CHAPTER 11
Depreciation, Impairments, and Depletion
LEARNING OBJECTIVES
1. Describe depreciation concepts and methods of depreciation.
2. Identify other depreciation issues.
3. Explain the accounting issues related to asset impairment.
CHAPTER REVIEW
*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.
1. Chapter 11 presents a discussion of the factors involved in the accounting and recording of
depreciation and depletion and the methods of writing off the cost of tangible assets and
Depreciation
2. (L.O. 1) Depreciation is the accounting process of allocating the cost of tangible assets
3. To compute depreciation, an accountant must establish (a) the depreciable base to be
4. The depreciable base is the difference between an asset’s cost and its residual value.
5. The useful life (service life) of a plant asset refers to the number of years that asset is
capable of economically providing the service it was purchased to perform. The service
6. The depreciation method selected for a particular asset should be systematic and rational.
Depreciation methods may be classified as:
A. Activity method (units of use or production).
7. The following information for a piece of machinery will be used to illustrate some of the
depreciation methods discussed in the following paragraphs.
8. When the activity method (units of use or production) is used, depreciation is assumed
to be a function of productivity rather than the passage of time. This method is most
appropriate for assets such as machinery or automobiles where depreciation can be
9. Use of the straight-line method results in a uniform charge to depreciation expense
during each year of an asset’s service life. This method is based upon the assumption
that the decline in an asset’s usefulness is the same each year. Although the straight-line
10. The diminishing-charge (accelerated depreciation) methods result in a higher deprecia-
11. The sum-of-the-years’-digits method and the declining-balance method are the two
most often used diminishing-charge methods. The sum–of-the-years’ digits method
requires multiplication of the depreciable base by a fraction that decreases during each
year of an asset’s service life. The declining-balance method requires the use of a
constant percentage applied to an asset’s book value (cost less accumulated
depreciation). Salvage value is initially ignored under the declining-balance method.
The declining-balance method utilizes a depreciation rate that is some multiple of the
straight-line method. One popular method is twice the straight-line rate. Thus, in our example
the 10-year asset life would translate into a 20% declining rate.
12. (L.O. 2) IFRS requires that each part of an item of property, plant, and equipment that is
significant to the total cost of the asset must be depreciated separately using component
depreciation.
Original Salvage Depreciable Useful Depreciation
Components Cost Value Cost Life (Straight-Line)
13. In general, depreciation should be based on the number of months an asset is used
during an accounting period. If a diminishing charge depreciation method is used for assets
purchased during an accounting period, a slight modification is appropriate. When this
situation occurs, determine depreciation expense for the full year and prorate the expense
14. Depreciation expense reduces net income for the accounting period in which it is recorded
15. The estimates involved in the depreciation process are sometimes subject to revision as
Impairments
16. (L.O. 3) To determine whether an asset is impaired, on an annual basis, companies
review the asset for indicators of impairment, i.e., a decline in the asset’s cash-generating
17. The impairment test compares the asset’s recoverable amount with its carrying
amount. If the carrying amount exceeds the recoverable amount, the difference is an
impairment loss. If the recoverable amount is greater than the carrying amount there is no
impairment.
18. The entry to record an impairment loss on a depreciable asset consists of a debit to Loss
19. If a review in a future period indicates that a depreciable asset in use is no longer
impaired because the recoverable amount is higher than the carrying amount, the
20. When it is not possible to assess a single asset for impairment because it generates cash
21. Impaired assets held for disposal, not use, are to be reported at the lower-of-cost-or–
net realizable value (LCNRV). Each period the asset is held, the company revalues it
Depletion
22. (L.O. 4) Mineral resources are one of the two sub-classifications of natural resources.
They have two main features: (a) the complete removal (consumption) of the asset, and (b)
23. Computation of the depletion base involves properly accounting for three types of
expenditures. Pre-exploratory costs are expensed as incurred. The accounting for
24. Development costs are divided into two groups: (a) tangible equipment costs, which are
25. Companies compute depletion on a units-of-production basis. A formula calculates the
cost per unit of product that is then multiplied by the number of units extracted in order to
determine the depletion cost for the period. The depletion cost per unit formula is:
26. Companies that own a single extractive natural resource may gradually distribute to
shareholders their capital investment by paying a liquidating dividend, which is a
27. Companies should disclose the following related to E&E expenditures: (a) the accounting
Revaluations
28. (L.O. 5) Companies may value their long-lived assets at cost or at fair value. The fair
value is determined by appraisal. Any revaluation increase generally goes to equity as
29. If a company decides to use fair value, it does not have to apply it to all long-lived assets. It
may choose to apply fair value to a single class of assets. However, every asset within that
Presentation and Analysis
30. (L.O. 6) The basis for valuing property, plant, equipment, and natural resources, which is
normally historical cost, should be disclosed in the financial statements along with any
pledges, liens, and other commitments related to these assets. Normally, assets not used
31. Analysts evaluate assets relative to activity (turnover) and profitability. The asset
turnover ratio measures how efficiently a company used its assets to generate sales.
