CHAPTER 2

Depreciation and Depletion

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 Depreciation—
Depreciation—Method of Cost Allocation

Depreciation is the accounting process of allocating the cost of

tangible assets to expense in a systematic and rational manner
to those periods expected to benefit from the use of the asset.

Allocating costs of long-lived assets:

Fixed assets = Depreciation expense

Intangibles = Amortization expense

Mineral resources = Depletion expense

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 Depreciation—
Depreciation—Cost Allocation

Factors Involved in the Depreciation Process

Three basic questions:
1. What depreciable base is to be used?
Depreciable Base=Cost-Residual Value
1. What is the asset’s useful life?
2. What method of cost apportionment is best?

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 Factors Involved in Depreciation Process

Estimation of Service Lives

Service life often differs from physical life.

Companies retire assets for two reasons:
1. Physical factors (casualty or expiration of physical life).

2. Economic factors

 inadequacy:
inadequacy: results when an asset ceases to be useful to
a company because the demands of the firm have
changed,
changed

 Supersession:
Supersession: is the replacement of one asset with
another more efficient and economical asset,
asset and

 Obsolescence:
Obsolescence is the catchall for situations not involving
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inadequacy and supersession.
 Depreciation—
Depreciation—Cost Allocation

Methods of Depreciation
The profession requires the method employed be “systematic
and rational.” Methods used include:

1. Activity method (units of use or production).

2. Straight-line method.

3. Diminishing (accelerated)-charge methods:

a) Sum-of-the-years’-digits.

b) Declining-balance method.

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 Methods of Depreciation

Activity Method ILLUSTRATION 11- 11-2

Data Used to Illustrate
Depreciation Methods

Data for
Stanley Coal
Mines

Illustration: If Stanley uses the crane for 4,000 hours the first
year, the depreciation charge is:

ILLUSTRATION 11-11-3
Depreciation Calculation,
Activity Method—Crane
Example

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 Methods of Depreciation

Straight-
Straight-Line Method ILLUSTRATION 11- 11-2
Data Used to Illustrate
Depreciation Methods

Data for
Stanley Coal
Mines

Illustration: Stanley computes depreciation as follows:

ILLUSTRATION 11-11-4
Depreciation Calculation,
Straight-Line Method—
Crane Example

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 Methods of Depreciation

Diminishing-
Diminishing-Charge Methods ILLUSTRATION 11- 11-2
Data Used to Illustrate
Depreciation Methods

Data for
Stanley Coal
Mines

Sum-
Sum-of-
of-the-
the-Years’-
Years’-Digits. Each fraction uses the sum of the years
as a denominator (5 + 4 + 3 + 2 + 1 = 15). The numerator is the
number of years of estimated life remaining as of the beginning of
the year.

Alternate sum-
sum-of-
of-the-
the- n(n+1) 5(5+1)
= = 15
years’ calculation 2 2
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 Methods of Depreciation

Sum-
Sum-of-
of-the-
the-Years’-
Years’-Digits

ILLUSTRATION 11-11-6
Sum-of-the-Years’-Digits
Depreciation Schedule—
Crane Example

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 Methods of Depreciation

Diminishing-
Diminishing-Charge Methods ILLUSTRATION 11- 11-2
Data Used to Illustrate
Depreciation Methods

Data for
Stanley Coal
Mines

Declining-
Declining-Balance Method.

Utilizes a depreciation rate (percentage) that is some multiple
of the straight-line method.

Does not deduct the salvage value in computing the

depreciation base.

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 Methods of Depreciation

Declining-
Declining-Balance Method

ILLUSTRATION 11-11-7
Double-Declining
Depreciation Schedule—
Crane Example

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 Component Depreciation

IFRS requires that each part of an item of property, plant,

and equipment that is significant to the total cost of the
asset must be depreciated separately.
Illustration: EuroAsia Airlines purchases an airplane for
€100,000,000 on January 1, 2016. The airplane has a useful life
of 20 years and a residual value of €0. EuroAsia uses the straight-
line method of depreciation for all its airplanes. EuroAsia identifies
the following components, amounts, and useful lives.

