ACCT 5120 Depreciation (or depletion and amortization) is a

Lecture Notes Ch. 10 FINAL process of allocating the cost of tangible assets in a
systematic and rational manner to periods expected to
benefit from the use of the asset. Allocating the costs
of long-lived assets takes three forms:
• Fixed Assets = Depreciation expense (Ch. 10)
Old Topic Accounting for PPE and Depreciation • Natural Resources = Depletion expense (Ch. 10)
• Intangible Assets = Amortization expense (Ch. 11)
Skim

PPE valued at original

cost, not FMV

Analyze

Journalize

Post to ledger

The cost of improvements or betterments are capitalized to the relevant “cost of FA” account (but for one exception).
The cost of ordinary repairs are expensed to repair and maintenance.
Matching principle requires that
expenses be recognized in the
same period that the associated
revenue is recognized.
- Some of the cost of long-lived
assets is expired during the sales
and production cycle but not in
direct association to the earning
of revenue.
- Therefore, asset cost must be
allocated “systematically and
rationally” to accounting periods
to provide at least an indirect
association to the earning of
revenue.

As a contra-asset account,
Accumulated Depreciation is
similar to Allowance for Doubtful
Accounts whose debits and credits
are just the opposite of a normal
asset account.

Accumulated depreciation is a “contra-asset account” with a normal credit balance that is netted
against the original cost of the asset to arrive at “net book value” (NBV).
 It is a process of cost
New Topic Calculating Depreciation allocation, not asset valuation

Straight-Line Method Depreciation related to time

 Deprecation = (Cost – Residual Value) / Expected Useful Life

Depreciable Base (or Cost)

equals the total amount to be
charged to expense over the
asset’s useful life

In Class Exercises: BE 10.2, BE 10.5

Declining Balance Method (accelerated method) Depreciation related to obsolesce

 Declining Balance Rate = (200% or 150%) x Straight-Line Rate

An alternative “accelerated
method” is Sum-of-the-Years’
 Depreciation Expense = Declining Balance Rate x Net Book Value
Digits as discussed below

Units-of-Production Method (Activity Method) Depreciation related to usage

 Depreciation Cost per Unit = (Cost – Residual Value) / Productive Capacity of Asset (total hours or units)

 Depreciation Expense = Depreciation Cost per Unit x Actual Usage of Asset (hours or units)

Simple to apply.
Reasonable to
use for many
fixed assets.

Estimates required for depreciation

 Useful life: period of time over which asset will be depreciated Thus, depreciable
 Salvage (residual) value: amount to be realized at end of asset’s useful life base is an estimate
Note: All depreciation methods use the same salvage value and yield the same total depreciation. as well
 Asset service potential is assumed to decline in an
Declining Balance Method accelerated manner due to rapid obsolescence

Double the straight-line rate

Note: double the rate used
under the straight-line method

While residual value or salvage

CPA MC #123 value is ignored in calculating
End of Yr. 2: depreciation expense, an asset
SOY 9/15
9/15 x $45K = = 60% x $50K
cannot be depreciated below its
$27K estimated residual value
= 60% x $30K
NBV = $23K
versus Standard depreciation expense
End of Yr. 2: (40% x 6,480 = 2,592) stops at
DDB 40%
NBV = $18K salvage value, limiting
= 60% x 60% x 40% x $50K depreciation in 2017 to 1,480

Analyze and journalize

Higher depreciation in early years and lower depreciation in later years aims to distribute
the combined cost of depreciation and maintenance, evenly, over the asset life. In Class Exercises: BE 10.4,
CPA MC #117, #118

Year Depreciation Base Remaining Life Depreciation Fraction Depreciation Expense Book Value E-O-Y
1 $450K 5 5/15 $150K $350K
2 $450K 4 4/15 9/15 $120K 270K $230K
3 $450K 3 3/15 $ 90K $140K
4 $450K 2 2/15 $ 60K $ 80K
5 $450K 1 1/15 $ 30K $ 50K (salvage value)

In Class Exercises: BE 10.3,

Units-of-Production Method Asset serviceCPA MC #119,
potential #120 with use
declines
 Variable cost per hour (unit of usage)

Stays same in relevant range

Actual usage shows production

varying widely, creating an
erratic patter of depreciation
expense – not predictable!

