Administrative

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Agenda

• Administrative
• Quiz Monday 3/11 Chapters 10 and 11(for Ch. 11,
  no impairment or depletion qs on quiz)
• Another Non-monetary exchange example
• Another capitalization example
• Ch 11 Depreciation, Impairments and Depletion

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Depreciation Concept

• Depreciation is a means of cost allocation
• It is not a method of valuation
• What does this mean? It means that we will see
  Book Value Fair Value only by coincidence
  (except for at the time when the asset is
  purchased)
• Depreciation involves
• allocating the cost of tangible assets to expense
  in a systematic and rational manner to periods
  expected to benefit from use of its depreciable
  assets
• ? Matching

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Factors in the Depreciation Process

• Questions to be answered
• What is the depreciable base of the asset?
• What is the assets useful life?
• What method of depreciation is best for the
  asset in question?

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Depreciable Base

• Depreciable base is the dollar amount subject to
  depreciation.
• It is determined as
• Original cost of the asset less
• Estimated salvage or disposal value
• (however note that for declining balance methods,
  we use original cost (and ignore salvage value)
  in the calculation, and only check that our
  deprecation does not cause the carrying value of
  the asset to drop below salvage value)

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Depreciation Methods Overview
Depreciation Methods
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Depreciation Methods Straight-Line

• Is a function of time rather than usage
• most commonly used method
• Results in an equal amount of depreciation
  expense for a given period
• Depreciation Expense is computed as
• Cost Salvage Value
• Estimated Life

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Example Depreciation Methods

• Josephus Inc. bought a new printing press for
  1,000,000 on June 30, 2005. The press has an
  estimated useful life of 15 years, and a salvage
  value of 50,000. It is estimated that the
  machine will provide 200,000 hours of use. From
  its purchase to Josephuss year end of December
  31, 2005, the press ran for 7,000 hours.
  Calculate depreciation expense for the machine
  for using the following methods straight-line,
  Activity, and Double Declining Balance (2x SL
  rate).

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Straight Line Method

• Depreciable Base
• 1,000,000 50,000 950,000
• Rate per year 950,000 / 15 63,333
• 6 months from July 1 to Dec 31 31,666
• Note unless told otherwise, assume that firms
  using SL depreciation go by month for part-year
  problems

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Depreciation Methods Activity Based

• Is a function of usage rather than time
• requires more effort in recording asset use
  (e.g., must read record odometer readings, or
  install hourly usage meters, etc.)
• Estimated life is in terms of total input/output
  of asset.
• Depreciation expense is computed as
• (Cost Salvage Value) x Input or Output in
  period
• Total Estimated Input or Output

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Activity Based Method

• Part-year? Doesnt impact calculation
• 950,000 / 200,000 hrs 4.75 / hr
• 7,000 x 4.75 33,250 Depn for 2005

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Depreciation Methods Decreasing Charge
(Accelerated)

• These methods result in higher depreciation
  expense in the earlier years and lower charges in
  the later years.
• Two decreasing charge methods are
• Declining balance
• Sum-of-the-years-digits

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Depreciation Methods Declining Balance

• Salvage value is not deducted when computing
  depreciable base.
• Often utilizes a depreciation rate () that is
  some multiple of the SL rate
• The depreciation rate is multiplied by the
  assets book value at the beginning of the period
  to get the depreciation expense for the period.
• Since the book value decreases over time this
  results in a decreasing amount of depreciation
  expense over time.
• An assets book value can never be less than its
  estimated salvage value.
• You must check this manually after calculating
  the depreciation expense for the year and cut
  back on depreciation that would drop carrying
  value below salvage value

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Double Declining Balance Method

