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Chapter11: Property, Plant, and Equipment and Intangible Assets: Utilization and Impairment

Depreciation

To demonstrate and compare the most common depreciation methods, we refer to the situation described in Illustration 11-1.

 

 LO2

ILLUSTRATION 11-1
Depreciation Methods
 

The Hogan Manufacturing Company purchased a machine for $250,000. The company expects the service life of the machine to be five years. During that time, it is expected that the machine will produce 140,000 units. The anticipated residual value is $40,000. The machine was disposed of after five years of use. Actual production during the five years of the asset's life was:

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Time-Based Depreciation Methods

STRAIGHT-LINE METHOD.  By far the most easily understood and widely used depreciation method is straight line an equal amount of depreciable base is allocated to each year of the asset's service life.. By this approach, an equal amount of depreciable base is allocated to each year of the asset's service life. The depreciable base is simply divided by the number of years in the asset's life to determine annual depreciation. In our illustration, the straight-line annual depreciation is $42,000, calculated as follows:

p. 561

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The straight-line depreciation method allocates an equal amount of depreciable base to each year of the asset’s service life.

ACCELERATED METHODS.  Using the straight-line method implicitly assumes that the benefits derived from the use of the asset are the same each year. In some situations it might be more appropriate to assume that the asset will provide greater benefits in the early years of its life than in the later years. In these cases, a more appropriate matching of depreciation with revenues is achieved with a declining pattern of depreciation, with higher depreciation in the early years of the asset's life and lower depreciation in later years. An accelerated depreciation method also would be appropriate when benefits derived from the asset are approximately equal over the asset's life, but repair and maintenance costs increase significantly in later years. The early years incur higher depreciation and lower repairs and maintenance expense, while the later years have lower depreciation and higher repairs and maintenance. Two commonly used ways to achieve such a declining pattern are the sum-of-the-years'-digits method and declining balance methods.

 

Accelerated depreciation methods are appropriate when the asset is more useful in its earlier years.

Sum-of-the-Years'-Digits Method.  The sum-of-the-years'-digits (SYD) method systematic acceleration of depreciation by multiplying the depreciable base by a fraction that declines each year. has no logical foundation other than the fact that it accomplishes the objective of accelerating depreciation in a systematic manner. This is achieved by multiplying the depreciable base by a fraction that declines each year and results in depreciation that decreases by the same amount each year. The denominator of the fraction remains constant and is the sum of the digits from one to n, where n is the number of years in the asset's service life. For example, if there are five years in the service life, the denominator is the sum of 1, 2, 3, 4, and 5, which equals 15.2 The numerator decreases each year; it begins with the value of n in the first year and decreases by one each year until it equals one in the final year of the asset's estimated service life. The annual fractions for an asset with a five-year life are: <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_im1101.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a> and <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_im1102.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>. We calculate depreciation for the five years of the machine's life using the sum-of-the-years'-digits method in Illustration 11-1A.

 

The SYD method multiplies depreciable base by a declining fraction.

ILLUSTRATION 11-1A
Sum-of-the-Years'-Digits Depreciation

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Declining Balance Methods.  As an alternative, an accelerated depreciation pattern can be achieved by various declining balance methods. Rather than multiplying a constant balance by a declining fraction as we do in SYD depreciation, we multiply a constant fraction by a declining balance each year. Specifically, we multiply a constant percentage rate times the decreasing book value (cost less accumulated depreciation), also referred to as carrying value, of the asset (not depreciable base) at the beginning of the year. Because the rate remains constant while the book value declines, annual depreciation is less each year.

p. 562

   The rates used are multiples of the straight-line rate. The straight-line rate is simply one, divided by the number of years in the asset's service life. For example, the straight-line rate for an asset with a five-year life is one-fifth, or 20%. Various multiples used in practice are 125%, 150%, or 200% of the straight-line rate. When 200% is used as the multiplier, the method is known as the double-declining-balance (DDB) method 200% of the straight-line rate is multiplied by book value. because the rate used is twice the straight-line rate.

 

Declining balance depreciation methods multiply beginning-ofyear book value, not depreciable base, by an annual rate that is a multiple of the straightline rate.

   In our illustration, the double-declining-balance rate would be 40% (two times the straight-line rate of 20%). Depreciation is calculated in Illustration 11-1B for the five years of the machine's life using the double-declining-balance method.

ILLUSTRATION 11-1B
Double-Declining-Balance Depreciation

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*Amount necessary to reduce book value to residual value.

   Notice that in the fourth year depreciation expense is a plug amount that reduces book value to the expected residual value (book value beginning of year, $54,000, minus expected residual value, $40,000 = $14,000). There is no depreciation expense in year 5 since book value has already been reduced to the expected residual value. Declining balance methods often allocate the asset's depreciable base over fewer years than the expected service life.