Analyze and journalize

Depreciation is determined as a rate per unit or hour based on asset’s production capacity;
in effect, converting depreciation into a variable cost (a cost that varies with units produced).
In Class Exercises: BE 10.1

Skim
Comparison of Depreciation Methods
 Straight-line method: Constant amount of depreciation expense in each period of the asset’s Related to time
life. Consistent with a constant rate of decline in service potential.
 Depreciation rate times the asset’s depreciable base (cost – salvage value)
 Widely used because of its simplicity and ease of usage

 Decreasing charge methods: Larger amount of depreciation expense in the early periods of
an asset’s life. Consistent with a decreasing rate of decline in service potential.
 Declining balance: Related to
- Usually double (or 150%) the straight-line depreciation rate obsolescence
- Depreciation rate times the asset’s net book value (cost – accumulated depreciation)
 Sum-of-the-years’ digits:
- Based on a decreasing fraction of the depreciable cost (original cost less salvage value
- Each fraction uses the sum-of-the-years as the denominator
- Each fraction shows the numerator as the number of estimated years of life remaining

 Units-of-production method: Amount of depreciation expense based on asset’s use, rising Related to
and falling accordingly. Not based on a pattern of declining service potential. usage

- Use when the decline in an asset’s service potential correlates with its usage
- Depreciation rate times the asset’s actual usage in units or hours

Factors to consider in any of the forgoing depreciation methods:

1) What depreciable base is to be used? (Depreciable base = Original cost less salvage value)

2) What is the asset’s estimated service life (used by the firm)

versus its physical life (how long it will last)? Group method (similar assets) is a bit
In Class Exercises: Questions 2, 9, 10;
3) What method of cost allocation is best for this asset? more reflective
CPA MC
of the component
#121,the
#122, #123 from the
method because deviation
average is not as great as the
New Topic composite method (dissimilar assets).
 Composite or Group Depreciation
 Composite method is used when the assets are dissimilar and have different useful lives.
 Group method is used when the assets are similar in nature with about the same useful lives.
 Choice of method depends on the nature of the assets involved.
 Computations are essentially the same for each: Find an average and depreciate on that basis.

Rationale: Averaging the economic

lives of capital assets and
depreciating the entire class of
assets over a single life simplifies
versus Component Unit (the standard approach) record keeping and depreciation
calculations.

If Mooney retires an asset before or

after the average service life of the
group is reached, it buries the
resulting gain or loss in the
Accumulated Depreciation account.

Illustration: Suppose that Mooney

Motors sold one of the campers with
a cost of $5,000 for $2,600 at the end
of the third year. The entry is:

Dr, Accum. Depreciation 2.4K

Note: the composite depreciation
Dr, Cash 2.6K
rate is applied to the original
cost, not to the depreciation base, It will take 3.3929 years to Cr, Equipment 5.0K
similar to the double declining depreciate these assets @ a
25% rate to their salvage value
balance method

If Mooney purchases a new type of asset (mopeds, for example), it must compute a new depreciation Disadvantage: However,
rate and apply this rate in subsequent periods. Advantage: Group or composite method simplifies depreciating by component unit
the bookkeeping and averages out errors caused by over depreciating or under depreciating an (the standard approach),
asset, thus avoiding distortions of income from gains or losses on asset disposal. represents the best estimate of
the depreciation of each asset,
Sample (real-world) financial statement disclosure rather than the averaging of
cost over longer periods of time.

Standard type of note disclosure

for composite depreciation.
In Class Exercise: BE 10.6;
Questions 11, 12
Dr, Cash 14K
Read Dr, Accum Dep* 36K
Cr, Plant Asset 50K
*Plug figure

New Topic Change in Estimated Asset Life and Salvage Value

 Changes are applied prospectively – no retroactive adjustments or restatements
 Changes affect only the income in current and subsequent accounting periods
 There is no change to previously reported results

Arcadia purchased equipment for $510,000 which was estimated to have a useful life of 10 years with a
residual value of $10,000 at the end of that time. Depreciation has been recorded for 7 years on a straight-
line basis. In 2020 (year 8), it is determined that the total estimated life should be 15 years (an increase of
five years from the original estimated life) with a residual value of $5,000 at the end of that time.

 What is the journal entry to correct the prior years’ depreciation? NO ENTRY REQUIRED
 ofCalculate
Calculation Net Bookdepreciation
Value after expense
7 years for 2020. See Next Chart
Equipment cost $510,000
(First, establish NBV at date of change in estimate)
Salvage value − 10,000
Balance Sheet as of 12-31-2019

Equipment $510K Depreciable base 500,000

 Be sure to note that changes in
asset life and salvage value are
changes in estimates and as such
affect only financial reporting in
the current year and prospective
years. There are NO retrospective
adjustments of any kind required to
prior year financial statements.

The illustration below demonstrates the proper accounting for a reduction in

asset life as opposed to an increase in asset life as covered in the example above.

