ 2 ,9 0 0 Depletion Depletion E11-19 (Depletion Computations—Timber) De ple t io n: Co s t o f tim b e r land p e r ac r e Co s t o f land p e r ac r e Co s t o f tim b e r o nly p e r ac r e T o tal ac r e s Value o f tim b e r Es tim ate d to tal b o ar d f e e t Co s t p e r b o ar d f o o t Bo ar d f e e t o f tim b e r s o ld Co s t o f tim b e r s o ld r e late d to d e p le tio n $ 1,4 0 0 (4 0 0 ) $ 1,0 0 0 9 ,0 0 0 $ 9 ,0 0 0 ,0 0 0 3 ,0 0 0 ,0 0 0 $ 3 .0 0 7 0 0 ,0 0 0 $ 2 ,10 0 ,0 0 0 Depletion Depletion Estimating Recoverable Reserves Same as accounting for changes in estimates. Revise the depletion rate on a prospective basis. Divides the remaining cost by the new estimate of the recoverable reserves. Depletion Depletion Liquidating Dividends - Dividends greater than the amount of accumulated net income. 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 1,650,000 Paid­in Capital in Excess of Par 1,350,000 Cash 3,000,000 Depletion Depletion Continuing Controversy Oil and Gas Industry: Full cost concept Successful efforts concept Presentation and Analysis Presentation and Analysis Presentation of Property, Plant, Equipment, and Natural Resources 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 Disclosure s Depreciation expense for the period. Balances of major classes of depreciable assets. Accumulated depreciation. A description of the depreciation methods used. Presentation and Analysis Presentation and Analysis The assets turnover is a measure of a firm’s ability to generate sales from a The particular investment in assets. Illustration 11-20 Presentation and Analysis Presentation and Analysis Presentation The profit margin on sales is a measure of the ability to generate operating income from a particular level of sales. Illustration 11-21 Presentation and Analysis Presentation and Analysis Presentation Rate of Return on Assets measures a firm’s success in using assets to generate earnings. Illustration 11-22 Presentation and Analysis Presentation and Analysis The analyst obtains further insight into the behavior of ROA by The analyst obtains further insight into the behavior of ROA by disaggregating it into components of profit margin on sales and asset turnover as follows: Rate of Return on Assets Net Income Average Total Assets = = Profit Margin on Sales Net Income Net Sales x x Asset Turnover Net Sales Average Total Assets Presentation and Analysis Presentation and Analysis The analyst obtains further insight into the behavior of ROA by disaggregating it into components of profit margin on sales and asset turnover as follows: Rate of Return on Assets $64.2 ($811.8 + 665.3) / 2 8.7% = = = Profit Margin on Sales $64.2 $420.1 15.28% x x x Asset Turnover $420.1 ($811.8 + 665.3) / 2 .569 The definition of property, plant, and equipment is essentially the same under GAAP and IFRS. Under both GAAP and IFRS, changes in depreciation method and changes in useful life are treated in the current and future periods. Prior periods are not affected. GAAP recently conformed to IFRS in this area. The accounting for plant asset disposals is the same under GAAP and IFRS. The accounting for the initial costs to acquire natural resources is similar under GAAP and IFRS. Under both GAAP and IFRS, interest costs incurred during construction must be capitalized. Recently, IFRS converged to GAAP. The accounting for exchanges of nonmonetary assets has recently converged between IFRS and GAAP. GAAP now requires that gains on exchanges of nonmonetary assets be recognized if the exchange has commercial substance. This is the same framework used in IFRS. GAAP also views depreciation as allocation of cost over an asset’s life. GAAP permits the same depreciation methods (straight­line, diminishing­balance, units­of­production) as IFRS. IFRS requires component depreciation. Under GAAP, component depreciation is permitted but is rarely used. Under IFRS, companies can use either the historical cost model or the revaluation model. GAAP does not permit revaluations of property, plant, and equipment or mineral resources. In testing for impairments of long­lived assets, GAAP uses a two­step model to test for impairments (details of the GAAP impairment test is presented in the About the Numbers discussion). As long as future undiscounted cash flows exceed the carrying amount of the asset, no impairment is recorded. The IFRS impairment test is stricter. However, unlike GAAP, reversals of impairment losses are permitted. ...
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