My video lectures about various depreciation methods such as straight line methods, double declining methods, sums of year year digit can be found in my intermediate accounting course and CPA exam lessons. Browns from menu above.
Chapter 11 presents a discussion of the factors involved in the accounting and recording of depreciation and depletion and the methods of allocating the cost of tangible assets and natural resources. Depreciation refers to a cost allocation of tangible plant assets. Depletion is the term used to describe the cost allocation related to natural resources, such as timber, oil, or coal. Amortization is the term used to describe the expiration of intangible assets. In addition to a thorough discussion of the accounting problems involved, the chapter presents a detailed analysis and explanation of the various depreciation and write off methods used in practice.
Factors Involved in the Depreciation Process
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. The cost allocation approach is justified because it matches costs with revenues and because fluctuation in market values is difficult to determine.
To compute depreciation, an accountant must establish (a) the depreciable base to be used for the asset, (b) the asset’s useful life, and (c) the cost allocation (depreciation) method to be used. Determination of the first two factors requires the use of estimates.
The depreciable base 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.
The useful life (service life) of a plant asset refers to the number of years (or, alternatively, the units of production) that the asset is capable of economically providing the function it was purchased to perform. The service life of an asset should not be confused with its physical life. For example, a machine may no longer provide a useful service to an organization even though it remains physically functional. Thus, the estimate of an asset’s service life is dependent upon both the economic factors and the physical factors related to its use.
Economic factors are characterized by inadequacy, supersession, and obsolescence.
Physical factors relate to wear and tear, decay, and casualties that prevent the asset from performing indefinitely.
The depreciation method selected for a particular asset should be systematic and rational. Depreciation methods may be classified as:
- Activity method (units of use or production).
- Straight-line method.
- Decreasing-charge methods (accelerated):
- Declining-balance method.
- Special depreciation methods.
- Group and composite methods.
- Hybrid or combination methods.
The following information for a piece of machinery will be used to illustrate some of the depreciation methods discussed in the following paragraphs.
Cost of machine $260,000
Estimated useful life 10 years
Estimated salvage value $20,000
Productive life in hours 60,000 hours
When the activity method (units-of–production approach) is used, depreciation is assumed to be a function of productivity rather than the passage of time. This method is most appropriate for assets such as machinery or automobiles where depreciation can be based on input and output measures such as units produced or miles driven. One problem associated with the use of this method concerns a before-the-fact estimation of the total output the asset will achieve during its useful life.
Assume the machine was used for 6,800 hours in the first year of its useful life.
|(Cost less Salvage Value) × Hours This Year||= Depreciation Charge|
|Total estimated hours|
|($260,000 – $20,000) × 6,800||= $27,200|
The straight-line method is a function of time and its use results in a uniform charge to depreciation expense during each year of an asset’s service life. This method is based upon the assumption that the decline in an asset’s usefulness is the same each year.
|Cost less Salvage Value||= Depreciation Charge|
|Estimated Service Life|
The decreasing-charge (accelerated depreciation) methods result in a higher depreciation cost during the early years of an asset’s service life and lower charges in later years. This approach is justified on the basis that assets are more productive in earlier years, and as a result, depreciation should be higher.
The sum-of-the-years’-digits method and the declining-balance method are the two most often used decreasing charge methods. The sum-of-the-years’ digits method requires multiplying the depreciable base by a fraction that decreases during each year of an asset’s service life. The declining-balance method requires use of a constant percentage applied to an asset’s book value (cost less accumulated depreciation) each year. Salvage value is initially ignored under the declining-balance method, as it is not part of the book value calculation.
(Cost – Salvage Value) × Depreciation Fraction = Depreciation Charge
Year 1: ($260,000 – $20,000) × 10/55* = $43,636
Year 2: ($260,000 – $20,000) × 9/55* = $39,273
The declining-balance method utilizes a depreciation rate that is some multiple of the straight-line method. One popular method is twice the straight-line rate. In the example provided, the 10-year asset life translates into a 20% declining rate: [1/10 × 2] = 20%.
Beginning Rate on
of the Year Declining Depreciation
Book Value × Balance = Charge
Year 1 $260,000 × 20% = $52,000
Year 2 $208,000 × 20% = $41,600
Special Depreciation Methods and Other Issues
Group and composite methods involve averaging the service life of many assets and applying depreciation as though a single unit existed. The composite approach refers to a collection of dissimilar assets, whereas the group approach refers to a collection of assets with similar characteristics. The method of computation for group or composite is essentially the same: find an average and depreciate on that basis. For example, the following assets would have the following composite rate and life.
Original Salvage Depreciable Useful Depreciation
Asset Cost Value Cost Life (Straight-Line)
A %%EDITORCONTENT%%nbsp; 65,000 %%EDITORCONTENT%%nbsp; 5,000 %%EDITORCONTENT%%nbsp; 60,000 5 yrs. $12,000
B 148,000 18,000 130,000 10 yrs. 13,000
C 95,000 11,000 84,000 12 yrs. 7,000
$308,000 $34,000 $274,000 $32,000
Composite Depreciation Rate: $32,000 ÷ $308,000 = 10.39%
Composite Life: $274,000 ÷ $32,000 = 8.56 years
These assets will be depreciated at $32,000 per year for 8.56 years.
