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CHAPTER 11

Depreciation and Depletion

Introduction: Chapter 11 presents a discussion of depreciation and depletion.

Depreciation refers to the decline in value of tangible plant assets. Depletion is the termused to describe the decline in natural resources such as timber, oil, or coal. Amortizationis the term used to describe the expiration of intangible assets which will be discussed inChapter 12.

Part I. Depreciation

1. Depreciation

Depreciation is the accounting process of allocating the cost of tangible assets toexpense in a systematic and rational manner to those periods expected to benefitfrom the use of the asset. Depreciation is not a valuation process.

Justification of the cost allocation approach instead of valuation:o Matching principle

o Reliability of information

Factors to be considered for computing depreciation:

o The depreciable base (depreciable cost) to be used for the asset. The

depreciable cost is the difference between an asset's cost and its salvagevalue. Salvage value is the estimated amount that will be received at thetime the asset is sold or removed from service.

o The asset's useful life. The useful life (service life) of a plant asset refers

to the number of years that asset is capable of economically providing theservice it was purchased to perform. The service life of an asset should notbe confused with its physical life.

o The depreciation method to be used.

2. Depreciation Methods

The depreciation method selected for a particular asset should be systematic andrational. Commonly used depreciation methods include:

o Activity method: Assumes that depreciation is a function of use.

o Straight-line method: Assumes that an assets usefulness is the same each year.

Its simple and widely used.

o Sum-of-the-years'-digits (SYD): Assumes that the asset is more efficient in the

earlier years, and therefore more depreciation should be charged in those years. It

requires the multiplication of the depreciable cost by a fraction, which uses the sumof the years digits as denominator and the remaining life as of the beginning of theyear as the numerator.

o Declining-balance method (DB): Same assumption as SYD. The computation is

based on the remaining book value (cost minus accumulated depreciation) insteadof depreciable cost. Salvage value is ignored initially.

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3. Special Depreciation Methods

o Inventory method: Used to value small assets such as hand tools. Depreciation

expense is computed in a way similar to that of CGS.

o Retirement and Replacement methods: Used to depreciate numerous

interchangeable items that have small unit value, such as utility poles and railroadties.

o The retirement method charges the cost of the retired asset (less salvage

value) to depreciation expense.

o The replacement method charges the cost of replacement units purchased

(less salvage value) to depreciation expense.

o The retirement method is equivalent to a FIFO cost flow assumption; the

replacement method is equivalent to a LIFO cost flow assumption.

o Group and Composite methods: Group methods are used for similar assets.

Composite methods are used for dissimilar assets. When an asset is retired, anyresulting loss or gain is charged (or credited) to the accumulated depreciationaccount. That is, no gain or loss is recognized on disposition of any unit. Thedifference between the sales price and the unit's cost is recorded to Accumulated

Depreciation.

4. Other Depreciation Related Issues

4.1. Fractional year depreciationo Compute depreciation expense based on the time the asset was actually used.

o Depreciate for a full-year the first year, and no depreciation the year of disposal.

o No depreciation for the first year, and depreciate a full year for the year of disposal.

o Half-year convention: depreciate for half a year the first year, and for half a year the

last year.

4.2. Changes in depreciation computationo Due to changes in depreciation methods discussed in a later chapter.

o Due to changes in estimates and/or capital expenditures

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5. Disclosures

The basis for valuing property, plant, equipment, and natural resources, which is normallyhistorical cost, should be disclosed in the financial statements along with any pledges,liens, and other commitments related to these assets. Normally, assets not used in aproductive capacity (held for future use or as an investment) should be segregated fromassets used in operations and classified as "Other Assets." Financial statementdisclosures related to depreciation include:

a. Depreciation expense for the period.b. Balances of major classes of depreciable assets, by nature and function.c. Accumulated depreciation, either by major classes of depreciable assets or

in total.d. A general description of the method or methods used in computing

depreciation with respect to major classes of depreciable assets.

6. Income Tax Depreciation

oFor assets acquired before 1981, depreciation for income tax purposes is based on

straight-line, sum-of-the-years'-digits, and declining-balance methods.oFor assets purchased in the years 1981 through 1986 the Accelerated Cost Recovery

System (ACRS) of depreciation is used.

oFor depreciable assets placed in service in 1987 and later, A Modified AcceleratedCost Recovery System, known as MACRS, which was enacted by Congress in the

Tax Reform Act of 1986, is used.o Three major differences exist between the computation of depreciation under

MACRS and GAAP: A mandated tax life, which is generally shorter than the economic life.

MACRS assigns assets to property classes which indicate thedepreciable tax life of the assets in each class. The depreciable taxlives range from 3-year property to 31.5-year property.

Cost recovery on an accelerated basis, and An assigned salvage value of zero.

7. Impairments of Plant Assets

The process to determine an impairment loss iso Review events for possible impairment,

o If events suggest impairment, determine if the sum of the expected future

net cash flows is less than the carrying amount, if so, theno The loss is the amount by which the carrying amount of the asset is greater

than the fair value of the asset.o If an impaired asset is expected to be disposed of, it should be recorded at

the lower of cost or net realizable value, and it is not depreciated.o If an asset is considered long-lived, the reduced carrying amount is now

considered its new cost basis and no write-up is allowed.o If an impaired asset is held for disposal, it can be written up or down as long

as the write-up is never greater than the carrying amount of asset at the timeof the original impairment.

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Part II. Natural Resources and Depletion

1. Cost of natural resources

o Cost of natural resources should include acquisition costs, exploration costs, and

development costs. Tangible assets used in extracting natural resources arenormally set up in a separate account and depreciated individually.

2. Depletion of natural resources

oCost to be depleted: the depletion base for natural resources includes acquisition

costs, exploration costs, development costs, and restoration costs reducedby any residual value related to the land.

oDepletion method: Depletion is normally based on the number of units extracted

during the period, which corresponds to the activity depreciation method discussedearlier.

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3. Special issues related to natural resources

oAccounting for exploration costs for oil and gas companies: Successful efforts

approach v. full costing approach.

oDiscovery value accounting (and reserve recognition accounting): Discovery

value is generally not recognized in accounts.

oThe tax law has long provided a deduction for the greater of cost or percentage

depletion against income from oil, gas, and most minerals. The percentage orstatutory depletion allows a write-off ranging from 5% to 22% (depending on thenatural resource) of gross revenue received. As a result, the amount of depletionmay exceed the investment cost that is assigned to a given natural resource.

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