ILLUSTRATION 11-
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Airplane Components
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 Component Depreciation

Computation of depreciation expense for

EuroAsia for 2016. ILLUSTRATION 11-
Computation of
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Component Depreciation

Depreciation journal entry for 2016.

Depreciation Expense 8,600,000
Accumulated Depreciation—Airplane 8,600,000

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 Component Depreciation

On the statement of financial position at the end of 2016,

EuroAsia reports the airplane as a single amount.

ILLUSTRATION 11- 11-10

Presentation of Carrying
Amount of Airplane

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 Methods of Depreciation
Special Depreciation Methods
Companies often depreciate multiple-asset accounts using one
rate. For example, A Company might depreciate telephone poles,
microwave systems, or switchboards by groups.
The choice of method depends on the nature of the assets
involved:
Group method used when the assets are similar in nature and
have approximately the same useful lives.
Composite approach used when the assets are dissimilar and
have different lives.
Companies are also free to develop tailor-made depreciation
methods, provided the method results in the allocation of an
asset’s cost in a systematic and rational manner (Hybrid or
Combination Methods).
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 Group and Composite Depreciation
The computation for group or composite methods is essentially
the same: find an average and depreciate on that basis.
Companies determine the composite depreciation rate by dividing
the depreciation per year by the total cost of the assets.
Illustration: Money Motors establishes the composite depreciation
rate for its fleet of cars, trucks, and campers as shown in the
following illustration:

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 Group and Composite Depreciation

If there are no changes in the asset account, Money will depreciate

the group of assets to the residual or salvage value at the rate of
$56,000 ($224,000 x 25%) a year. As a result, it will take Mooney 3.39
years to depreciate these assets.
The length of time it takes a company to depreciate it assets on a
composite basis is called the composite life.
If Money retires an asset before, or after, the average service life of
the group is reached, it buries the resulting gain or loss in the
Accumulated Depreciation account. This practice is justified because
Money will retire some assets before the average service life and
others after the average life. For this reason, the debit to
Accumulated Depreciation is the difference between original cost and
cash received. Mooney does not record a gain or loss on disposition.
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 Group and Composite Depreciation

To illustrate, suppose that Mooney Motors sold one of the campers

with a cost of $5,000 for $2,600 at the end of the third year. The
entry is:
Accumulated Depreciation 2,400
Cash 2,600
Cars, Trucks, and Campers 5,000
If Money purchases a new type of asset (mopeds, for example),
it must compute a new depreciation rate and apply this rate in
subsequent periods.

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 Depreciation—
Depreciation—Cost Allocation

Special Depreciation Issues

1. How should companies compute depreciation for partial
periods?
periods

Companies determine the depreciation expense for
the full year and then

prorate this depreciation expense between the two

periods involved.

This process should continue throughout the useful life of

the asset.

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 Depreciation and Partial Periods

Illustration—
Illustration—(Four Methods): Maserati Corporation purchased a new
machine for its assembly process on August 1, 2015. The cost of this
machine was €150,000. The company estimated that the machine
would have a salvage value of €24,000 at the end of its service life.
Its life is estimated at 5 years and its working hours are estimated at
21,000 hours. Year-end is December 31.

Instructions: Compute the depreciation expense under the following

methods.
(a) Straight-line depreciation. (c) Sum-of-the-years’-digits.
(b) Activity method (d) Double-declining balance.

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 Depreciation and Partial Periods

Straight-
Straight-line Method
Current
Depreciable Annual Partial Year Accum.
Year Base Years Expense Year Expense Deprec.
2015 € 126,000 / 5 = $ 25,200 x 5/12 = € 10,500 $ 10,500
2016 126,000 / 5 = 25,200 25,200 35,700
2017 126,000 / 5 = 25,200 25,200 60,900
2018 126,000 / 5 = 25,200 25,200 86,100
2019 126,000 / 5 = 25,200 25,200 111,300
2020 126,000 / 5 = 25,200 x 7/12 = 14,700 126,000
€ 126,000
Journal entry:

2015 Depreciation expense 10,500

Accumultated depreciation 10,500

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 Depreciation and Partial Periods

Activity Method (Assume 800 hours used in 2015)

(€126,000 / 21,000 hours = €6 per hour)
(Given) Current
Hours Rate per Annual Partial Year Accum.
Year Used Hours Expense Year Expense Deprec.
2015 800 x $6 = € 4,800 € 4,800 € 4,800
2016 x =
2017 x =
2018 x =
2019 x =
800 € 4,800

Journal entry:
2015 Depreciation expense 4,800
Accumultated depreciation 4,800

11-22 Advance slide in presentation mode to reveal answer.

