THE DEWOSKIN COMPANY Machinery and Equipment Acquisitions
2. Small oil companies generally prefer the full-cost method because it results in higher asset values on the balance sheet and delaying the recognition of
CHAPTER 10
DEPRECIATION AND DEPLETION
CONTENT ANALYSIS OF EXERCISES AND PROBLEMS
Number Content
Time Range (minutes) E10-1 Depreciation Methods. Straight-line, hours worked, units of
output.
5-10
E10-2 Depreciation Methods. Straight-line, sum-of-the-years'-digits, double-declining balance. Return on assets.
5-10
E10-3 Acquisition Cost and Depreciation. Computation of acquisition cost and annual depreciation under units of production and sum-of-the-years'-digits methods.
10-15
E10-4 Depreciation Methods. Recognition of method used given the
expense. Computation of expense. 5-10
E10-5 Rate of Return. Determination under straight-line and double-
declining balance methods. 5-10
E10-6 Acquisition Cost. Computation under straight-line, sum-of-the-
years'-digits, and double-declining-balance methods. 5-10 E10-7 Group Depreciation. Straight-line. Journal entries to record
transactions. 5-15
E10-8 Composite Depreciation. Straight-line. Journal entries to
record transactions. 5-15
E10-9 Retirement/Replacement Methods. Journal entries to record
transactions. 5-10
E10-10 (AICPA adapted). Depreciation. Determination of amount to be capitalized and expensed.
10-15
E10-11 Partial Periods. Straight-line to nearest day, to nearest month, to nearest whole year, to one-half year.
10-15
E10-12 Asset Impairment. Determine if asset impaired. Compute impairment loss. Journal entry.
15-20
E10-13 Depreciation. Financial statements, income taxes, straight-line,
double-declining balance, ACRS. 15-20
Number Content
Time Range (minutes) E10-14 Changes and Corrections. Straight-line to sum-of-the-years'-
digits. Increased asset life. Residual value ignored. Journal entries.
15-20
E10-15 (AICPA adapted). Change in Depreciation Method. Compute book value under straight-line depreciation and effect of switch to sum-of-years'-digits method.
15-20
E10-16 Depletion. Determination of depletion cost per unit, inventory cost, and cost of goods sold.
10-15
E10-17 (AICPA adapted). Depletion. Expense determination. 5-10 P10-1 Depreciation Methods. Straight-line, hours worked, units of
output, sum-of-the-years'-digits, double-declining-balance, 150% declining-balance. Return on assets.
20-25
P10-2 Depreciation Methods. Straight-line, hours worked, units of output.
15-20
P10-3 Depreciation Methods. Straight-line, sum-of-the-years'-digits, double-declining-balance, 150% declining-balance. Return on assets.
20-25
P10-4 Declining Balance. Fixed percentage. Computation of
depreciation rate and yearly deduction. 10-15
P10-5 Changing Depreciation. Double-declining-balance to straight-
line at varying points in asset's life. 20-30
P10-6 Cost of Asset. 150% declining-balance. Determination of
acquisition cost and depreciation expense. 10-20
P10-7 Partial Periods. Depreciation computed to one-half year.
Journal entries to record depreciation and sale. 20-30 P10-8 Group and Composite Depreciation. Straight-line. Journal
entries to record various transactions (depreciation, retirement).
30-40
P10-9 Composite Depreciation. Straight-line. Journal entries to record various transactions (depreciation, acquisition, retirement).
15-20
P10-10 Asset Impairment. Determine if asset impaired. Compute impairment loss. Journal entry. Effects of changed assumptions.
20-30
P10-11 Depreciation and Income Taxes. Straight-line and ACRS.
Prepare income statements for financial reporting and income tax purposes.
20-30
Number Content
Time Range (minutes) P10-12 Depletion. FIFO. Calculation of depletion amount in ending
inventory and the income statement. Balance sheet preparation.
20-30
P10-13 Depletion. FIFO. Calculation of expense and cost of inventory.
Recalculation of per unit amount and expense. 20-30 P10-14 Changes and Corrections. Double-declining-balance to
straight-line. Change in service life. Residual value included in depreciation computation. Journal entries.
20-30
P10-15 (AICPA adapted). Adjusting Entries. Straight-line depreciation to one-half year. Construction, donation, parking lot. Journal entries.
40-60
P10-16 Comprehensive: Various Issues. Journal entries to record various transactions. Determination of account balances.
Includes topics from Chapter 8.
40-60
P10-17 (AICPA adapted). Comprehensive: Capitalized Costs and Depreciation. Prepare schedules to determine land and building costs, and depreciation expense.
