Depreciation and Depletion - INTERMEDIATE ACCOUNTING FOR BSA PDF

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CHAPTER 2PROPERTY, PLANT AND EQUIPMENTDEPRECIATION AND DEPLETIONLearning ObjectivesAfter studying this chapter, the student should be able to: Understand depreciation and the methods of computing depreciation. Use straight-line, accelerated, and group methods to compute annual depreciation expense. ...

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CHAPTER 2

PROPERTY, PLANT AND EQUIPMENT DEPRECIATION AND DEPLETION

Learning Objectives After studying this chapter, the student should be able to: 1. Understand depreciation and the methods of computing depreciation. 2. Use straight-line, accelerated, and group methods to compute annual depreciation expense. 3. Apply the productive-output method to depletion of natural resources. 4. Incorporate changes in estimates and methods into the computation of depreciation for current and future periods. 5. Identify whether an asset is impaired, and measure the amount of the impairment loss. 6. Account for the sale of depreciable assets in exchange for cash and in exchange for other depreciable assets. 7. Compute depreciation for partial periods.

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CHAPTER 2 PROPERTY, PLANT AND EQUIPMENT DEPRECIATION AND DEPLETION A fundamental task of accrual accounting is appropriately allocating the cost of long-lived assets to expense. If you are a Phillipine shipmaster setting the price that you will charge for the use of your ship on a spice-trading voyage to any part of the Philippines, you must somehow allocate the cost of the ship over the expected number of voyages the ship can complete. Three different terms are used to describe the process of allocating the cost of long-lived assets to periodic expense. The allocation of tangible property costs is referred to as depreciation.! For minerals and other natural resources, the cost allocation process is called depletion. For intangible assets, such as patents and copyrights, the process is referred to as amortization. This chapter discusses what happens to a long-lived asset after acquisition. The first decision facing management relates to estimating and recognizing the expense associated with a longlived asset’s use. We will cover the common depreciation methods and the depletion of natural resources. We will also address the issues associated with the proper treatment of changes in depreciation estimates. The chapter also describes when an impairment loss should be recognized and the proper accounting for the retirement of depreciable assets. Concept of depreciation Property, plant and equipment, except land, normally are usable for a number of years after which the assets have relatively little value either for service or for sale. The difference between the original cost of a property and any remaining value when it is retired or worn out is an expense that should be distributed to the periods during which the asset is used. The portion that is allocated to expense in a particular period is referred to as depreciation. Depreciation is not a process through which a company accumulates a cash fund to replace its long-lived assets. Instead, depreciation is the systematic allocation of the cost of an asset over the different periods benefited by the use of the asset. Accumulated depreciation is not an asset replacement fund but is the sum of all the asset cost that has been expensed in prior periods. Similarly, the book value of an asset (historical cost less accumulated depreciation) is the asset cost remaining to be allocated to future periods but is not an estimate of the asset’s current value. Depreciation expense is the recognition of the using up of the service potential of an asset. The nature of depreciation expense is conceptually no different from the expenses that recognize the expiration of insurance premiums or prepaid rent; the practical difference is that noncurrent assets are depreciated over several years, whereas prepaid rent is usually expensed over a period of months. Factors Affecting the Periodic Depreciation Charge Four factors are taken into consideration in determining the appropriate amount of annual depreciation expense. ! Asset cost 42