 Depreciation and Partial Periods

5/12 = .416667
Sum-
Sum-of-
of-the-
the-Years’-
Years’-Digits Method 7/12 = .583333
Current
Depreciable Annual Partial Year Accum.
Year Base Years Expense Year Expense Deprec.

2015 € 126,000 x 5/15 = 42,000 x 5/12 € 17,500 € 17,500

2016 126,000 x 4.58/15 = 38,500 38,500 56,000

2017 126,000 x 3.58/15 = 30,100 30,100 86,100

2018 126,000 x 2.58/15 = 21,700 21,700 107,800

2019 126,000 x 1.58/15 = 13,300 13,300 121,100

2020 126,000 x .58/15 = 4,900 4,900 126,000

€ 126,000
Journal entry:
2015 Depreciation expense 17,500
Accumultated depreciation 17,500
Advance slide in presentation mode to reveal answer.
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 Depreciation and Partial Periods

Double-
Double-Declining Balance Method
Current
Depreciable Rate Annual Partial Year
Year Base per Year Expense Year Expense

2015 € 150,000 x 40% = € 60,000 x 5/12 = € 25,000

2016 125,000 x 40% = 50,000 50,000

2017 75,000 x 40% = 30,000 30,000

2018 45,000 x 40% = 18,000 18,000

2019 27,000 x 40% = 10,800 Plug 3,000

€ 126,000
Journal entry:
2015 Depreciation expense 25,000
Accumultated depreciation 25,000
11-24 Advance slide in presentation mode to reveal answer.
 Depreciation—
Depreciation—Cost Allocation

Special Depreciation Issues

2. Does depreciation provide for the replacement of assets?
assets

Does not involve a current cash outflow.

Funds for the replacement of the assets come from the
revenues.
3. How should companies handle revisions in depreciation
rates?
rates

Accounted for in the current and prospective periods

Not handled retrospectively

Not considered errors or extraordinary items

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 Revision of Depreciation Rates

Arcadia HS, purchased equipment for $510,000 which was estimated to

have a useful life of 10 years with a residual value of $10,000 at the end
of that time. Depreciation has been recorded for 7 years on a straight-
line basis. In 2015 (year 8), it is determined that the total estimated life
should be 15 years with a residual value of $5,000 at the end of that
time.

Questions:
 What is the journal entry to correct No Entry
the prior years’ depreciation? Required

 Calculate the depreciation expense

for 2015.
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 After 7
Revision of Depreciation Rates years

Equipment cost $510,000 First, establish NBV

Salvage value - 10,000 at date of change in
Depreciable base 500,000 estimate.
Useful life (original) 10 years
Annual depreciation $ 50,000 x 7 years = $350,000

Balance Sheet (Dec. 31, 2014)

Equipment $510,000
Accumulated depreciation 350,000
Net book value (NBV) $160,000

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 After 7
Revision of Depreciation Rates years

Net book value $160,000 Depreciation

Salvage value (new) 5,000 Expense calculation
Depreciable base 155,000 for 2015.
Useful life remaining 8 years
Annual depreciation $ 19,375

Journal entry for 2015

Depreciation Expense 19,375

Accumulated Depreciation 19,375

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 Depletion-
Depletion-Natural Resources

Natural resources, often called wasting assets can be

divided into two categories:

1. Biological assets (timberlands)

2. Mineral resources (oil, gas, and mineral mining).
They have two main features:
1. complete removal (consumption) of the asset, and
2. replacement of the asset only by an act of nature.
Depletion - process of allocating the cost of natural
resources.
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 Depletion-
Depletion-Natural Resources

Establishing a Depletion Base

Computation of the depletion base involves four factors:
1. Acquisition cost (The amount paid to obtain the property
right to search and find an undiscovered natural resource. It
also includes the price paid for an already discovered
resource.)

