Operational Assets: Depreciation, Impairment, and Depletion of Operational Assets

DEPRECIATION CONCEPTS Depreciation - expiration or consumption of the economic service potential of plant assetsplant assets.

AN ECONOMIC FACT

Depreciation accounting - the systematic andsystematic and rationalrational allocation of the cost of tangible capital assets, less salvage, over the estimated useful life of the asset

AN ACCOUNTING PROCEDURE

– Depreciation accounting is a cost allocation process and is not related to the “market value” of the asset

DEPRECIATION CONCEPTSRelated Areas

Depletion accounting - periodic allocation of the cost of natural resourcesnatural resources against revenue earned.

Amortization accounting - periodic allocation of intangible assetsintangible assets against revenue earned.

DEPRECIATION CONCEPTS

Factors Impacting Computed DepreciationExpense

Asset cost.

Estimated residual value.

Estimated useful life.

Method of depreciation.

(1) Straight-line.

(2) Based on inputs and outputs (Activity).Service hours (SH) method.Productive output (PO) or units-of-production.

(3) Accelerated methods.Sum-of-the-years’-digits (SYD).Declining-balance (normally 200% - DDB).

(4) Tax depreciation.

(5) Depreciation systems.Group and composite.

Retirement and replacement.

DEPRECIATION METHODS

STRAIGHT-LINE (SL)

Annual SLDepreciation

Acquisition cost – Residual value Estimated useful life in years

=

SL

ACTIVITY METHODSInputs and Outputs

Depreciation based upon measures of input or output like. . .– Service hours– Productive output (units-of-production)

No depreciation is taken if the asset is idle.

DepreciationDepreciation Per PeriodPer Period == Depreciation Number of hoursDepreciation Number of hours

Per SH running timePer SH running time××

DepreciationDepreciation Per SHPer SH == Acquisition cost – Residual value Acquisition cost – Residual value

Estimated service life in hoursEstimated service life in hours

Service Hours (SH)

DepreciationDepreciation ExpenseExpense == Depreciation Number of unitsDepreciation Number of units

rate per unit producedrate per unit produced××

Depreciation rateDepreciation rateper unit of outputper unit of output == Acquisition Cost – Residual Value Acquisition Cost – Residual Value

Estimated Productive Output in UnitsEstimated Productive Output in Units

PRODUCTIVE OUTPUT (PO)

Sum-of-the-Years’-Digits

Declining Balance Methods

ACCELERATED DEPRECIATION

SUM-OF-YEARS’-DIGITS

No. of years remainingin useful life

SYDDepreciation

Fraction =

Depreciation perperiod

DepreciationFraction

(Cost - SV)= x

DOUBLE-DECLINING-BALANCE (DDB)

DDB rate = 2 x Straight-line rate(SL Rate = 1/Useful Life(SL Rate = 1/Useful Life

Depr. base = Book value (Cost - Accum. deprAccum. depr.) at beginning of the year

Depr. per period = Depr. rate x Depr. base

For income tax reporting the IRS permits the use of “modified accelerated cost recovery system” (MACRS).

MACRS ignores residual value. Depreciation is based upon percentages related

to the “class life” of the asset.

TAX DEPRECIATION

DEPRECIATION POLICY

If a company expected asset obsolescence,accelerated methods are appropriate.

Many companies use SL for financial reporting and accelerated depreciation for tax reporting.

SL depreciation is the most popular method (about 94% of companies surveyed use SL).

DEPRECIATION POLICY

Depreciation expense is a tax shield because it is a noncash expense that is deductible for income tax purposes.

By lowering our income taxes, depreciation improves our cash flows.

FRACTIONAL-YEAR DEPRECIATION

So far we have assumed that the depreciable asset

was purchased at the beginning of the year.

If the asset is purchased sometime during the year,

we have to adjust annual depreciation.

Depreciation expense.

Balances of major classes of depreciable assets.

Accumulated depreciation by asset or in total.

General description of depreciation methods used.

DEPRECIATION DISCLOSURES

PLANT ASSET IMPAIRMENT Impairment is the loss of a

significant portion of the utility of an asset through casualty, obsolescence or lack of demand for the company’s asset.

When plant assets suffer a permanent impairment in value, a loss should be recorded.

