Accounting study guide Essay

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Chapter 11: Depreciation, Impairments and Depletion

Depreciation is a means of cost allocation (it isn’t a matter of valuation)
Depreciation: 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
Depletion: the reduction in the cost of natural resources over a period of time
Amortization: the expiration of intangible assets, such as patents and copyrights

Factors involved in the depreciation process
Depreciable base for the asset
Base established for depreciation is a function of original cost and salvage or disposal value
Salvage value: the estimated amount that a company will receive when it sells the asset or removes it from service
Depreciation base = original cost – salvage value
Estimation of service lines
Companies retire assets for two reasons: physical factors (i.e. casualty or expiration of physical life) and economic factors (obsolescence)
Three categories of economic or functional factors
Inadequacy: results when an asset ceases to be useful for a company because the demands of the firm have changed
Supersession: the replacement of one asset with another more efficient and economical asset
Obsolescence: the catchall for situations not involving inadequacy and supersession

Methods of depreciation
Depreciation Methods
Activity method (units of use or production)
Straight-line method
Decreasing-charge method (accelerated):
Sum-of-the years’-digits
Declining-balance method
Special depreciation methods:
Group and composite methods
Hybrid or combination methods
Activity method
Assumes that depreciation is a function of use or productivity, instead of the passage of time
Company considers the life of the asset in terms of output it provides (units it produces) or input measure (i.e. number of hours it works)
Depreciation charge = (cost less salvage value) x hours this year / total estimated hours
Major limitation is that it is inappropriate in situations in which depreciation is a function of time instead of activity
In cases where loss of services results from activity or productivity, the activity method does the best to record expenses in the same period as associated revenues
Straight-line method
Considers depreciation as a function of time rather than a function of usage
Widely used because of simplicity
Depreciation charge = cost less salvage value / estimated service life
Major objection to method from two assumptions
The asset’s economic usefulness is the same each year and
The maintenance and repair expense is essentially the same each period
Another problem with straight-line is that distortions in the rate of return analysis (income/assets) develop
Decreasing-charge methods
Provide for a higher depreciation cost in the earlier years and lower charges in later periods
Allow for higher early-year charges than straight-line depreciation
Sum-of-the-years’-digits: results in a decreasing depreciation charge based on a decreasing fraction of depreciable cost
Numerator is number of years of estimated life remaining as of the beginning of the year
Each fraction uses the sum of the years as a denominator
Declining-balance method: utilizes a depreciation rate (percentage) that is some multiple of the straight-line method
Companies apply the constant rate of the declining book value each year
Does not deduct the salvage value in computing the depreciation base
Double-declining-balance-method: depreciates assets at twice the straight-line rate

Special depreciation methods
Group and composite methods
Companies frequently use the group method when the assets are similar in nature and have approximately the same useful life
They use composite approach when the assets are dissimilar and have different lives
Composite depreciation rate = depreciation per year / total cost of assets
Composite life- the length of time it takes a company to
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