Chapter 11

Question 1

What is depreciation?

Answer 1

A means of cost allocation.

Question 2

What is the formal definition of depreciation?

Answer 2

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.

Question 3

Why use the cost allocation approach?

Answer 3

Because it matches costs with revenues and because fluctuations in fair value are uncertain and difficult to measure.

Question 4

What is depletion?

Answer 4

Depletion is the reduction in the cost of natural resources over a period of time.

Question 5

What is amortization?

Answer 5

Amortization is the expiration of intangible assets.

Question 6

What are the factors involved with the depreciation process?

Answer 6

Depreciable base, useful life, and what method of cost allocation to use.

Question 7

How to calculate depreciable base?

Answer 7

Cost - Salvage

Question 8

What is salvage value?

Answer 8

The estimated amount that a company will receive when it sells the asset or removes it from service.

Question 9

What are the reasons that companies retire assets?

Answer 9

Physical factors (casualty or expiration of physical life) and economic factors (obsolescence).

Question 10

What does physical factors include?

Answer 10

Wear and tear, decay, and casualties that make it difficult for the asset to perform indefinitely.

Question 11

What is the classification of economic or functional factors?

Answer 11

INADEQUACY, when asset is not useful anymore because the demands of the firm have changed. SUPERSESSION, the replacement of one asset with another more efficient and economical asset. OBSOLESCENCE, the catchall situation not involving inadequacy and supersession.

Question 12

What are the methods of depreciation?

Answer 12

Straight-line, Activity method, and Decreasing charge methods (accelerated): Sum of the Years digits and Declining balance method.

Question 13

What are some characteristic of the activity method?

Answer 13

It assumes that depreciation is a function of use instead of the passage of time.
Considers the life of the asset in terms of either the output it provides or an input measure such as the number of hours it works.

Question 14

What are some of the limitations of the activity method?

Answer 14

It is inappropriate in situations in which depreciation is a function of time instead of activity. (Ex. A building deteriorates due to the elements (time) regardless of use.

Question 15

When does the activity method works best?

Answer 15

In cases where loss of services results from activity or productivity. Companies that desire low depreciation during periods of low productivity, and high depreciation during high productivity.

Question 16

How to calculate depreciation using the activity method?

Answer 16

1. Divide depreciable base by the total estimated hours to get the rate.
2. Multiply the rate times the hours or output.

Question 17

What are the characteristic of the straight line method?

Answer 17

It considers depreciation as a function of time rather than function of usage. Most used because it’s simplicity.

Question 18

How to calculate depreciation using the straight line method?

Answer 18

Divide the depreciable base by the estimated service life.

Question 19

What is an objection to the straight line method?

Answer 19

It rests on two tenuous assumptions: the asset’s economic usefulness is the same each year and the repair and maintenance expense is essentially the same each period.

Question 20

What are two type of Decreasing Charge methods?

Answer 20

Sum of the years digits and declining balance methods.

Question 21

What is an objective for the decreasing charge methods (Accelerated)?

Answer 21

To provide higher depreciation cost in the earlier years and lower charges in later periods.

Question 22

What is the main justification of decreasing charge methods?

Answer 22

The rationale is that companies should charge more depreciation in earlier years because the asset is most productive in its earlier years. It provides constant cost because the depreciation charge is lower in the later periods at times when repair and maintenance costs are often higher.

Question 23

How to calculate Sum of the years digits?

Answer 23

1. Find the sum of the years by dividing n(n+1) by 2 and using that number are the denominator.
2. Multiply that by the depreciable base.

Question 24

What are characteristic of the Declining Balance Method?

Answer 24

It utilizes a depreciation rate that depreciates twice as fast as the straight line method. It does not deduct salvage value. It multiplied by the book value each year. Applies a constant declining balance rate.

Question 25

How to calculate depreciation using the declining balance method?

Answer 25

1. Take the straight line rate and multiply it times two to find the rate.
2. Multiply that rate times the book value of the year. (Book value should not be less than salvage value.)

Question 26

How to compute depreciation for partial periods?

Answer 26

Determine the depreciation expense for the full year and then prorate this depreciation expense between the two periods involved. (Unless otherwise stipulated, companies normally compute depreciation on the basis of the nearest full month.

Question 27

Where does the funds for the replacement of an asset come from?

Answer 27

The revenues not depreciation.

Question 28

What are natural resources?

Answer 28

Oftern called wasting assets, include petroleum, minerals, and timber.

Question 29

What are the 2 main features of depletion?

Answer 29

The complete removal (consumption) of the asset, and replacement of the asset only by an act of nature.

Question 30

What factors are involved for a depletion base?

Answer 30

1. Acquisition cost of the deposit
2. Exploration costs
3. Development costs
4. Restoration cost

Question 31

What is the Acquisition cost?

Answer 31

The price paid to obtain the property right to search and find an undiscovered natural resource. Also can be the price paid for an already discovered resource or lease payments for peroperty containing a productive natural resource; included are royalty payments to the owner of property.

Question 32

What is the exploration cost?

Answer 32

As soon as a company has the right to use the property it incurs exploration cost. Can be capitalized into depletion base.

Question 33

What are development cost?

Answer 33

Tangible equipment costs and intangible development cost. Do not include tangible equipment into depletion base but include intangible development cost.

Question 34

What are restoration cost?

Answer 34

Cost incurred to restore property to its natural state after extraction has occurred. Compute into depletion base.

Question 35

How to compute depletion?

Answer 35

As an activity approach.

1. Total Cost - Salvage Value
2. Divided by estimated units available to get the depletion cost per unit.

Question 36

How to journalize depletion?

Answer 36

Debit Inventory for the Depletion and Credit Accumulated Depletion

Question 37

How to show depletion on the balance statement?

Answer 37

Name of Asset

Less: Accumulated Depreciation

Question 38

How to handle the change in depreciation rate?

Answer 38

Accounted for in the period of change and future periods. (Prospectively) Not considered extraordinary items or errors.

Question 39

How the compute the change of depreciation?

Answer 39

By dividing the remaining book value less any salvage value by the remaining estimated life.

Question 40

What is an impairment?

Answer 40

Write-offs of some long lived assets.

Question 41

What are some circumstances that might lead to an impairment?

Answer 41

Significant decrease in the fair value of an asset. Significant change in the manner in which an asset is used. Adverse change in legal factors or in the business climate. An accumulation of costs in excess of the amount originally expected to acquire or construct an asset. A projection or forecast that demonstrates continuing losses associated with an asset.

Question 42

How to measure an impairment?

Answer 42

Review events for possible impairment.
If the review indicates impairment, apply the recoverability test. If the sum of the expected future net cash flows from the long-lived asset is less than the carrying amount of the asset, an impairment has occurred.
Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market value or the present value of expected future net cash flows.

Question 43

What is the recoverability test?

Answer 43

If the sum of the expected future net cash flows is less than the carrying amount of the asset then consider the asset impaired.