*32. (L.O. 7) The general rules for revaluation accounting are as follows:
a. When a company revalues its long-lived tangible assets above historical cost, it
reports an unrealized gain (often referred to as revaluation surplus) that increases
other comprehensive income and accumulated other comprehensive income. It is not
*33. Many companies do not favor revaluation of long-lived assets because any unrealized
gain eventually ends up as an increase in Retained Earnings when the asset is sold.
Therefore, companies with assets that appreciate in value over their lives are unable to
LECTURE OUTLINE
Chapter 11 can be covered in two class sessions. Most students are already familiar with the
three primary chapter topics: depreciation accounting, impairments, depletion accounting, and
revaluations.
A. (L.O. 1) Depreciation, Depletion, and Amortization: Procedures to indicate that the service
potential of an asset has declined. Depreciation and depletion are discussed in this chapter.
Amortization is discussed in Chapter 12.
B. Factors involved in the depreciation process:
1. Depreciation base. This is equal to the original cost minus the expected salvage value.
C. Methods of Depreciation. Describe the characteristics of these methods and the factors
that influence the choice of method, as described below.
1. Activity Method: Assumes that depreciation is a function of use. The life of the asset is
2. Straight-line Method: This method is widely used because of its simplicity in charging
3. Diminishing-Charge (Accelerated Depreciation) Methods: Justified on the grounds
that since the asset is more efficient in the earlier years more depreciation should be
D. (L.O. 2) Component Depreciations.
1. IFRS requires that each component that is significant to the total cost of an asset be
depreciated separately.
E. Special Depreciation Issues.
1. Depreciation for partial periods. Many methods are applied and are acceptable as
long as they are used consistently.
2. Depreciation as a source of asset replacement funds. Point out that depreciation does
not provide funds; revenues provide funds. Depreciation retains funds by reducing
taxable income and does not involve a current cash outflow.
3. Revision of estimates. Changes in estimates of salvage value or service life are
shown in current and prospective (future) periods as required by IFRS.
a. In a change of accounting estimate, no retroactive adjustment of opening balances
F. (L.O. 3) Impairments
1. Companies review their long-lived assets annually for indications of impairment. If they
exist, then an impairment test is conducted.
2. The impairment test consists of comparing the asset’s recoverable amount to its
carrying amount. If the carrying amount exceeds the recoverable amount, the
difference is an impairment loss.
3. The entry to record the impairment loss is:
4. The loss is reported in the “Other income and expense” section of the income
statement.
6. In future periods, if the recoverable amount exceeds the carrying value, the impairment
loss may be reversed.
a. The amount of the recovery is limited to the carrying value that would result if the
7. Cash-generating units (CGU) are the smallest group of assets that generate cash
8. Impaired assets held for disposal are reported at the lower-of-cost-or–net realizable
value (LCNRV).
a. Assets are valued at LCNRV each year asset is held.
G. (L.O. 4) Depletion: Used to account for mineral resources that are physically consumed
over the period of use, such as petroleum, minerals, and gas.
1. Establishment of depletion base. The costs of mineral resources may be classified as
either:
a. Acquisition cost: the price paid to obtain the property.
2. Write-off of resource cost: Normally the units–of–production method is used. The
depletion rate is established by dividing the total estimated units available into the
depletion base.
4. Special problems in depletion accounting.
a. Difficulty of estimating recoverable reserves. Estimates of natural resource re–
5. Companies should disclose the following related to E&E expenditures.
a. The accounting policies for E&E expenditures, including the recognition of E&E
assets.
H. (L.O. 5) Revaluations. Companies may value their long-lived assets at cost or at fair value.
1. Revaluation increases are recorded as an unrealized gain on revaluation and are
referred to as revaluation surplus.
a. The entry is:
2. Revaluation decreases are recognized as impairment losses.
a. Impairment losses are reported in income.
I. (L.O. 6) Presentation and Analysis
1. Disclosures for Property, Plant, and Equipment:
a. The basis of valuation (usually historical cost).
2. Analysis ratios:
a. Asset turnover =
Net sales
Average total assets
J. (L.O. 7) Appendix 11A, Revaluation of Property, Plant, and Equipment
1. Revaluation of land
a. Revaluation gains or recognized as unrealized gains that increase equity.
b. Any subsequent decrease in fair value below cost results in the elimination of
the unrealized gain (decreasing equity) and the recognition of an impairment loss
(decreasing income).
2. Revaluation of depreciable assets
a. Revaluation occurs at year-end after periodic depreciation has been recorded.
c. When fair value subsequently falls below carrying value:
(1) Record annual depreciation expense.
d. Recovery of impairment loss:
(1) Record annual depreciation expense.
e. Subsequent sale of the asset at carrying value.
(1) No gain or loss is recognized as the asset was sold at carrying value.