! Residual or salvage value ! Useful life Asset Cost – The cost of an asset includes all the expenditures relating to its acquisition and preparation for use as described in Chapter 1. The cost of property less the expected residual value, if any, is the depreciable cost or depreciation base, that is, the portion of asset cost to be expensed in future periods. Residual or Salvage Value – The residual (salvage) value of property is an estimate of the amount for which the asset can be sold when it is retired. The residual value depends on the retirement policy of the company as well as market conditions and other factors. If, for example, the company normally uses equipment until it is physically exhausted and no longer serviceable, the residual value, represented by the scrap or junk value that can be salvaged, may be quite small. If, however, the company normally replaces its equipment after a short period of use, the residual value, represented by the selling price or trade-in value, may be relatively high. From a theoretical point of view, any estimated residual value should be subtracted from cost in arriving at the portion of asset cost to be charged to depreciation. In practice however, residual values are frequently ignored in determining periodic depreciation charges. This practice is acceptable when residual values are relatively small or are not subject to reasonable estimation. Useful Life – Noncurrent operating assets other than land have a limited useful life as a result of certain physical and functional factors. The physical factors that limit the service life of an asset are (1) wear and tear, (2) deterioration and decay, and (3) damage or destruction. Everyone is familiar with the processes of wear and tear that render an automobile, a building, or furniture no longer usable. A tangible asset, whether used or not, also is subject to deterioration and decay through aging. Finally, fire, flood, earthquake or accident may reduce or terminate the useful life of an asset. The primary functional factor limiting the useful lives of assets is obsolescence. An asset may lose its usefulness when as a result of altered business requirements or technological progress, it no longer can produce sufficient revenue to justify its continued use. Although the asset is still physically usable, its inability to produce sufficient revenue has cut short its economic life. Look aroung: How many old personal computers are stored in corners, still perfectly operational, but unable to run the software that is currently being used? Both physical and functional factors must be considered in estimating the useful life of a depreciable asset. This recognition requires estimating what events will take place in the future and requires careful judgment on the part of the accountant. Physical factors are more readily apparent than functional factors in predicting asset life. When functional factors are expected to hasten the retirement of an asset, these also must be considered. In practice, many companies as a matter of policy dispose of certain classes of assets after a predetermined period without regard to the serviceability of individual assets within a class. Company automobiles, for example, may be replaced routinely every two or three years. The useful life of a depreciable plant asset may be expressed in terms of either an estimated time factor or an estimated use factor. The time factor may be a period of months or years; the use

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factor may be a number of hours of service or a number of units of output. The cost of the asset is allocated in accordance with the lapse of time or extent of use. The rate of cost allocation may be modified by other factors, but basically depreciation must be recognized on a time or use basis. Recording Periodic Depreciation The general form of the journal entry used to recognize depreciation is as follows: Depreciation Expense xxx Accumulated Depreciation xxx In manufacturing operations, depreciation is sometimes charged to a production overhead account and then allocated to the cost of inventory. This merely extends the period of deferral; instead of going straight to an expense account, depreciation goes to inventory and then to expense (Cost of Sales). The allowance account that is credited in recording periodic depreciation is commonly titled Accumulated Depreciation. The accumulation of expired cost in a separate account rather than crediting the asset account directly permits identification of the original cost of the asset and the accumulated depreciation. Companies are required to disclose both cost and accumulated depreciation for plant assets on the balance sheet or in the notes to the financial statements. This enables the user to estimate the relative age of plant assets and provides some basis for predicting future cash outflows for the replacement of plant assets. Depreciation period Depreciation of an asset begins when it is available for use, meaning, when the asset is in the location and condition necessary for it to be a capable of operating in the manner intended by management. Depreciation ceases when the asset is derecognized. Therefore, depreciation does not cease when the asset becomes idle temporarily. Temporary idle activity does not preclude depreciating the asset as future economic benefits are consumed not only through usage but also through wear and tear and obsolescence. Methods of depreciation There are a number of different methods for computing depreciation expense. The depreciation method used in any specific instance is a matter of judgment and, conceptually, should be selected to most closely approximate the actual pattern of use expected from the asset. 1. Equal or uniform charge methods a. Straight line b. Composite method

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c. Group method 2. Variable charge or use-factor or activity methods a. Working hours or service hours b. Output or production method 3. Decreasing charge or accelerated or diminishing balance methods a. Sum of years’ digits b. Declining balance method Straight-line method Straight-line depreciation relates depreciation to the passage of time and recognizes equal depreciation in each year of the life of the asset. The simple assumption behind the straight-line method is that the asset is equally useful during each time period, and depreciation is not affected by asset productivity or efficiency variations. In applying the straight-line method, an estimate is made of the useful life of the asset, and the depreciable asset cost (the difference between the asset cost and residual value) is divided by the useful life of the asset in arriving at the periodic depreciation amount. The formula for the computation of the annual depreciation following the straight line method is as follows:

Annual depreciation =

Cost minus residual value -----------------------------------------Useful life in years

Cost minus residual value equals depreciable amount. Depreciable amount multiplied by the annual straight line rate of depreciation also gives the amount of annual depreciation. The straight line rate is determined by dividing 100% by the life of the asset in years. For example, if the useful life of the asset is 5 years, the annual straight line rate is 20%, computed by dividing 100% by 5 years. Examples of assets which depreciate principally because of passage of time are buildings, radio and tv towers, bridges, equipments, machineries, computers. Illustration The following data relate to a machinery acquired on January 1, 2016: Machinery

100,000

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Residual value Useful life

5,000 5 years

A table summarizing annual depreciation for the entire life of the asset, using the straight-line method, follows.

End of Year

Computation

2016 2017 2018 2019 2020

95,000 / 5 95,000 / 5 95,000 / 5 95,000 / 5 95,000 / 5

(a) Depreciation Amount

P19,000 19,000 19,000 19,000 19,000 P95,000

(b) Accumulated Depreciation

P19,000 38,000 57,000 76,000 95,000

(c) Asset Book Value P100,000 81,000 62,000 43,000 24,000 5,000

(a) Depreciable amount of P95,000 divided by 5 years equals P19,000 or the annual rate of 20% multiplied by P95,000 equals P19,000. (b) Preceding balance of accumulated depreciation plus column (a). Thus, the accumulated depreciation at the end of the second year is equal to P19,000 (preceding balance, end of first year) plus the depreciation for the second year, P19,000, equals P38,000. (c) Acquisition cost of P100,000 minus column (b). Thus, at the end of the first year, P100,000 minus accumulated depreciation balance of P19,000 equals P81,000; at the end of the second year, P100,000 minus P38,000 equals P62,000, and so on. At the end of the useful life of the asset, the carrying amount should equal the residual value. When assets are acquired or disposed of in the middle of a year, depreciation for the partial year should be recognized. Group and Composite Methods It was assumed in preceding discussions that depreciation expense is associated with individual assets and is applied to each separate unit. This practice is called unit depreciation. From a practical standpoint, it often makes sense to compute depreciation for an entire group of assets as if the group were one asset. Group cost allocation procedures are referred to as group depreciation when the assets in the group are similar (e.g., all of a companys delivery vans) and composite depreciation when the assets in the group are related but dissimilar (e.g., all of a company’s desks, chairs, and computers). The group depreciation procedure treats a collection of assets as a single group. Depreciation is accumulated in a single account, and the depreciation rate is based on the average life of assets in

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the group. Group depreciation is generally computed as an adaptation of the straight-line method, and the illustrations in this chapter assume this approach. Accounting procedures a. Depreciation is reported in a single accumulated depreciation account. Thus, the accumulated depreciation account is not related to any specific asset account. b. The composite or group rate is multiplied by the total cost of the assets in the group to get the periodic depreciation. c. When an asset in the group is retired, no gain or loss is reported. The asset account is credited for the cost of the asset retired and the accumulated depreciation account is debited for the cost minus salvage proceeds. d. When the asset retired is replaced by a similar asset, the replacement is recorded by debiting the asset account and crediting cash or other appropriate account. Subsequently the composite or group rate is multiplied by the balance of the asset account to get the periodic depreciation. Composite method The following computation is necessary in determining the composite life and composite rate: (a) (b) (a ÷ b) Residual Depreciable Estimate Life Annual Depreciation Asset Cost Value Cost in Years Expense (Straight-Line) A P20,000 P1,200 P18,800 4 P4,700 B 60,000 3,000 57,000 6 9,500 C 120,000 12,000 108,000 10 10,800 P200,000 P16,200 P183,800 P25,000 The composite life is determined by dividing the total depreciable amount by total annual depreciation. Thus, P183,800 divided by P25,000 equals 7.352 years. The composite rate is determined by dividing the total annual depreciation by the total cost. Thus, P25,000 divided by P200,000 equals 12.5% composite rate. All of the assets in the group are acquired at the beginning of current year. The annual depreciation for the current year is recorded as follows: Depreciation Expense Accumulated depreciation

25,000 25,000

The accumulated depreciation account is not related to any specific asset account in the group.

