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An electronic presentationAn electronic presentationBy Norman SundermanBy Norman Sundermanand Kenneth Buchananand Kenneth BuchananAngelo State University
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1. Identify the factors involved in depreciation.
2. Explain the alternative methods of cost allocation, including time-based and activity-based methods.
3. Record depreciation.
4. Explain the conceptual issues regarding depreciation methods.
5. Understand the disclosure of depreciation.
6. Understand additional depreciation methods, including group and composite methods.
Objectives
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7. Compute depreciation for partial periods.
8. Explain the impairment of property, plant, and equipment.
9. Understand depreciation for income tax purposes.
10. Explain changes and corrections of depreciation.
11. Understand and record depletion.
Objectives
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Depreciation
Depreciation is the process of allocating the cost of an asset in a
systematic and rational manner over the periods benefited.
Depreciation is the process of allocating the cost of an asset in a
systematic and rational manner over the periods benefited.
Land is not depreciated because it generally does not have a limited life.
Land is not depreciated because it generally does not have a limited life.
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Factors Involved in Depreciation
Asset cost Service life Residual value Method of cost
allocation
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Asset CostAsset Cost
The cost of an asset includes all the acquisition costs a company incurs
to obtain the benefits from the asset.
The cost of an asset includes all the acquisition costs a company incurs
to obtain the benefits from the asset.
Factors Involved in Depreciation
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Service LifeService Life
The service life of an asset is the measure of the service units expected
from the asset before its disposal.
The service life of an asset is the measure of the service units expected
from the asset before its disposal.
Factors Involved in Depreciation
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Service LifeService Life
The factors that limit the service life of an asset can be divided into
two general categories:
The factors that limit the service life of an asset can be divided into
two general categories:
Physical causes Functional causes
Factors Involved in Depreciation
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Residual ValueResidual Value
Residual, or salvage, value is the net amount that can be expected to be obtained when the asset is disposed at the end of its service
life.
Residual, or salvage, value is the net amount that can be expected to be obtained when the asset is disposed at the end of its service
life.
Factors Involved in Depreciation
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Methods of Cost Allocation
Time-based methodsa. Straight-line
b. Accelerated (declining charge)1) Sum-of-the-years’-digits
2) Declining balance
Activity (or use) methods
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Depreciation
Problem Information
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Depreciation Rate =Cost – Residual Value
Service Life
= $120,000 – $20,000
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Time-Based Method: Straight LineTime-Based Method: Straight Line
Methods of Cost Allocation
= $20,000 per year
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Time-Based Method: Sum of the Years’ DigitsTime-Based Method: Sum of the Years’ Digits
Years of service Years of service Year Year remainingremaining atat
Number beginning of yearNumber beginning of year 11 5 5
22 4 4 3 3 3 3 4 4 2 2 5 5 1 1
Sum of the Years’ Digits = Sum of the Years’ Digits = 15 15
Years of service Years of service Year Year remainingremaining atat
Number beginning of yearNumber beginning of year 11 5 5
22 4 4 3 3 3 3 4 4 2 2 5 5 1 1
Sum of the Years’ Digits = Sum of the Years’ Digits = 15 15
Methods of Cost Allocation
n(n + 1) 30 2 2
n(n + 1) 30 2 2
= = 15
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Depreciation Book Value at Year Base Fraction Depreciation Year-End
Depreciation expense for the period Balance of major classes of depreciable assets,
by nature or function, at the balance sheet date Accumulated depreciation, either by major
classes of depreciable assets or in total, at the balance sheet date
A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets
GAAP requires the following:
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Disclosure of Depreciation
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IFRS vs. U.S. GAAP
IFRS require that depreciation be “systematic,” rather than “systematic and rational.”
IFRS also require that the estimated useful lives and residual values, and the depreciation method, be reviewed at least once a year. U.S. GAAP only requires this review when events or circumstances indicate that the estimate has changed.
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IFRS vs. U.S. GAAP
IFRS also require that companies disclose the accumulated depreciation for each class of asset, not just the total amount as allowed by U.S. GAAP.