30-40
P10-18 (AICPA adapted). Comprehensive: Depreciation. Completion of the fixed asset and depreciation schedule. Acquisition, exchange, construction, donation, sale.
40-60
P10-19 Errors. Calculate increase or decrease in prior four years earnings resulting from errors. Group depreciation. Sale, exchange, acquisition, retirement. Journal entry to correct the books.
40-60
P10-20 (AICPA adapted). Comprehensive: Depreciation and PPE.
Schedules for depreciation and amortization expense,
accumulated depreciation and amortization, and gain or loss from disposal. Balance sheet disclosure.
40-60
P10-21 (AICPA adapted). Comprehensive: Acquisitions, Disposals, Depreciation. Schedules for changes in plant assets, depreciation expense, and gain or loss on asset disposal.
40-60
P10-22 Comprehensive: Financial Statements. Preparation of income statement, statement of retained earnings, and balance sheet based on journal entries for various transactions (including material from previous chapters).
40-60
ANSWERS TO QUESTIONS
Q10-1 All three terms--depreciation, depletion, and amortization--refer to the process of allocating the cost of an asset to the periods in which the benefits are recognized as revenues. It is the nature of the asset that distinguishes the three terms. Depreciation is used in reference to tangible assets; depletion refers to natural resources such as oil or gas; and amortization is the allocation of the cost of intangible assets such as goodwill or leased property. Amortization is sometimes used as the general term to describe the periodic allocation of costs.
Q10-2 The four factors used in a company’s computation of the periodic depreciation amount are:
1. Asset cost - all the costs necessary to acquire, install, and prepare the asset for use.
2. Service life - the time of useful service or units of production expected from an asset.
3. Residual (salvage) value - the net amount expected to be obtained from the disposition of the asset at the end of its service life.
4. Method of cost allocation - the "systematic and rational" means to assign the cost of the asset to the periods benefitted.
Q10-3 The depreciation base is the cost of an asset less the estimated residual value. This is the amount that is allocated over the estimated service life of the asset.
Q10-4 The objective of accounting for depreciation is to match the cost of an asset with the revenues, or benefits, derived from the asset in a systematic and rational manner.
Since the cost of an asset less any expected residual value is the total lifetime expense, it is recognized systematically against the revenues, or benefits, received.
Q10-5 Note: Part c involves an understanding of cash flow concepts discussed briefly in Chapter 4. The recording of depreciation affects a company’s financial statements as follows:
a. Income statement - the company expenses depreciation directly or through cost of goods sold (for manufacturing assets). In either case, it decreases income before income taxes, income tax expense, and net income.
b. Balance sheet - the Accumulated Depreciation account offsets the related asset account. Thus, recording depreciation reduces the book value of a company's assets. Depreciation included in manufacturing costs on unsold inventory affects the cost of the inventory on the balance sheet. Since net income is reduced, retained earnings are also reduced.
c. Statement of cash flows - depreciation is an expense that does not require an outlay of cash. Consequently, it is added back to net income to show net cash
Q10-6 Depreciation is not a means of generating funds for the replacement of an asset. It is only a method of allocating the cost of an asset over its life. The availability of funds for replacement is a separate consideration.
Q10-7 By definition, a cost is considered variable if it changes in proportion to changes in production. Thus, when depreciation is based on activity levels, such as hours worked or output produced, it is a variable cost. In contrast, depreciation based on time is a fixed cost.
Q10-8 Depreciation results primarily from physical causes and functional causes. Wear and tear, which is due to operational usage, suggests the use of an activity method of depreciation. Deterioration and decay are more dependent upon time and thus a time method of depreciation, such as the straight-line, declining-balance, or sum-of- the-years'-digits method, is more appropriate. The functional causes of depreciation- -obsolescence or inadequacy--seem to relate more to time methods of depreciation.
However, each situation must be evaluated separately because there are no steadfast rules for a depreciation method--only that it be "systematic and rational."
The requirement that all companies use the same method of depreciation is not desirable because different patterns of benefits do exist for different types of assets. If the purpose of such a requirement is to reduce the differences in financial
statements, this would not accomplish it. Even if two companies are using the same method of depreciation, by assuming different useful lives or salvage values, the depreciation amount can be markedly different. Such a requirement would be an example of form over economic substance.
Q10-9 Accelerated methods of depreciation are the most appropriate when it can be assumed that the benefits derived from the asset will be declining each year during its service life.
Q10-10 The group and composite methods of depreciation are similar in that they are both applied to a combination of assets. The group method is used when the assets are similar in nature and are expected to have similar service lives and residual values.