SWITCH FROM ACCELERATED TO STRAIGHT LINE.  The result of applying the double-declining-balance method in our illustration produces an awkward result in the later years of the asset's life. By using the double-declining-balance method in our illustration, no depreciation expense is recorded in year 5 even though the asset is still producing benefits. In practice, many companies switch to the straight-line method approximately halfway through an asset's useful life.

   In our illustration, the company would switch to straight line in either year 3 or year 4. Assuming the switch is made at the beginning of year 4, and the book value at the beginning of that year is $54,000, an additional $14,000 ($54,000 −40,000 in residual value) of depreciation must be recorded. Applying the straight-line concept, $7,000 ($14,000 divided by two remaining years) in depreciation is recorded in both year 4 and year 5.

   It should be noted that this switch to straight line is not a change in depreciation method. The switch is part of the company's planned depreciation approach. However, as you will learn later in the chapter, the accounting treatment is the same as a change in depreciation method.

 

It is not uncommon for a company to switch from accelerated to straight line approximately halfway through an asset’s useful life as part of the company’s planned depreciation approach.

Activity-Based Depreciation Methods

The most logical way to allocate an asset's cost to periods of an asset's use is to measure the usefulness of the asset in terms of its productivity. For example, we could measure the service life of a machine in terms of its output (for example, the estimated number of units it will produce) or in terms of its input (for example, the number of hours it will operate). We have already mentioned that one way to measure the service life of a vehicle is to estimate the number of miles it will operate. The most common activity-based method is called the units-of-production method computes a depreciation rate per measure of activity and then multiplies this rate by actual activity to determine periodic depreciation..

   The measure of output used is the estimated number of units (pounds, items, barrels, etc.) to be produced by the machine. We could also use a measure of input such as the number of hours the machine is expected to operate. By the units-of-production method, we first compute the average depreciation rate per unit by dividing the depreciable base by the number of units expected to be produced. This per unit rate is then multiplied by the number of units produced each period. In our illustration, the depreciation rate per unit is $1.50, computed as follows:

p. 563

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   Each unit produced will require $1.50 of depreciation to be recorded. As we are estimating service life based on units produced rather than in years, depreciation is not constrained by time. However, total depreciation is constrained by the asset's cost and the anticipated residual value. In our illustration, suppose the company intended to dispose of the asset at the end of five years. Depreciation for year five must be modified. Depreciation expense would be an amount necessary to bring the book value of the asset down to residual value. Depreciation for the five years is determined in Illustration 11-1C using the units-of-production method. Notice that the last year's depreciation expense is a plug amount that reduces book value to the expected residual value.

 

Activity-based depreciation methods estimate service life in terms of some measure of productivity.

FINANCIAL
Reporting Case
  Q2,p.557

The units-of-production method computes a depreciation rate per measure of activity and then multiplies this rate by actual activity to determine periodic depreciation.

ILLUSTRATION 11-1C
Units-of-Production Depreciation

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*Amount necessary to reduce book value to residual value.

DECISION MAKERS' PERSPECTIVE—SELECTING A DEPRECIATION METHOD

Illustration 11-1D compares periodic depreciation calculated using each of the alternatives we discussed and illustrated.

ILLUSTRATION 11-1D
Comparison of Various Depreciation Methods

All methods provide the same total depreciation over an asset’s life.

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   Theoretically, using an activity-based depreciation method provides a better matching of revenues and expenses. Clearly, the productivity of a plant asset is more closely associated with the benefits provided by that asset than the mere passage of time. Also, these methods allow for random patterns of depreciation to correspond with the random patterns of asset use.

p. 564

   However, activity-based methods quite often are either infeasible or too costly to use. For example, buildings don't have an identifiable measure of productivity. Even for machinery, there may be an identifiable measure of productivity such as machine hours or units produced, but it frequently is more costly to determine each period than it is to simply measure the passage of time. For these reasons, most companies use time-based depreciation methods.

 

Activity-based methods are theoretically superior to time-based methods but often are impractical to apply in practice.

   Graphic 11-3 shows the results of a recent survey of depreciation methods used by large public companies.3

GRAPHIC 11-3

Use of Various Depreciation Methods

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   Why do so many companies use the straight-line method as opposed to other time-based methods? Many companies perhaps consider the benefits derived from the majority of plant assets to be realized approximately evenly over these assets' useful lives. Certainly a contributing factor is that straight-line is the easiest method to understand and apply.

   Another motivation is the positive effect on reported income. Straight-line depreciation produces a higher net income than accelerated methods in the early years of an asset's life. In Chapter 8 we pointed out that reported net income can affect bonuses paid to management or debt agreements with lenders.

