# Intermediate Accounting by Kieso, Depreciation, Impairments, and Depletion

## 83 terms · Chapter 11

### accelerated-depreciation methods

Depreciation methods that allow for higher depreciation charges in the early years and lower charges in later periods. 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.

### 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.

### amortization

The allocation of the cost of intangible assets in a systematic way.

### 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.

### composite approach

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

### 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.

### cost depletion

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

### 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.

### 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.

### depletion

The process of allocating the cost of natural resources.

### 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.

### 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.

### 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.

### double-declining-balance method

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

### exploration cost

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.

### 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.

### 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.

### 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.

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.

### 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.

### 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.

### 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.

### 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.

### 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.

### 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.

### 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.

### reserve recognition accounting (RRA)

A method for measuring the economic substance of oil and gas exploration which, is different from either the full-cost or successful-efforts approaches, which are also historical cost approaches, rather than fair value. 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. Not acceptable under GAAP.

### restoration costs

The costs incurred to restore property to its natural state after extraction has occurred.

### 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.

### 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 sim¬plicity. .

### 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.

### 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.

### 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.

### MACRS

Modified Accelerated Cost Recovery System - 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.

### How do the accelerated method and the straight-line method affect AD, BV, gain, and loss?

Accelerated method = higher AD = lower BV = greater gain = lower loss; Straight-line method = lower AD = higher BV = lower gain = greater loss

### What's the length of time between the beginning of 2000 to 2003? From the end of 2000 to 2003?

3 yrs (2000, 2001, 2002) and 2 yrs (2001, 2002)

### What are the two special depreciation methods?

Group and composite methods and hybrid or combination methods.

### Explain the accounting procedures for depletion of natural resources.

(1) Establish the depletion base, and (2) write off resource cost. Four factors are involved in establishing the depletion base: (a) Acquisition costs, (b) exploration costs, (c) development costs, and (d) restoration costs. Companies normally compute depletion on the units of production method.

### The basis of valuation for __ should be __

property, plant, and equipment and for natural resources; disclosed along with pledges, liens, and other commitments related to these assets.

### Property, plant, and equipment not currently employed as producting assets in the business should be __

segregated from assets used in operations.

### What are different names for salvage value?

residual value and scrap value

### What are different names for the activity method?

Variable charge approach, units of output, or the units of production method.

### What are different names for book value?

Carrying value, carrying amount, net asset value, or undepreciated value.

Depreciable cost

### When an asset being depreciated by a group or composite depreciation method is disposed of, __

no gain or loss is recorded; the difference between the original cost of the asset and the proceeds from disposal is charged to AD.

### What approaches can be used to account for exploration costs in the oil and gas industry?

Either the full-cost approach or the successful-efforts approach may be used.

### When can a company choose between either a full-cost approach or the successful-efforts approach to account for costs?

When accounting for exploration costs in the oil and gas industry.

### What following guidelines must be followed subsequent to recognizing the loss from impairment?

(1) If the asset is to be held for use, it will be depreciated based on the new cost basis. (2) If the asset is to be sold, no more depreciation is taken once the asset is no longer used. (3) Restoration of the impairment loss is not permitted for an asset which held for use. (4) Restoration of the impairment loss is allowed for an asset held for sale. Because assets held for disposal will be recovered through sale rather than through use in operations, they are continually revalued. Each period they are reported at the lower of cost or net realizable value. Thus, an asset held for disposal can be written up or down in future periods, as long as the write-up does not produce a new carrying value greater than the carrying amount of the asset before an adjustment was made to reflect a decision to dispose of the asset.

### Losses or gains related to impaired assets __

should be reported as part of income from continuing operations. Thus, they are not calssified as extraordinary items.

### What are the two reasons that companies retire assets for?

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

### Physical factors

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

### What are the three categories of economic or functional factors?

(1) Inadequacy, (2) supersession, and (3) obsolescence.

### In a highly industrial economy such as that of the United States, __

where research and innovation are so prominent, technological factors have as much effect, if not more, on service lives of tangible plant assets as physical factors do.

### The accounting profession requires that the depreciation method be __

"systematic and rational".

### Depreciation attempts to __

match the cost of an asset to the periods that benefit from the use of that asset.

### What are the different kinds of depreciation methods?

(1) Activity method, (2) straight-line method, (3) decreasing charge methods, and (4) special depreciation methods

### What are the different kinds of decreasing charge methods?

Sum-of-the-year's-digits and declining-balance method.