The composite method is for assets that are heterogeneous; they have similar
purposes or characteristics but do not necessarily have similar service lives or residual values. Under both methods gains or losses on disposal are not recognized until all the assets are retired.
Q10-11 Both the retirement and replacement methods of expense recognition record the expense when an asset is retired. The retirement method expenses the cost of the old asset, less any residual value, at the time of retirement. Under the replacement method, it is the cost of the new asset, again less any residual value, that is expensed.
Q10-12 A manufacturing company debits depreciation on manufacturing assets to a Goods in Process account (an inventory account). In this way, it recognizes the expense of depreciation when it sells the inventory rather than when it records the depreciation.
Thus, if a company manufactures more goods than it sells and these goods remain in inventory, the depreciation included in the income statement is less than the asset's depreciation amount.
Q10-13 The depreciation on an asset is not intended to produce a book value equal to the market value. It is a method of cost allocation. Therefore, even though the cost of replacement goes up, a company records depreciation as long as the estimated residual value is less than the book value.
Q10-14 Depreciation of an asset is not an attempt to measure the value of an asset. Thus, a company should use an accelerated method of depreciation if the benefits of the asset are greater in the early years and decline in later years, not because of the loss in value during the early years.
Q10-15 The manager seems to be using the term "depreciate" in another sense. With regular repairs and maintenance, perhaps the transmission lines have extended useful lives and do not lose their value. In the accounting sense, depreciation is the allocation of the cost of an asset. Unless the lines have an unlimited useful life, or an estimated residual value greater than their cost, the cost should be allocated over the service life. Depreciation is not a means of valuing an asset and does not represent a decline in the value of an asset.
Q10-16 The required disclosures for depreciation as set forth in APB Opinion No. 12 are as follows:
1. Depreciation expense for the period
2. Balances of depreciable assets, classified by nature or function, at balance sheet date
3. Accumulated depreciation, by major classification or total, at balance sheet date
4. A description of the method(s) used in computing depreciation with respect to the major classes of depreciable assets
Q10-17 Because the underlying purposes behind depreciation are different for financial reporting and for income tax reporting, the method for each is different. Accounting principles require the depreciation method to be "systematic and rational" and that it match the depreciation amounts to the benefits received from the assets. For
income tax purposes, a company uses the Accelerated Cost Recovery System (ACRS) for assets purchased from 1981 through 1986, and uses the Modified ACRS for assets purchased in 1987 and later years. (For assets purchased before 1981, it uses accelerated depreciation methods). The MACRS allows the expensing of more of the cost early in the life of the asset and thus increases the net benefits to the company (on a present value basis). The acceleration of the expensing under MACRS results from the use of a shorter life, the accelerated methods (for assets with lives of 3, 5, 7, 10, 15, and 20 years), and the use of a zero residual value.
Q10-18 A company’s depletion for income tax purposes and financial reporting are the same if it uses the cost method for both. However, for income tax purposes it may use the percentage-depletion method, which departs from the concept of cost allocation. Under this tax method, the company may deduct a stated percentage of gross income as depletion expense over the life of the asset. In addition, the total
ANSWERS TO CASES
C10-1 (AICPA adapted solution)
1. a. The unit method of recording depreciation involves the treatment of fixed assets or substantial additions thereto as individual items. The method entails maintaining detailed records of the costs of specific assets and related allowances for
depreciation. Computation of depreciation is based on the estimated useful life of the individual asset. The method is distinguished from group and composite-life methods under which the cost and estimated life of the assets are commingled. Depreciation may be recorded by straight-line, accelerated, or other accepted computation methods.
b. Under the group or composite-life methods, assets are aggregated into accounting units. Such grouping might be horizontal, vertical, or geographical. Horizontal
grouping assembles together all assets of similar physical characteristics, such as trucks, presses, or returnable containers. A vertical or functional grouping comprises all assets contributing to a common economic function, such as a sugar refinery or service station. The geographical grouping includes all assets in a district or region, such as telegraph poles.
Depreciation under these methods requires development of a weighted average rate from the assets' depreciable cost and estimated life. Separate accounts are
established for the total cost of each asset grouping and its related allowance for depreciation. The asset grouping should be composed of a large number of units to obtain a reliable average life.
2. Arguments for the use of the unit method of computing depreciation include:
(1) The method is simple in that it does not require involved mathematical computations.
(2) The gain or loss on the retirement of a particular asset can be computed.
(3) For cost purposes, depreciation on idle equipment can be isolated.