• Ignore Salvage Value
• Calculate full- year depreciation
• 1,000,000 x 2/15 133,333
• Since only half-year
• 133,333 x 6/12 66,667
• What about next year in 2006?
• The remaining 66,667 is attributable to the
  first 6 months of 2006
• Then calculate depreciation for the next 12
  months (1,000,000 133,333) x 0.1333 115,556
• Then allocate 6 months of the 115,556 to the
  last six months of 2006
• 115,556 X 6/12 57,778
• 2006 depreciation 66,667 57,778 124,445

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Depreciation Methods Sum-of-the-Years Digits

• A fraction is multiplied by the depreciable base
  to arrive at the depreciation expense per period.
• The fraction is
• Numerator number of years remaining in the
  assets life as of the beginning of the period.
• Denominator sum of the years in the life
• For example, a 5 year life property would have
  depreciation expense for the first year as
• (Cost Salvage value) X 5 (years remaining)
• 15 (computed as 54321)

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SYD Method

• Calculate full- year depreciation
• 950,000 x 15/120 118,750
• Since only half-year
• 118,750 x 6/12 59,375
• What about next year in 2006?
• The remaining 59,375 is attributable to the
  first 6 months of 2006
• Then calculate depreciation for the next 12
  months 950,000 x 14/120 110,833
• Then allocate 6 months of the 110,833 to the
  last six months of 2006
• 110,833 X 6/12 55,417
• 2006 depreciation 59,375 55,417 114,792

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Partial Year Depreciation

• When an asset is bought sometime during the year,
  follow the companys policy for treatment
• In some cases, a partial depreciation charge is
  required
• In other cases, the firm may choose to take a
  full years depreciation in the year purchased,
  and none in the year of disposal (or even ½ year
  when purchased and ½ year when disposed)
• If the firm allocates proportionately based on
  months owned, determine depreciation for a full
  year, and allocate the amount between the two
  periods affected

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Revision of Depreciation Estimates

• Determination of depreciation involves initial
  estimates (e.g., life, salvage value)
• When these estimates are revised, depreciation
  must be re-computed
• Remaining B.V. Est. Salvage Value
• Remaining Est. Life
• These revised depreciation expenses apply
  prospectively to the remaining life of asset.
• No Adjustment to prior periods

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Revision Example

• Kennedy Floatation Devices Inc. (KFD) bought a
  plastic foam manufacturing machine on November 1,
  2005. At that time, KFD assumed the machine
  would last for 10 years, and would have a salvage
  value of 1,000. The machine cost 50,000.
• On July 1, 2007, KFD installed a new part on the
  machine at a cost of 15,000. The new part
  extended the life of the machine for an
  additional 15 years, although at that date it
  would have a salvage value of only 500.
• Calculate the depreciation expense for the
  machine for the 2007 fiscal year (ended December
  31).

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Solution

• Book value on July 1, 2007, before new part
• 2005 depreciation (50,000 1,000)/10 4,900 x
  2/12 817
• 2006 depreciation 4,900
• 2007 depreciation (up to July 1) 4,900 x 6/12
  2,450
• Total AD 817 4900 2450 8,167
• Book Value before new part 50,000 8,167
  41,833
• BV after new part 41,833 15,000 56,833
• Remaining Life 15 years
• New Depreciation per year (56,833 500) / 15
  3,756 per year
• Total Depreciation for 2007 2,450 3,756 X
  (6/12) 4,328

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Impairments

• An impairment of a depreciable asset occurs
  when
• The carrying amount of the asset (or asset group)
  is not recoverable, and therefore a write-off is
  needed.
• The recoverability test determines if an
  impairment has occurred.