Year Depreciation
Facts: 1 $5,000 (50,000/10)
Original Accum. Dep. = 10K
Equipment was purchased for 2 $5,000 (50,000/10)
$50K with an expected life of 3 $10,000 (40,000/4)
10 years. In year 3, 4 $10,000 (40,000/4) 50K – 10K = 40K NBV
equipment usage was New Est.
5 $10,000 (40,000/4) 4 years remaining
reassessed and is now 6 $10,000 (40,000/4)
useful life
expected to last a total of only
six years. Equipment is
depreciated on the S/L basis Dr, Depreciation Expense $10,000
with no salvage value. Cr, Accumulated Depreciation $10,000

To record depreciation expense in year 3 (following change in est. useful life)

In Class Exercise: BE 10-7

New Topic Impairment
 Definition – “a permanent decline in the future benefit or service potential of an asset”
 GAAP requirement – fixed assets need to be tested annually for impairment
- Step 1. Existence: An impairment exists if the future net cash flows expected to be
generated by the asset are less than the asset’s book value (net carrying amount). Recoverability Test

Undiscounted future net cash inflows (-) asset book value

If positive, no impairment loss.

If negative, asset impairment exists.
 Fair Value Test

- Step 2. Measurement: If an impairment exists, the impairment loss is measured as the

difference between the book value and the fair value (or PVFCF) of the asset.
 Reporting impairment loss (restoration of previously recognized impairments is prohibited,
though restoration is permitted if asset is held for sale or disposal and not for use)

Dr, Loss from Impairment An impairment loss is normally

recorded as an increase to the
Cr, Account of Impaired Asset accumulated depreciation account

Measuring Impairments
1. Review events for possible impairment.

2. If the review indicates impairment, apply

the recoverability test. If the sum of the
expected undiscounted future net cash
flows from the long-lived 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 either the
market price OR the present value of
expected future net cash flows.
Assets held for disposal are
reported at lower of cost
or net realizable value

GAAP requires all fixed

assets to be examined for
impairment annually.

Because undiscounted
FCF exceed NBV, no
measurement of
impairment loss is needed.
 Measurement of Impairment Loss
The recoverability test indicates that the
expected future net cash flows of
$580,000 from the use of the asset are
less than its carrying amount of
$600,000. Therefore, an impairment
has occurred. Assume this asset has a
fair value of $525,000. Determine the
impairment loss, if any.
FV of equipment $525K
Carrying value:
Cost $800K
Accum. Depreciation -200K
NBV $600K
Impairment loss $ 75K

Journal entry to record Impairment Loss:

Dr, Loss on Impairment $75K
Cr, Accumulated Depreciation $75K

Read
Restoration of Impairment Loss ASSETS HELD FOR USE
After recording an impairment loss:
FMV or PV of FCF
 Reduced carrying amount for the asset becomes the new cost basis
(-) Net Carrying Value
 GAAP permits no change in the new cost basis except for depreciation or Impairment Loss
amortization in future periods or for additional impairments 1. Write asset down
2. Depreciate new cost
 No restoration of impairment loss for an asset held for use is permitted 3. Restoration not permitted
because the new cost basis puts the impaired asset on an equal basis with
other assets that are unimpaired

A SSETS HELD
FORImpairment
DISPOSAL of Assets to be disposed of:
FMV or PV of FCF
Assets held for disposal are like inventory; therefore, companies
(-) Net Carrying Value
 Should report at lower-of-cost-or-net realizable value Impairment Loss
 Write up or down an asset held for disposal in future periods, as long as + Cost of disposal
carrying value after write-up never exceeds carrying amount of asset Total Impairment Loss
before impairment 1. Write asset down
2. No depreciation taken
 Should report losses (or gains) related to impaired assets as part of 3. Restoration is permitted
income from continuing operations

In Class Exercise: BE 10.8; BE

10.9. Questions 16, 17, 18, 19
New Topic Depletion of Natural Resources
 Depletion base
- Cost to purchase the natural resource (acquisition)
- Plus exploration / development costs to prepare the resource for extraction
Total Cost Depletion Base =
- Plus any required restoration costs Total Cost (-)
- Less any residual value once the resources have been extracted Residual Value

 Depletion expense = unit depletion rate times (x) the # of units extracted / sold

Normally, companies compute depletion (cost depletion) on a units-of-production method

(activity approach). Depletion is a function of the number of units extracted during the period. Cost Depletion
method required
- Depletion rate = Depletion base / Estimated recoverable units by GAAP
- Total depletion = Depletion rate x Extracted units
- COGS depletion = Depletion rate x Extracted units sold
- Inventory (natural resources) = Depletion rate x Extracted units not sold
 Acquisition cost

