Ch 11 Flashcards
Depletion
Describes reduction in cost of natural resources over
Period of time
(timber, gravel, oil, coal)
Depreciation, is the accounting process of…
allocating cost of tangible assets to expense in systematic manner to periods expected to benefit from use of asset
Amortization
Expiration of intangible assets
such as patents and copyrights
3 basic questions used in the depreciation process?
1 what Depreciable base is used for the asset?
2 what’s the asset’s useful life?
3 what method of cost appointment is best for this asset?
Salvage value
Estimated amount company will receive when it sells
Asset or removes it from service
Depreciation base
Total amount of depreciation that has occurred over asset’s useful life
Ex. Asset that cost $10,000 with a salvage value of $1,000
Has a depreciation base of $9,000
2 reasons companies retire assets?
1 physical factors (such as casualty or expiration of
Physical life)
2 economic factors (obsolescence)
3 economic or functional factors that cause retirement of asset?
1 inadequacy
2 supersession
3 obsolescence
Economic/fct. Factor: inadequacy?
Asset ceases to be useful to company because demands
Have changed
Economic/fct. Factor: supersession
Replacement of one asset with another more efficient
And economical asset
Economic/fct. Factor: obsolescence
Different situations not involving inadequacy or
Supersession
Activity method of depreciation AKA variable charge, units of production approach
Assumes depreciation is function of use of productivity,
Not passage of time
Depreciation: Activity Method equation
Depreciation charge =
((cost - salvage value) x (hours this yr.))/total estimated hours
Depreciation: straight line method
Considers depreciation as function of time
Not a function of usage
Depreciation: straight line method equation
Depreciation charge = (cost - salvage value)/estimated service life
The expense recognition principle does not justify a constant charge to income. If the benefits from the asset decline as the asset ages, then a…
Decreasing charge to income better matches cost
To benefits
Decreasing-charge methods AKA Accelerated depreciation methods
Provide for high depreciation cost in earlier years
And lower charges in later periods
Sum of years digits method depreciation?
Results in a decreasing depreciation charge based on
Decreasing fraction of Depreciable cost
Depreciable cost
Original cost - salvage value
Declining balance method depreciation
Utilizes depreciation rate (expressed as percentage)
That is sum multiple of straight line method
Does not deduct salvage value in computing
Depreciation base
Double declining balance method
Depreciates assets at twice (200%) the straight line rate
Companies often switch from the declining balance
method to the straight line method to ensure that they…
Depreciate asset only to its salvage value
Special depreciation method: group method
Used when assets are similar in nature and have
Similar useful lives
Special depreciation method: composite method
Used when assets are dissimilar and have different
Lives
Composite depreciation rate equation?
Composite depreciation rate =
Depreciation per year/ total cost of assets
Composite life
Length of time it takes to depreciate assets on
composite basis
Companies are free to develop their own special or tailor-made depreciation methods. GAAP requires only that the method result in the…
Allocation of asset’s cost over asset’s life in
Systematic and rational manner
Hybrid depreciation method used in steel industry:
Product Variable Method
Combination straight line/activity approach
Half year convention
Charge one half year’s depreciation both in year of
Acquisition and in year of disposal
How should companies compute depreciation for partial periods unless otherwise stipulated?
Compute depreciation on basis of nearest full month
Does depreciation provide for the replacement of assets?
What generates for replacement of assets specifically?
Depreciation in no way provides funds for replacement of
assets
The funds for replacement of assets come from revenues
Generated from use of asset
How should companies handle revisions of depreciation rates?
Report change of rate of depreciation in current and
prospective reports
Divided remaining book value - salvage value by
remaining estimated life
Lower of cost or market for inventories does not apply to…
Property, plant and equipment
Under GAAP, companies don’t report fair value of
Long lived assets because a…
Does not plan to sell such assets
If assumption of being able to recover the cost of an investment is not valid, then the company should…
Report reduction in value
Impairments
Write offs of long lived assets
Recoverability test
Used to determine whether impairment has occurred
Recoverability test estimates the future net cash flows expected from the…
Use of that asset and it’s eventual disposition
If the sum of net cash flows is less than carrying amount of asset then… Greater than…
Asset is impaired (less)
Asset not impaired
IFRS Fair value test, difference btw GAAP recoverability test
Used to measure impairment loss, more strict than GAAP
Doesn’t include first stage of recoverability test comparing
Undiscounted cash flows to carrying amount
Impairment loss
Amount by which carrying amount of asset exceeds its
Fair value
If no active market exists for an asset, to measure fair value…
The present value of expected future net cash flows
Used to calculate fair value
Impairment write-ups IFRS VS. GAAP?
IFRS permits write ups for subsequent recoveries of
Impairment up to original amount
GAAP prohibits write ups, except for assets to be
Disposed of
Assets held for disposal should be reported at…
Lower of cost or net realizable value
An asset held for disposal in future periods can be written up or down as long as…
Carrying value after write up never exceeds carrying
Amount of asset before impairment
How should companies report losses or gains for assets held for future disposal?
Part of income from operations
Natural resources AKA wasting assets
Petroleum, minerals and timber
2 main features of natural resources?
1 complete removal (consumption) of asset
2 replacement of asset only by an act of nature
Depletion
Process of allocating cost of natural resources
Four factors involved in computation of depletion base?
1 acquisition cost of deposit
2 exploration cost
3 development costs
4 restoration costs
Acquisition cost
Price company pays to obtain property right to
Search and find undiscovered natural resources
Exploration costs
Costs needed to find resource
2 types of development costs
Tangible equipment costs
Intangible development costs
Tangible equipment costs
Include all transportation and heavy equipment needed
To extract resource and get it ready for market
Normally not included in depletion base
Intangible development costs
Drilling costs, tunnels, shafts and wells needed for
Production of natural resource
Considered part of depletion base
Restoration costs
Costs of restoring land after extraction of natural resource
Costs part of depletion base
How do companies usually compute cost of depletion
Using the units of production method (an activity approach)
Computation of depletion rate equation?
Depletion cost per unit =
(total cost - salvage value)/total estimated units available
Liquidating dividends
Dividends greater than amount of accumulated
Net income
Full cost concept
Cost of drilling a dry hole is cost needed to find
commercially profitable wells
Successful efforts concept
Capitalize costs only of successful projects
Reserve recognition accounting (RRA)
As soon as company discovers oil, it reports value
On balance sheet and income statement
No longer used after 1981
IFRS and GAAP permit oil exploration companies today to use either…
Full cost or successful efforts approaches
Companies should disclose the following info for property, plant and equipment, 4 things?
1 depreciation expense for period
2 balances of major classes of Depreciable assets
By nature and function
3 acc. Depr.
4 general description of depreciation method used
Asset turnover, what does it measure? Equation?
How efficiently company uses assets to generate sales
Asset turnover = net sales/avg. total assets
Profit margin on sales, what does it measure?, equation?
Measure for analyzing the use property, plant
and equipment for profitability
Profit margin on sales = net income/net sales
Return on assets (ROA), what does it measure? 2 equations?
Measures profitability
Return on assets = profit margin on sales x asset turnover
Return on assets = net income/avg. total assets