(4) The method results in a more accurately computed depreciation provision in any given year, as the total depreciation amount represents the best estimate of the
depreciation of each asset and is not the result of averaging the cost over a longer period of time.
Arguments against the unit method are as follows:
(1) Considerable additional bookkeeping is necessary to account for each asset and its related depreciation. (The advent of computer accounting methods reduces the work burden, however.)
(2) There is a point of diminishing returns in the accumulation of accounting data under this method; that is, additional accuracy may not justify the additional cost of record keeping.
C10-1 (continued) 2. (continued)
(3) Under a decentralized financial control system where a measure of the division's efficiency is the rate of return on the gross book value of the investment, a division manager might scrap fully or nearly fully depreciated equipment to improve a division's rate of return even though the equipment is still serviceable.
(4) There may be reluctance on the part of a division manager to replace equipment not fully depreciated with more efficient equipment because of the effect of the loss on the division's profits in the year of replacement.
Among arguments for the use of the group and composite-life methods are the following:
(1) The methods require less detailed bookkeeping.
(2) The application of depreciation to the whole group tends to average out or offset errors, economic or operating, caused by underdepreciation or overdepreciation.
(3) Periodic income is not distorted by gains or losses on disposal of assets.
(4) A more useful deduction from income is derived from these methods because of their recognition that depreciation estimates are based on averages and that gains and losses on individual assets are of little significance.
Arguments against the use of the group and composite-life methods would include:
(1) The methods would conceal faulty estimates for a long period of time.
(2) When there is an early heavy retirement of assets a debit balance might appear in the Allowance for Depreciation account and present an accounting problem.
(3) Information is not available regarding a particular machine for cost-calculation purposes.
(4) Under a decentralized financial control system where a measure of the division's efficiency is the rate of return on the gross book value of the investment, to improve a division's financial reports a division manager might scrap idle but serviceable
equipment or equipment that is not earning a satisfactory return on book value. The company would sustain an actual loss in the amount of the value of the equipment scrapped.
(5) Under the same situation as in argument 4, except that net book value is used, where the assets, although serviceable, are fully or almost fully depreciated, the division manager might hesitate to replace them because of the high rate of return on investment.
3. Under the unit method, retirements are recorded by removing from the accounts the cost of the asset and its related accumulated depreciation. The difference between the two accounts, adjusted for salvage and disposal costs, if any, is recognized as a gain or loss.
C10-1 (continued) 3. (continued)
Under the group and composite-life methods, the cost of the retired asset is removed from the Asset account, and the Accumulated Depreciation account is reduced by the amount of the cost of the retired asset, adjusted for salvage, salvage costs, and removal costs.
Accordingly, there is no periodic recognition of gain or loss; the Depreciation Allowance account serves as a suspense account for the recognition of gain or loss until the final asset retirement.
C10-2 (AICPA adapted solution)
1. The costs that should be capitalized when equipment is purchased for cash include the gross invoice price of the equipment less discounts plus all incidental costs relating to its purchase or preparation for use. Any available discounts whether taken or not should be deducted from the gross invoice price of the equipment.
For equipment purchased under a long-term payment plan, the amount capitalized is the same as for equipment purchased for cash, i.e., the capitalizable cost represents the cash equivalent price. The interest amounts should not be capitalized.
2. The physical factors that cause the equipment to depreciate are wear and tear from operation, action of time and other elements, and deterioration and decay. The functional factors that cause the equipment to depreciate are inadequacy, obsolescence, and supersession.
3. The factors that should be considered in computing depreciation expense are the cost of the asset, the estimated residual (salvage) value, and the allocation over the estimated service life of the asset by a systematic and rational allocation procedure.
4. Accelerated depreciation methods are justified based on the following assumptions:
a. An asset is more efficient in the earlier years of its estimated useful life. Therefore, larger depreciation amounts in the earlier years would be matched against the larger
revenues generated in the earlier years.
b. Repair expenses on an asset increase in the later years of its estimated useful life.
Therefore, smaller depreciation amounts in the later years would be combined with the larger repair expenses incurred in the later years resulting in a smooth or level pattern of these expenses.
C10-3 (AICPA adapted solution)
1. a. The capitalized cost for the computer includes all costs reasonable and necessary to prepare it for its intended use. Examples of such costs are the cash purchase price, delivery, installation, testing, and set up.
b. The objective of depreciation accounting is to allocate the depreciable cost of an asset over its estimated useful life in a systematic and rational manner. This process matches the depreciable cost of the asset with revenues generated from its use.
Depreciable cost is the capitalized cost less its estimated residual (salvage) value.