Total cost Carried on books as

an operating asset
Residual value
Est. recoverable units

800K = tons of coal mined in 2013

Analyze and journalize

In the HW, credit accumulated
depletion to the asset account.
See p, 10-23 (top of page)
What is the mine’s NBV?
Original cost: $38M
(-) Accum. Dep: $3M
NBV $35M

Analyze and journalize

Depletion Illustration - Calculation

MaClede Co. acquired the right to use 1,000 acres of land in Alaska to mine for silver. The lease cost is $50,000,
and the related exploration costs on the property are $100,000. Intangible development costs incurred in opening
the mine are $850,000. MaClede estimates that the mine will provide approximately 100,000 ounces of silver.
Depletion base = Total cost (-) residual value
Depletion base = $1M
Depletion rate (cost per unit) = Depletion base / Estimated recoverable units
$1,000,000 / 100,000 ounces = $10 per ounce

Depletion Illustration – Journal Entries

If MaClede extracts 25,000 ounces in the first year, then the depletion for the year is $250K (25K ounces x $10).
Dr, Inventory (Silver) $250K
Cr, Silver Mine $250K
MaClede debits COGS when the silver is sold. If 10K ounces are sold, the journal entry to record is as follows:
Dr, Cost of Goods Sold $100K
Cr, Inventory (Silver) $100K

Estimating Recoverable Units

 Same as accounting for changes in estimates. (See Ch. 3)
 Revise the depletion rate on a prospective basis.
 Divide the remaining cost by the new estimate of the
In Class Exercise: BE 10.10.
remaining recoverable reserves CPA MC #124, #125
BRIEF EXERCISE 10.1

($50,000 – $2,000) X 23,000

2025: = $6,900
160,000

($50,000 – $2,000) X 31,000

2026: = $9,300
160,000

BRIEF EXERCISE 10.2

$80,000 – $8,000
(a) = $9,000
8

$80,000 – $8,000
(b) X 4/12 = $3,000
8

BRIEF EXERCISE 10.3

(a) ($80,000 – $8,000) X 8/36* = $16,000 *[8(8 + 1)] ÷ 2

(b) [($80,000 – $8,000) X 8/36] X 9/12 = $12,000

BRIEF EXERCISE 10.4

(a) $80,000 X .25* = $20,000 *(1/8 X 2)

(b) ($80,000 X .25) X 3/12 = $5,000

BRIEF EXERCISE 10.5

Depreciable Base = ($28,000 + $200 + $125 + $500 + $475) – $3,000 = $26,300.

BRIEF EXERCISE 10.6

Asset Depreciation Expense

A ($70,000 – $7,000)/10 = $ 6,300
B ($50,000 – $5,000)/5 = 9,000
C ($82,000 – $4,000)/12 = 6,500
$202,000 $21,800

Composite rate = $21,800/$202,000 = 10.8%

Composite life = $186,000*/$21,800 = 8.5 years
*($63,000 + $45,000 + $78,000)
BRIEF EXERCISE 10.7

Annual depreciation expense: ($8,000 – $1,000)/5 = $1,400

Book value, 1/1/26: $8,000 – (2 x $1,400) = $5,200*
Depreciation expense, 2026: ($5,200* – $500)/2 = $2,350

BRIEF EXERCISE 10.8

Recoverability test:

Future net cash flows ($550,000) > Carrying amount ($520,000*); therefore, the
asset is not impaired and no impairment loss will be recorded.

*($900,000 - $380,000)

BRIEF EXERCISE 10.9

Recoverability test:
Future net cash flows ($500,000) < Carrying amount ($520,000*);
therefore, the asset has been impaired.
*($900,000 - $380,000)

Journal entry:
Loss on Impairment.............................................................................................. 120,000
Accumulated Depreciation—
Equipment ($520,000 – $400,000)....................................................... Fair Value test 120,000

FV 400K
NBV - 520K
Loss 120

BRIEF EXERCISE 10.10

Inventory................................................................................................................ 73,500**
Coal Mine.................................................................................................. 73,500

($400,000 + $100,000 + $80,000 – $160,000)

= $105* per ton
4,000

700 X $105* = $73,500**

Questions:

2. The factors relevant in determining the annual depreciation for a depreciable asset are the initial recorded
amount (cost), estimated salvage value, estimated useful life, and depreciation method.
Depreciable base = Original cost (-) Salvage

Assets are typically recorded at their acquisition cost, which is in most cases objectively determinable. But cost
assignment in other cases—“basket purchases” and the selection of an implicit interest rate in asset
acquisitions under deferred-payment plans—may be quite subjective, involving considerable judgment.
 The salvage value is the estimated amount that a company will receive when the asset is sold or when the
asset is retired from service. The estimate is based on judgment and is affected by the length of the useful life
of the asset.