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Impairments

• Recoverability test should be performed when
  circumstances change indicating a carrying amount
  may not be recoverable
• Significant decrease in market price
• Significant change in use or physical condition
• Significant change in legal factors or in
  business climate that could affect assets value
• Accumulation of cost significantly greater than
  amount originally expected to acquire or
  construct a long-lived asset
• Expectation that entity will sell or otherwise
  dispose of long-lived asset significantly before
  the end of its previously estimated useful life

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Impairments The Recoverability Test
Impairment?
Sum of expected future net cash flows (NO
DISCOUNTING) from use and disposal of asset is
less than the carrying amount
Sum of expected future net cash flows from use
and disposal of asset is equal to or more than
the carrying amount
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Impairments Measuring Loss
Loss Carrying amount less Fair value of asset
Does an active market exist for the asset?
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Impairment Accounting
Impairment has occurred

• 1. Loss Carrying value
• less Fair value
• 2. Depreciate new cost basis
• i.e., this is a change in
• estimate
• 3. Restoration of impairment
• loss is NOT permitted

1. Loss Carrying value less Fair Value
less cost of disposal 2. No depreciation
is taken 3. Restoration of impairment loss is
permitted
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Graphic of Accounting for Impairments
Not Discounted
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Impairment Example

• Rocky Inc. manufactured a pet rock making
  machine. Raw materials and direct labor costs
  totaled 100,000, plus another 5,000 of
  allocated overhead and 3,000 of capitalized
  interest. On January 1, 2003, the machine was
  put into use. On that date, Rocky estimated that
  it would have a useful life of 10 years and no
  scrap value. In 2004, another 3,000 was spent
  on overhauling the machine. This did not extend
  the life or output of the machine, and was part
  of its regular maintenance.
• After sales declined in early 2006, Rockys
  controller assessed whether the machines value
  was impaired. He estimated that the machine
  would generate net cash flows of 14,000 per year
  for the next 4 years (including 2006), but would
  not generate any future cash flows after that.
  No market existed for the machine. Rockys
  discount rate is 10. Rocky intends to continue
  to use the machine to make pet rocks.
• Show any journal entries that might be required
  for 2006 with respect to the machine.

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Solution

• We need the BV as of January 1, 2006
• 108,000 / 10 10,800 x 3 years (2003 to 2005)
  32,400
• BV 108,000 32,400 75,600
• (note the 3000 expenditure in 2004 is regular
  maintenance, and was charged to expense in 2003)
• Total future net cash flows 14,000 x 4 56,000
• Because 56,000 lt 75,600, there is an impairment
  (move to stage 2)
• No market exists for the machine, so use PV ?
  i10, n4, pmt14,000 ? PV 44,378
• Dr. Impairment Loss (75,600 44,378) 31,222
• Cr. AD machine 31,222
• Dr. Depreciation Expense (44,378 / 4) 11,095
• Cr. AD machine 11,095

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What if

• What if the market improved in 2007, and expected
  future cash flows increased?
• We would do nothing, unless the expected useful
  life of the machine also increased. In that
  case, we would revise our depreciation rate from
  3 years remaining to some new number
• What if a market existed for the machine in 2006,
  and its fair value was 50,000?
• We would have written the machine down to 50,000
  instead of 44,378
• What if Rocky had decided to sell the machine
  instead of continue to use it?
• We would write the machine down to its present
  value less any estimated disposal costs (e.g.,
  fees paid to an auction)
• No more depreciation!
• If a market existed, and its market value
  increased in the future, we could recognize a
  recovery of the loss we recognized in 2006 (but
  we could not increase its book value above the
  original 75,600)

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Depletion Terminology

• Depletion refers to the cost basis write-off of
  natural resources (e.g., coal, oil, timber)
• Note that cost here includes (future)
  restoration costs (e.g., replanting logged areas)
  
• Depletion expense per unit is calculated
• Cost Estimated Salvage Value
• Total Estimated Units Available
• The per unit cost is multiplied by the units
  extracted during a period to derive the depletion
  for the period.

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Oil and Gas A Special Case

• How to you treat dry well costs?
• There are no future benefits from dry wells so
  you could write off all related expenses
  (successful efforts method)
• However, there will always be dry wells dug in
  the process of finding good wells
• So perhaps the cost of dry wells could be
  capitalized and added to the depletion base of
  good wells (full cost)
• Currently, both methods are acceptable