2. Exploration costs (the cost incurred to find the resource)

3. Development costs
• Tangible Costs: Include all of the transportation and other
heavy equipment needed to extract the resource and get it
ready for market (depreciation expense).
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 Depletion-
Depletion-Natural Resources

 Intangible costs: drilling costs, tunnels, shafts, and wells.

These costs have no tangible characteristics but are
needed for the production of the natural resource.
Intangible development costs are considered part of the
depletion base.

4. Restoration costs: The costs incurred to restore property

to its natural state after extraction has occurred.
Companies consider restoration costs part of the
depletion base.

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 Depletion

Write-off of Resource Cost

Normally, companies compute depletion on a units-of-
production method (activity approach). Depletion is a function
of the number of units extracted during the period.

Calculation:

Total Cost – Residual value

= Depletion Cost Per Unit
Total Estimated Units Available

Units Extracted x Cost Per Unit = Depletion

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 Depletion

Illustration: MaClede Co. acquired the right to use 1,000 acres of

land in South Africa to mine for silver. The lease cost is €50,000,
and the related exploration costs on the property are €100,000.
Intangible development costs incurred in opening the mine are
€850,000. MaClede estimates that the mine will provide
approximately 100,000 ounces of gold. ILLUSTRATION 11-
11-19
Computation of Depletion Rate

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 Depletion

If MaClede extracts 25,000 ounces in the first year, then the

depletion for the year is €250,000 (25,000 ounces x €10).
Inventory 250,000
Accumulated Depletion 250,000

ILLUSTRATION 11- 11-20

MaClede’s statement of financial position: Statement of Financial Position
Presentation of Mineral Resource

Depletion cost related to inventory sold is part of cost of goods sold.

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 Depletion-
Depletion-Natural Resources

Depletion Computations—Timber: Stanislaw Timber Company

owns 9,000 acres of timberland purchased in 1996 at a cost of
$1,400 per acre. At the time of purchase the land without the timber
was valued at $400 per acre. In 1997, Stanislaw built fire lanes and
roads, with a life of 30 years, at a cost of $84,000. Every year
Stanislaw sprays to prevent disease at a cost of $3,000 per year and
spends $7,000 to maintain the fire lanes and roads. During 1998,
Stanislaw selectively logged and sold 700,000 board feet of timber,
of the estimated 3,500,000 board feet. In 1999, Stanislaw planted
new seedlings to replace the trees cut at a cost of $100,000.
Instructions: Determine the depreciation expense and the cost of
timber sold related to depletion for 1998.

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 Depletion-
Depletion-Natural Resources
Depletion Computations—Timber
Depletion:
Cost of timberland per acre $ 1,400
Cost of land per acre (400)
Cost of timber only per acre $ 1,000
Total acres 9,000
Value of timber $ 9,000,000
Estimated total board feet 3,500,000
Cost per board foot $ 2.57
Board feet of timber sold 700,000
Cost of timber sold related to depletion $ 1,800,000

Depreciation Expense: Fire lanes and roads

Fire lanes and roads $ 84,000
Useful life 30
Depreciation expense per year $ 2,800
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 Depletion-
Depletion-Natural Resources
Revising Estimation of Recoverable Reserves
 Sometimes companies need to change the estimate
of recoverable reserves either because they have
new information or because more sophisticated
production processes are available.
 It involves same as accounting for changes in
estimates for the useful lives of plant and
equipment.
 The procedure is to revise the depletion rate on a
prospective basis: A company divides the remaining
cost by the new estimate of the recoverable
reserves.
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 Presentation of PPE & Natural Resources

Presentation of Property, Plant, Equipment, and Mineral

Resources

Depreciating assets, use Accumulated Depreciation.

Depleting assets may include use of Accumulated Depletion

account, or the direct reduction of asset.

Disclosures Basis of valuation (usually cost)

Pledges, liens, and other commitments

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