# Chapter 11

## 34 terms

### accelerated depreciation methods

Depreciation methods that allow for higher depreciation charges in the early years of an asset's life and lower charges in later years of an asset's life. Termed accelerated because these methods allow for higher early depreciation changes than the straight-line method allows. Also called decreasing-charge methods. Generally, companies use one of two decreasing-charge methods: sum-of-the-years'-digits or declining-balance. (p. 610).

### activity method Depreciation

method that assumes that depreciation is a function of use or productivity, instead of the passage of time. Using this method, a company considers the life of the asset in terms of either the output it provides (units it produces) or an input measure such as the number of hours it works. Also called the variable-charge or units-of-production approach. (p. 609).

### amortization

The allocation of the cost of intangible assets in a systematic way. (p. 606).

### asset turnover ratio

Profitability ratio that measures how efficiently a company uses its assets to generate sales. Computed as net sales divided by average total assets for the period. The resulting number is the dollars of sales produced by each dollar invested in assets. (p. 627).

### composite approach

A method of depreciating multiple-asset accounts using one rate; often used when the assets are dissimilar and have different lives. (p. 612).

### composite depreciation rate

Used with the composite approach to depreciating multiple-asset accounts; determined by dividing the depreciation per year by the total costs of the assets. (p. 612).

### cost depletion

A method of allocating the cost of natural resources to accounting periods, normally computed on a units-of-production method. (p. 622).

### declining-balance method

Accelerated deprecation method that uses a depreciation rate (expressed as a percentage) that is some multiple of the straight-line method. Companies apply that constant rate to the declining book value of the asset at the beginning of each period. Applying the constant-declining-balance rate to a successively lower book value results in lower depreciation charges each year. This process continues until the book value of the asset equals its estimated salvage value, at which time the company discontinues depreciation. (p. 611).

### decreasing-charge methods

Depreciation methods that allow for higher depreciation charges in the early years and lower charges in later periods. Also called accelerated depreciation methods. Generally, companies use one of two decreasing-charge methods: sum-of-the-years'-digits or declining-balance. (p. 610).

### depletion

The process of allocating the cost of natural resources. (pp. 606, 620).

### depreciation

The 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. Depreciation is not a matter of valuation but rather a means of cost allocation. (p. 606).

### depreciation base

The cost of a tangible asset that will be al¬located to expense through depreciation. The base established for depreciation is a function of two factors: an asset's original cost minus its salvage (disposal) value. (p. 606).

### development costs

Part of the expenditures required to find and use natural resources. Usually divided into two parts: (1) tangible equipment costs, and (2) intangible development costs. (p. 621).

### double-declining-balance method

Declining-balance depreciation method in which a company depreciates assets at twice (200 percent) the straight-line rate. (p. 611).

### exploration costs

The expenditures required to find natural resources; when substantial, companies may capitalize them into the depletion base. Other companies, based on their industry, either capitalize or expense the costs. (p. 621).

### full-cost concept

Related to the accounting for the oil and gas company, this view holds that the cost of drilling a dry hole is a cost needed to find the commercially profitable wells. (p. 623).

### group method

A method of depreciating multiple-asset accounts using one rate, often used when the assets are similar in nature and have approximately the same useful lives. (p. 611).

### impairment (long-lived assets)

A write-off of the carrying amount of a long-lived asset (property, plant, and equipment or intangible asset) that is not recoverable. Companies use a recoverability test to determine whether an impairment has occurred and if it has, they then use a fair value test to measure the amount of the impairment loss. (p. 617).

### inadequacy

The state of an asset in which the asset has ceased to be useful to a company because the demands of the firm have changed. Inadequacy is a physical factor that leads to a company's decision to retire an asset (end its service life). An example would be the need for a larger building to handle increased production. Although the old building may be still be sound, it may not be adequate for the company's purpose. Retired assets are not depreciated and are removed from the books when disposed of. (p. 607).

### liquidating dividends

Dividends based on amounts other than retained earnings, implying that the dividends are a return of the stockholder's investment rather than of profits. Any dividend not based on earnings reduces corporate paid-in capital. (p. 623).

### natural resources

Often called wasting assets, these include petroleum, minerals, and timber, and have two main features: (1) the complete removal (consumption) of the asset, and (2) replacement of the asset only by an act of nature. (p. 620).

### obsolescence

The state of an asset in which the asset becomes out of date before it physically wears out. Obsolescence is an economic factor that leads to a company's decision to retire an asset (end its service life). Retired assets are not depreciated and are removed from the books when disposed of. (p. 607).

### percentage depletion

A tax law that allows some companies a write-off ranging from 5 percent to 22 percent (depending on the natural resource) of gross revenue received; Congress has since repealed this deduction for most oil and gas companies. (p. 622)(n).

### profit margin on sales ratio

Profitability ratio that measures the company's use of its assets to produce net income. Also called rate of return on sales. Computed as net income divided by net sales. This measure indicates the percentage of each dollar of sales that results in net income. By relating the profit margin on sales to the asset turnover for the period, we can find out how profitably the company used assets during that period of time. (p. 628).

### rate of return on assets (ROA)

The rate of return a company achieves through use of its assets. Computed as net income divided by average total assets. ROA indicates the amount of net income generated by each dollar invested in assets. By relating the profit margin on sales to the asset turnover for the period, analysts can find out how profitably the company used assets during that period of time. (p. 628).

### recoverability test

A test to determine whether an impairment of a long-lived asset has occurred. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, the asset is considered impaired. If the test indicates impairment has occurred, the company then computes the amount of the impairment loss to record, based on a fair value test. (p. 618).

### reserve recognition accounting (RRA)

A method for measuring the economic substance of oil and gas exploration than either the full-cost or successful-efforts approaches. Under RRA, as soon as a company discovers oil, it reports the value of the oil on the balance sheet and in the income statement, thus reflecting a fair value approach. (p. 624).

### restoration costs

The costs incurred to restore property to its natural state after extraction has occurred. (p. 621).

### salvage value

The estimated amount that a company will receive when it sells an asset or removes it from service. It is the amount to which a company writes down or depreciates the asset during its useful life. (p. 606).

### straight-line method

Depreciation method that considers depreciation a function of time rather than of usage and thus charges the same amount for each year of the asset's service life. Companies widely use this method because of its simplicity. (p. 609).

### successful-efforts concept

Related to the accounting for exploration costs in the oil and gas industry, this view holds that companies should capitalize only the costs of successful projects. Companies should report any remaining costs as period charges. (p. 623).

### sum-of-the-years'-digits method

Depreciation method that uses a decreasing fraction of depreciable cost (original cost less salvage value), using the sum of the years of the asset's service life as a denominator and the number of years of estimated life remaining as of the beginning of the year as the numerator. The numerator decreases year by year, and the denominator remains constant, which results in a decreasing depreciation charge. At the end of the asset's service life, the balance remaining should equal the salvage value. (p. 610).

### supersession

The replacement of one asset with another more efficient and economical asset. Supersession results in a company retiring an asset (ending its service life). Retired assets are not depreciated and are removed from the books when disposed of. (p. 607).

### Modified Accelerated Cost Recovery System (MACRS)

Enacted by Congress in the Tax Reform Act of 1986, to stimulate capital investment through faster write-offs, the computation of tax depreciation under MACRS differs from GAAP in three respects: (1) a mandated tax life, which is generally shorter than the economic life; (2) a cost recovery on an accelerated basis; and (3) an assigned salvage value of zero. (p. 630).