IFRS require that when an operating asset is made up of individual components that are significant with respect to the total cost of the item (e.g., an airplane and its engines) that the initial cost be allocated to the significant components and each component be depreciated separately.
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IFRS vs. U.S. GAAP
U.S. GAAP neither requires nor prohibits a company from depreciating components.
IFRS allow a company to write up the value of its property, plant, and equipment assets to fair value. Such a write-up would affect the amount of depreciation that the company records each period.
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A company purchased 10
cars for $20,000 each, and the
average expected service
life is 3 years with a residual value of $5,000
each.
Group Depreciation
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To record the purchase:To record the purchase:
Cars 200,000 Cash 200,000
To record the first year’s depreciation expense:To record the first year’s depreciation expense:
Because $2,000,000 is less than $2,600,000 (the book value), an
impairment loss must be recognized.
Because $2,000,000 is less than $2,600,000 (the book value), an
impairment loss must be recognized.
Impairment TestImpairment Test
Impairment of Property, Plant, and Equipment
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Measurement of the LossMeasurement of the Loss
Present value of the expectednet cash flows (fair value) = $400,000 × 3.274294
= $1,309,718 (rounded)
n = 5, i = 0.16 from
Table 4 in the Time Value of Money Module
n = 5, i = 0.16 from
Table 4 in the Time Value of Money Module
Fair value $(1,309,718) Book value 2,600,000Impairment loss $(1,290,282)
Impairment of Property, Plant, and Equipment
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GAAP does not specify how to record the write-down. It does indicate that the
reduced book value is to be accounted for as the new cost.
GAAP does not specify how to record the write-down. It does indicate that the
reduced book value is to be accounted for as the new cost.
Impairment of Property, Plant, and Equipment
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Loss from Impairment 1,290,282Accumulated Depreciation: Factory 200,000Accumulated Depreciation: Machinery 1,200,000Factory (new cost) 327,429Machinery (new cost) 982,289 Factory (old cost)
The recognition of an impairment loss is intended to enhance the usefulness of a
company’s financial statements.
The recognition of an impairment loss is intended to enhance the usefulness of a
company’s financial statements.
All these issues could result in earnings management. For example, management
might prefer to recognize as large a loss as possible, thereby reducing the book value to
the lowest possible amount. This would result in lower depreciation expense and
higher net income in the future.
All these issues could result in earnings management. For example, management
might prefer to recognize as large a loss as possible, thereby reducing the book value to
the lowest possible amount. This would result in lower depreciation expense and
higher net income in the future.
Conceptual Evaluation of Asset Impairment
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IFRS vs. U.S. GAAP
IFRS use a “trigger” value, which is the (1) higher of the asset’s fair value (less costs to sell), or (2) its usage value to determine if an asset is impaired. U.S. GAAP uses undiscounted cash flows.
Typically, this should mean that international companies will recognize impairment losses earlier than U.S. companies. Under IFRS, the impairment loss is the difference between the book value and the “trigger” value defined above.
IFRS allow an impairment loss to be reversed if the value is recovered, which is not allowed under GAAP.
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1. A mandated tax life, which is usually shorter than the economic life
2. Acceleration of the cost recovery (except for buildings)
3. Elimination of the residual value
For assets purchased in 1987 and later, the Modified Accelerated Cost Recovery System (MACRS) is required for tax purposes. A company’s computations of depreciation for income tax purposes and financial reporting purposes differ in three major respects:
Depreciation for Tax Purposes
On January 1, 2009, Melville Company purchased an asset for $200,000. The estimated economic life
and MACRS life are 8 years and 5 years, respectively. The estimated residual value is
$20,000.
On January 1, 2009, Melville Company purchased an asset for $200,000. The estimated economic life
and MACRS life are 8 years and 5 years, respectively. The estimated residual value is
$20,000.
Examine the next slide to determine the annual depreciation rates for 2009
through 2014
Examine the next slide to determine the annual depreciation rates for 2009
through 2014
MACRS Principles
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MACRS Percentages
Determine depreciation for 2009–2014.Determine depreciation for 2009–2014.