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Thus, a statement of financial position prepared at the current year-end would report the property, plant and equipment as follows: Asset A Asset B Asset C Total Accumulated depreciation Carrying amount

20,000 60,000 120,000 200,000 (25,000) P175,000

If Asset A is retired after four years and sold for P2,000, the journal entry is: Cash Accumulated depreciation Asset A

2,000 18,000 20,000

If there are no proceeds from the retirement of Asset A, the journal entry is: Accumulated depreciation Asset A

20,000 20,000

After the retirement of Asset A, the remaining cost of the assets in group is P180,000 (P200,000 minus P20,000). Consequently, the annual depreciation is no longer P25,000. The annual depreciation starting the fifth year would be P22,500, computed by multiplying the composite rate of 12.5% by the remaining cost of P180,000, Upon the retirement of Asset A, the same is replaced by a similar asset costing P30,000. Thus, the total cost of the assets in the group is now P210,000. Accordingly the annual depreciation starting the fifth year should be 12.5% times P210,000 or P26,250. Depreciation shall be discontinued when the same would result to a carrying amount of the assets in the group which is below the residual value of the assets in the group. Group method Bhuddy Corporation purchased 100 similar equipments on January 1, 2016 at a total cost of P2,000,000 or at an average cost of P20,000 per equipment. The equipment have an average useful life of 5 years or an annual depreciation rate of 20%. The equipments are retired as follows

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Date December 31, 2019 December 31, 2020 December 31, 2021

Number of equipment

Salvage proceeds

30 40 30

None 20,000 40,000

The journal entries to record the depreciation and retirement of the equipments are: 2016 Depreciation Accumulated depreciation

400,000

2017 Depreciation Accumulated depreciation

400,000

2018 Depreciation Accumulated depreciation

400,000

2019 Depreciation Accumulated depreciation

400,000

400,000

400,000

400,000

400,000

Accumulated depreciation 600,000 Equipments Retirement of 30 equipments. 2020 Depreciation 280,000 Accumulated depreciation Depreciation on remaining 70 equipments costing P1,400,000 at an annual rate of P20%. Cash 20,000 Accumulated depreciation 780,000 Equipments Retirement of 40 equipments 2021 Depreciation Accumulated depreciation

600,000

280,000

800,000

60,000 60,000

Cash 40,000 Accumulated depreciation 560,000 Equipments 600,000 To record the retirement of 30 equipments. Carrying amount Salvage proceeds

P100,000 (40,000)

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Depreciation for 2021

P60,000

Depreciation should be limited to the remaining carrying amount of the asset reduced by salvage proceeds, if any. Variable charge or use-factor or activity methods Use-factor depreciation methods view asset exhaustion as related primarily to asset use or output and provide periodic charges varying with the degree of such service. Service life for certain assets can best be expressed in terms of hours or service but for others in terms of units of production. Service-hours depreciation Service-hours depreciation is based on the theory that the purchase of an asset represents the purchase of a number of hours of direct service. This method requires an estimate of the life of the asset in terms of service hours. Depreciable cost is divided by total service hours in arriving at the depreciation rate to be assigned for each hour of asset use. The use of the asset during the period is measured, and the number of service hours is multiplied by the depreciation rate in arriving at the periodic depreciation charge. Depreciation charges against revenue fluctuate periodically according to how much the asset is used. Illustration The following data relate to a machinery acquired on January 1, 2016: Machinery Residual value Useful life in years Service life

100,000 5,000 5 years 20,000 hours

The rate to be applied for each service hour is determined as follows: C–R Rate (per hour) = n

End of Year 2016 2017 2018 2019 2020

P100,000 – P5,000 or

= P4.75 per hour 20,000 hours

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