IMPAIRMENT OFLONG-LIVED ASSETS

Background SFAS No. 121 SFAS No. 144

Reporting requirements

Disclosure requirements

IMPAIRMENT OF LONG-LIVED ASSETSAssets to be Held and Used

Reviewed when circumstancescircumstances indicate the carrying value may not be recoverable

Recognition of impairment loss– Required if sum of expected future net cash

flows is less than carrying value of the asset– Evaluated on a “component basis”

Measurement of impairment lossThe amount by which the carrying value of the asset exceeds the fair value of the asset

IMPAIRMENT OF LONG-LIVED ASSETSAssets to be Held and Used -

Continued Presentation of impairment losses

Shown as a component of income fromcontinuing operations before taxes

Restoration of impairment lossesReduced carrying value is basis for futureaccounting and restoration is prohibited

IMPAIRMENT OF LONG-LIVED ASSETS

Disclosure Requirements

Description of impaired assets

Circumstances leading to impairment

Amount of impairment loss

How fair value was determined

Segment in which the impaired asset group is reported – SFAS 131

I guess this boat is about fully depreciated!

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NATURAL RESOURCES

Sometimes referred to as wasting wasting assetsassets.

Supplied by nature and extracted from natural environment.– Gold, oil, timber, coal, and other

minerals. Presented on the balance sheet as

noncurrent assets.

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SFAS No. 19 identifies total costs as including– acquisition costs– exploration costs– development costs– production costs– support equipment and facilities cost.

Total cost is allocated over periods benefited by means of depletiondepletion.

NATURAL RESOURCES

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NATURAL RESOURCESDepletion

Depletion is calculated using theunits-of-production method.

Unit depletion rateUnit depletion rate is calculated as follows:

Estimated Recoverable Units

Capitalized Cost of Residual Natural Resource Value–

The numerator, cost – residual value, is called the depletion base.

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NATURAL RESOURCESTotal depletion cost for a period is:

The unit depletion rate . . .•is inventoried with each extracted unit. •is expensed as a part of cost of goods sold for each unit sold.•remains in inventory with each unsold unit.

UNIT DEPLETION RATE

NUMBER OF UNITSEXTRACTED IN PERIOD×

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NATURAL RESOURCESRestoration Costs

In some cases, the extractor is required to restore the land to its original state subsequent to the resources being extracted.

The estimated cost of restoration increases the depletion base.

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RESTORATION COSTSAssume mine property has a capitalized cost of $4,000,000, estimated recoverable ore of 2,000,000 tons, with 300,000 tons produced in Year 1. If the company must restore the land to its original state after mining at an estimated cost of$1 million, present the entry for production.

Unit depletion rate = ($4,000,000 + $1,000,000) / 2,000,000 tons = $2.50 per ton

Entry: Inventory of ore 750,000* Accum depletion - Mine property 600,000** Estim. Liability for mine restoration 150,000***

*300,000 tons x $2.50**300,000 tons x $2,00***300,000 tons x $.50

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NATURAL RESOURCESChange in Estimate

The unit depletion rate is based on estimated recoverable unitsestimated recoverable units.

Those estimates may change over time. The revised unit depletion rate is

computed for the remaining costs. Prior depletion costs are not revised.

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NATURAL RESOURCESIncome Tax Reporting

The cost-based depletioncost-based depletion method is for financial reporting purposes.

The Internal Revenue Code allows the use of statutory depletionstatutory depletion (also called percentage depletion) for tax purposes.

Use of different methods for tax and financial reporting purposes leads to different incomes.

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EXPLORATION COSTSOil and Gas Industry

The costs of exploration for the oil and gas industry are very large.

An accounting question arises as to how much of the exploration costs can be capitalized.

Two basic methods are allowed when accounting for those costs:– Successful-efforts method– Full-cost method

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EXPLORATION COSTSSuccessful-Efforts Method

Only the exploration costs associated with successful wells are capitalized in the cost of the natural resource.

The costs associated with unsuccessful wells are expensedas incurred.

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EXPLORATION COSTSFull-Cost Method

All exploration costs are capitalized as part of the cost of the natural resource.

This method tends to be used by smaller firms primarily in the exploration business.