### What are the different kinds of special depreciation methods?

Group and composite methods and hybrid or combination methods.

### The activity method assumes __

that depreciation s a function of use or productivity, instead of a passage of time.

### The straight-line method considers __

depreciation a function of time rather than a function of usage.

### When is the decline in usefulness for an asset constant from period to period?

When creeping obsolescence is the primary reason for a limited service life, thus the straight-line method is justified.

### What are the major objections to the straight-line method?

(1) That the asset's economic usefulness is the same each year, and (2) the repair and maintenance expense is essentially the same each period. Another problem that occurs in using the straight-line method is that distortions in the rate of return analysis (income/assets) develop.

### The matching concept does not __

justify a constant charge to income. If the benefits from the asset declines as the asset ages, then a decreasing charge to income better matches cost to benefits.

### What is the justification for the use of the decreasing-charge methods?

That companies should charge more depreciation in earlier years because the asset is most productive in its earlier years and also that depreciation charge is lower in later periods when repair and maintenance costs are often higher.

### The group or composite method __

simplifies the bookkeeping process and tends to average out errors caused by over- or underdepreciation. As a result, gains or losses on disposals of assets do not distort periodic income.

### What are the advantages of the unit method over the group or composite methods?

(1) It simplifies the computation mathematically, (2) it identifies gains and losses on disposal, (3) it isolates depreciation on idle equipment, and (4) it represents the best estimate of the depreciation for each asset.

companies are free to develop their own special or tailor-made depreciation methods. GAAP requires only that the method result in the allocation of an asset's cost over the asset's life in a systematic and rational matter.

### What depreciation method best matches revenues with expenses if revenues generated by the asset are constant over its useful life?

The straight-line method.

### What depreciation method best matches revenues with expenses if revenues generated by the asset are higher (or lower) at the beginning of the asset's life?

The decreasing (or increasing) method.

### How is depreciation similar and different than other expenses?

It's similar in that it reduces net income, but different in that it does not involve a current cash outflow. Therefore it does not provide funds for the replacement of fixed assets.

### The general accounting standard of lower-of-cost-or-market for inventories __

does not apply to property, plant, and equipment.

### The going-concern concept assumes that the company can __

recover the investment in its assets. Under GAAP companies do not report the fair value of long-lived assets because a going concern does not plan to sell such assets,. However, if the assumption of being able to recover the cost of the investment is not valid, then a company should report a reduction in value.

### The FASB and international accounting standard-setters have developed what rules for recognizing impairments on long-lived assets?

When the carrying amount of an asset is not recoverable, a company records a write-off. This write-off is referred to as an impairment.

### What are some events and changes in circumstances that might lead to an impairment?

A significant decrease in the market value of an asset; A significant change in the extent or manner in which an asset is used; A significant adverse change in legal factors or in the business climate that affects the value of an asset; An accumulation of costs significantly 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

### impairment loss

The amount by which the carrying amount of the asset exceeds its fair value. The impairment loss is computed when a recoverability test indicates an impairment.

### How is the fair value of an asset determined?

It is measured based on market value if an active market for the asset exists, otherwise the present value of expected future net cash flows is used to determine fair value.

### A company that recognizes an impairment loss should disclose __

the asset(s) impaired, the events leading to the impairment, the amount of the loss, and how it determined fair value (disclosing the interest rate used, if appropriate).

### After recording an impairment loss, __

the reduced carrying amount of an asset held for use becomes its new cost basis. A company does not change the new cost basis except for depreciation or amortization in future periods or for additional impairments.

### acquisition cost

Acquisition cost is the price paid to obtain property right to search and find an undiscovered natural resource. It also can be the price paid for an already-discovered resource, or lease payments for property containing a productive natural resource; included in this acquisition costs are royalty payments to the owner of the property.

### The acquisition cost of natural resources is recorded __

in an account titled Undeveloped Property and later the costs are assigned to natural resource if exploration efforts are successful. It the efforts are unsuccessful, the acquisition costs are written off as a loss.

### In the oil and gas industry, where the costs of finding the resource __

are significant and the risk of finding the resource are very uncertain, most large companies expense these costs and smaller companies capitalize them.

### Because companies can move heavy equipment from one extracting site to another, __

companies do not normally include tangible equipment costs in the depletion base. Instead, they use a separate depreciation charges to allocate the costs of such equipment.