Hybrid or combination methods are often used. GAAP requires only that the method used results in the allocation of an asset’s cost over the asset’s service life in a systematic and rational manner.
In general, depreciation should be based on the number of months an asset is used during an accounting period. If a decreasing charge depreciation method is used for assets purchased during an accounting period, a slight modification is appropriate. When this situation occurs, determine depreciation expense for the full year and prorate the expense between the two periods involved. This process continues throughout the service life of the asset. For example, assume an asset with a 5-year useful life and a depreciable cost of $45,000 is purchased on October 1. At the end of the first full year, the depreciation charge under the sum-of-the-years’-digits method would be:
1st full year: $45,000 × 5/15 = $15,000
2nd full year: $45,000 × 4/15 = $12,000
Year 1 expense (10/1 to 12/31): $15,000 × 3/12 = $3,750
Year 2 expense: ($15,000 × 9/12) + ($12,000 × 3/12)
Total 12 months expense: $11,250 + $3,000 = $14,250
Depreciation expense reduces net income for the accounting period in which it is recorded even though a current cash outflow is not involved. However, depreciation should not be considered a source of cash. Cash is generated by revenues, not accounting procedures.
The estimates involved in the depreciation process are sometimes subject to revision as a result of unanticipated occurrences. Such revisions (as well as changes in the depreciation method used) are classified as changes in accounting estimates and should be handled in the current and prospective periods.
The process to determine an impairment loss is: (a) review events and changes for possible impairment, (b) if events or changes indicate impairment, apply the recoverability test to determine if the sum of the expected future net cash flows is less than the carrying amount. (c) assuming an impairment the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset.
If deemed to be impaired and if the asset is held for use, then (c) recognize a loss for the amount by which the carrying amount of the asset is greater than the fair value of the asset (or if no active market exists, the present value of the expected future net cash flows). If an impaired asset is expected to be disposed of, then (c) it should be recorded at the lower of cost or net realizable value, and it is not depreciated.
If an impairment loss is recognized on an asset held for use, the reduced carrying amount is now considered its new cost basis and no write-up is allowed. 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 the asset at the time of the original impairment.
Depletion refers to the process of recording the consumption of natural resources (wasting assets). The depletion base for natural resources includes acquisition costs, exploration costs, intangible development costs, and restoration costs reduced by any residual value related to the land. Tangible assets used in extracting natural resources are normally set up in a separate account and depreciated separately.
Depletion is normally based on the number of units extracted during the period, which corresponds to the activity depreciation method discussed earlier.
A major problem one faces when computing depletion is estimating recoverable reserves. Not infrequently, it must be revised either because new information has become available or because production processes have become more sophisticated.
A company may gradually distribute capital investments to stockholders by paying liquidating dividends—dividends greater than the amount of accumulated net income. Because the dividend is a return of the investor’s original contribution, the company should debit Paid-in Capital in Excess of Par instead of Retained Earnings.
Companies in the oil and gas industry may account for natural resource costs using either the successful-efforts approach or the full-cost approach. Both successful efforts and full cost are historical cost approaches. The SEC once favored the development of a value-based accounting method for companies in the oil and gas industry known as Reserve Recognition Accounting (RRA). However, the development of RRA was abandoned and the SEC has asked the FASB to develop a comprehensive package of disclosures for oil and gas producers.
Presentation and Analysis
The basis for valuing property, plant, equipment, and natural resources is normally historical cost, and 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 plant assets include:
- 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.
Financial statement disclosures related to natural resources:
- The basis of valuation (usually historical cost)
- Pledges, liens, and other commitments or liabilities related to the property.
- The accounting method used for oil and gas producing activities—full-cost or successful-efforts.
- The manner of disposing of costs relating to oil and gas producing activities (e.g., expensing immediately versus depreciation and depletion.)
- Public companies must also supply supplemental information regarding reserve quantities, capitalized costs, acquisition, exploration and development activities, and measures of discounted net cash flows related to proved oil and gas reserve quantities.
The asset turnover measures how efficiently a company uses its assets to generate sales. It is computed by dividing net sales by average total assets. The profit margin on sales (net income divided by net sales) measures how well a company generates profit on each dollar of sales revenue.
The rate of return on assets (net income divided by average total assets) measures the return a company achieves through use of its assets. The key components of this measure are profit margin and asset turnover.
Income Tax Depreciation
For assets acquired before 1981, depreciation for income tax purposes is based on straight-line, sum-of-the-years’-digits, and declining-balance methods. For assets purchased in the years 1981 through 1986 the Accelerated Cost Recovery System (ACRS) of depreciation is used. A Modified Accelerated Cost Recovery System, known as MACRS, was enacted by Congress in the Tax Reform Act of 1986. It applies to depreciable assets placed in service in 1987 and later.
Three major differences exist between the computation of depreciation under MACRS and GAAP: (a) a mandated tax life, which is generally shorter than the economic life, (b) cost recovery computed on an accelerated basis, and (c) an assigned salvage value of zero.
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 39-year property.
ethods of depreciation adopted for financial reporting should reflect a systematic and rational manner of allocating the cost of depreciable assets to expense over the expected useful lives of the assets. Due to a cost-benefit perspective, some firms adopt tax depreciation methods for book purposes.