   Conflicting with the desire to report higher profits is the desire to reduce taxes by reducing taxable income. An accelerated method serves this objective by reducing taxable income more in the early years of an asset's life than straight line. You probably recall a similar discussion from Chapter 8 in which the benefits were described of using the LIFO inventory method during periods of increasing costs. However, remember that the LIFO conformity rule requires companies using LIFO for income tax reporting to also use LIFO for financial reporting. No such conformity rule exists for depreciation methods. Income tax regulations allow firms to use different approaches to computing depreciation in their tax returns and in their financial statements. The method used for tax purposes is therefore not a constraint in the choice of depreciation methods for financial reporting. As a result, most companies use the straight-line method for financial reporting and the Internal Revenue Service's prescribed accelerated method (discussed in Appendix 11A) for income tax purposes. For example, Graphic 11-4 shows Merck & Co.'s depreciation policy as reported in a disclosure note accompanying recent financial statements.

 

A company does not have to use the same depreciation method for both financial reporting and income tax purposes.

GRAPHIC 11-4
Depreciation Method Disclosure—Merck & Co.

Real World Financials

 

Summary of Accounting Policies (in part): Depreciation
Depreciation is provided over the estimated useful lives of the assets, principally using the straight-line method. For tax purposes, accelerated methods are used.

   It is not unusual for a company to use different depreciation methods for different classes of assets. For example, Graphic 11-5 illustrates the International Paper Company depreciation policy disclosure contained in a note accompanying recent financial statements.

GRAPHIC 11-5
Depreciation Method Disclosure— International Paper Company

Real World Financials

 

Summary of Accounting Policies (in part): Plants, Properties, and Equipment

Plants, properties, and equipment are stated at cost, less accumulated depreciation. The units-of-production method of depreciation is used for major pulp and paper mills and the straight-line method is used for other plants and equipment.

p. 565

INTERNATIONAL FINANCIAL REPORTING STANDARDS

 

Depreciation. IAS No. 16 requires that each component of an item of property, plant, and equipment must be depreciated separately if its cost is significant in relation to the total cost of the item.4 In the United States, component depreciation is allowed but is not often used in practice.

  

Consider the following illustration:

Cavandish LTD. purchased a delivery truck for $62,000. The truck is expected to have a service life of six years and a residual value of $12,000. At the end of three years, the oversized tires, which have a cost of $6,000 (included in the $62,000 purchase price), will be replaced.

   Under U.S. GAAP, the typical accounting treatment is to depreciate the $50,000 ($62,000 −12,000) depreciable base of the truck over its six-year useful life. Using IFRS, the depreciable base of the truck is $44,000 ($62,000 −12,000 −6,000) and is depreciated over the truck's six-year useful life, and the $6,000 cost of the tires is depreciated separately over a three-year useful life.

    U.S. GAAP and IFRS determine depreciable base in the same way, by subtracting estimated residual value from cost. However, IFRS requires a review of residual values at least annually.

Sanofi-Aventis a French pharmaceutical company, prepares its financial statements using IFRS. In its property, plant, and equipment note, the company discloses its use of the component-based approach to accounting for depreciation.

      

Property, plant, and equipment (in part)
The component-based approach to accounting for property, plant, and equipment is applied. Under this approach, each component of an item of property, plant, and equipment with a cost which is significant in relation to the total cost of the item and which has a different useful life from the other components must be depreciated separately.

      

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 LO10
 
 
 
 

IFRS ILLUSTRATION

 
 
 
 
 
 
 
 
 
 

Real World Financials

CONCEPT REVIEW EXERCISE

DEPRECIATION METHODS

The Sprague Company purchased a fabricating machine on January 1, 2011, at a net cost of $130,000. At the end of its four-year useful life, the company estimates that the machine will be worth $30,000. Sprague also estimates that the machine will run for 25,000 hours during its four-year life. The company's fiscal year ends on December 31.

Required:

Compute depreciation for 2011 through 2014 using each of the following methods:

1.

 

Straight line.

2.

 

Sum-of-the-years'-digits.

3.

 

Double-declining balance.

4.

 

Units of production (using machine hours). Actual production was as follows:

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SOLUTION

1.

 

Straight line.

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p. 566

2.

 

Sum-of-the-years'-digits.

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3.

 

Double-declining balance.

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4.

 

Units of production (using machine hours).

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2A formula useful when calculating the denominator is n(n + 1)/2.

3Accounting Trends and Techniques—2009 (New York: AICPA, 2009), p. 404.

4“Property, Plant and Equipment,” International Accounting Standard No. 16 (IASCF), par. 42, as amended effective January 1, 2009.

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