The useful life is also based on judgment. It involves selecting the “unit” of measure of service life and
estimating the number of such units embodied in the asset based on the company’s experience with such
assets. Such units may be measured in terms of time periods or in terms of activity (for example, years or
machine hours). When selecting the life, one should select the lower (shorter) of the physical life or the
economic life. Physical life involves wear and tear and casualties; economic life involves such things as
technological obsolescence and inadequacy.

Selecting the depreciation method is generally a judgment decision, but a method may be inherent in the
definition adopted for the units of service life, as discussed earlier. For example, if such units are machine
hours, the method is a function of the number of machine hours used during each period. A method should
be selected that will best measure the portion of services expiring each period. Once a method is selected,
it may be objectively applied by using a predetermined, objectively derived formula.

9. Depreciation base:

Cost $162,000 Straight-line, $147,000 ÷ 20 = $ 7,350

Salvage (15,000)

$147,000 20,000
Units-of-output, $147,000 X = $35,000
84,000
14,300
Working hours, $147,000 X = $50,050
42,000

Sum-of-the-years’-digits, $147,000 X 20/210* = $14,000

Double-declining-balance, $162,000 X .10** = $16,200

**[(1 ÷ 20) X 2]

10. From a conceptual point of view, the method which best matches revenue and expenses should be used;
in other words, the answer depends on the decline in the service potential of the asset. If the service
potential decline is faster in the earlier years, an accelerated method would seem to be more desirable. On
the other hand, if the decline is more uniform, perhaps a straight-line approach should be used. Many firms
adopt depreciation methods for more pragmatic reasons. Some companies use accelerated methods for
tax purposes but straight-line for book purposes because a higher net income figure is shown on the books
in the earlier years, but a lower tax is paid to the government. Others attempt to use the same method for
tax and accounting purposes because it eliminates some recordkeeping costs. Tax policy sometimes also
plays a role.

11. The composite method is appropriate for a company which owns a large number of heterogeneous plant
Group method assets and which would find it impractical to keep detailed records for them. Group method: Homogeneous
(similar assets) is a
bit more reflective The principal advantage is that it is not necessary to keep detailed records for each plant asset in the
of the component
group. The principal disadvantage is that after a period of time the book value of the plant assets may not
method because
the deviation from reflect the proper carrying value of the assets. Inasmuch as the Accumulated Depreciation account is
the average is not debited or credited for the difference between the cost of the asset and the cash received from the retirement
as great as the of the asset (i.e., no gain or loss on disposal is recognized), the Accumulated Depreciation account is self-
composite method correcting over time.
(dissimilar assets).

12. Cash............................................................................................................... 14,000

 Accumulated Depreciation—Plant Assets....................................................... 36,000
Plant Assets................................................................................. 50,000
No gain or loss is recognized under the composite method.

16. The accounting standards require that if events or changes in circumstances indicate that the carrying
amount of such assets may not be recoverable, then the carrying amount of the asset should be assessed.
The assessment or review takes the form of a recoverability test that compares the sum of the expected
future cash flows from the asset (undiscounted) to the carrying amount. If the cash flows are less than the
carrying amount, the asset has been impaired. The impairment loss is measured as the amount by which
the carrying amount exceeds the fair value of the asset (fair value test). The fair value of assets is
measured by their market value if an active market for them exists. If no market price is available, the
present value of the expected future net cash flows from the asset may be used.
Once an operational asset is
17. Under U.S. GAAP, impairment losses on assets held for use may not be restored. written down, it stays down

18. An impairment is deemed to have occurred if, in applying the recoverability test, the carrying amount of
the asset exceeds the expected future net cash flows from the asset. In this case, the expected future net
cash flows of $705,000 exceed the carrying amount of the equipment of $700,000, so no impairment is
assumed to have occurred; thus, no measurement of the loss is made or recognized even though the fair
value is $590,000.

19. Impairment losses are reported as part of income from continuing operations, generally in the “Other
expenses and losses” section. Impairment losses (and recovery of losses for assets to be disposed of) are
similar to other costs that would flow through operations. Thus, gains (recoveries of losses) on assets to be
disposed of should be reported as part of income from continuing operations in the “Other revenues and
gains” section.