Slide 1Is Accounting Helpful for Valuation?Discussion QuestionsCost AllocationCost Allocation – An OverviewCost Allocation – An OverviewDiscussion QuestionsMeasuring Cost AllocationEstimation of Service LifeDepreciable BaseMethods of DepreciationStraight-LineExample 1a: Straight Line DepreciationExample 1b: Activity Based DepreciationDeclining-Balance MethodAccelerated MethodsExample 1c: Double-Declining BalanceUse of Various Depreciation MethodsExample 2: DDB to Straight LineExample 2: ContinuedPartial-Period DepreciationExample 3: Partial-PeriodExample 3: ContinuedExample 3: ContinuedE11-6E11-6: ContinuedE11-6: ContinuedCHAPTER 11 DEPRECIATION, IMPAIRMENTS, AND DEPLETIONSommers – ACCT 3311Is Accounting Helpful for Valuation?•Conceptual Framework (FASB)–Purpose of Accounting: “financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.”–Caveat: Accounting information “may help those who desire to estimate the value of a business enterprise, but financial accounting is not designed to measure directly the value of an enterprise.”Discussion QuestionsQ11–1 Distinguish among depreciation, depletion, and amortization.Allocating costs of long-term assets:Fixed assets = Depreciation expenseIntangibles = Amortization expenseNatural resources = Depletion expenseDepreciation is 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.Cost AllocationSome of the cost is expensed each period.Some of the cost is expensed each period.Cost Allocation – An Overview•The matching principle requires that part of the acquisition cost of operational assets be expensed in periods when the future revenues are earned.•Depreciation, depletion, and amortization are cost allocation processes used to help meet the matching principle requirements.ExpenseExpenseAcquisitionCostAcquisitionCost(Balance Sheet) (Income Statement)Caution! Depreciation, depletion, and amortizationare processes of cost allocation, not valuation!Cost Allocation – An OverviewDepreciation on the Balance SheetProperty, plant, and equipment: Land and buildings 150,000$ Machinery and equipment 200,000 Office furniture and equipment 175,000 Land improvements 50,000 Total 575,000$ Less Accumulated depreciation (122,000) Net property, plant and equipment 453,000$Discussion QuestionsQ11–7 What basic questions must be answered before the amount of the depreciation charge can be computed?Cost allocation requires three pieces of information for each asset:The estimated expected use from an asset. The estimated expected use from an asset. Total amount of cost to be allocated.Cost - Residual Value (at end of useful life)Total amount of cost to be allocated.Cost - Residual Value (at end of useful life)The systematic approach used for allocation. The systematic approach used for allocation. Depreciable BaseDepreciable BaseService LifeService LifeAllocation MethodAllocation MethodMeasuring Cost AllocationService life often differs from physical life.Companies retire assets for two reasons: 1. Physical factors (casualty or expiration of physical life).2. Economic factors (inadequacy, supersession, and obsolescence).Estimation of Service LifeDepreciable Base•How much is value going to decrease while company owns it?•This amount has to be transferred to expense during the period that the company is using the item.The profession requires the method employed be “systematic and rational.” Examples include:(1) Activity method (units of use or production).(2) Straight-line method. (3) Sum-of-the-years’-digits.(4) Declining-balance method.(5) Group and composite methods.(6) Hybrid or combination methods.Accelerated methodsSpecial methodsMethods of DepreciationStraight-LineTime:Activity:Acquisition Cost –Residual ValueEstimated Service Life in YearsAnnual Straight-line Depreciation =Acquisition Cost –Residual ValueEstimated Output in UnitsDepreciation rate per unit of output =Depreciation =Depreciation rate per unit ×Units of outputExample 1a: Straight Line DepreciationOn January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using:•Straight lineExample 1b: Activity Based DepreciationOn January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using:•Units of production using miles driven as a measure of output,and the following actual mileage: ($33,000 – $3,000) / 100,000 miles= $0.30 / mile deprec rateYear Miles Depreciation2011 22,0002012 24,0002013 15,0002014 20,0002015 21,000Sometimes called a Decreasing-Charge Method or an Accelerated MethodDeclining-Balance Method. Utilizes a depreciation rate (percentage) that is some multiple of the straight-line method.Does not deduct the salvage value in computing the depreciation base.Declining-Balance MethodAccelerated Methods•Accelerated methods result in more depreciation in the early years of an asset’s useful life and less depreciation in later years of an asset’s useful life•Note that total depreciation over the asset’s useful life is the same as the Straight-line MethodDeclining-Balance depreciation –•Based on the straight-line rate multiplied by an acceleration factor•Computations initially ignore residual value•Stop depreciating when BV = Residual Value•Note that the Book Value will get lower each yearAcceleration FactorExample 1c: Double-Declining BalanceOn January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van