CHAPTER 11 DEPRECIATION IMPAIRMENTS AND DEPLETION Overview This chapter completes our discussion of accounting for property plant and equipment and intangible assets We address the allocation of the cost of these assets to the periods benefited by their use The usefulness of most of these assets is consumed as the assets are applied to the production of goods or services Cost allocation corresponding to this consumption of usefulness is known as depreciation for plant and equipment and depletion for natural resources We also consider impairment of these assets and the treatment of expenditures incurred subsequent to acquisition Learning Objectives LO11 1 LO11 2 LO11 3 LO11 4 LO11 5 LO11 6 LO11 7 LO11 8 LO11 9 Explain the concept of cost allocation as it pertains to property plant and equipment Determine periodic depreciation using both time based and activity based methods Calculate the periodic depletion of a natural resource Explain the appropriate accounting treatment required when a change is made in the service life or residual value of property plant and equipment Explain the appropriate accounting treatment required when a change in depreciation or depletion method is made Explain the appropriate treatment required when an error in accounting for property plant and equipment is discovered Identify situations that involve a significant impairment of the value of property plant and equipment and describe the required accounting procedures Discuss the accounting treatment of repairs and maintenance additions improvements and rearrangements to property plant and equipment Discuss the primary differences between U S GAAP and IFRS with respect to the utilization and impairment of property plant and equipment COST ALLOCATION Cost allocation for long lived revenue producing assets is known as depreciation for plant and equipment and depletion for natural resources Depreciation and depletion are processes of cost allocation not valuation Beginning of year 1 End of year 5 Year 1 Year 2 Year 3 Year 4 8 200 cost Year 5 2 200 residual 6 000 MEASURING COST ALLOCATION The process of cost allocation requires that three factors be established at the time the asset is put into use The service life or useful life of an asset is the amount of use that the company expects to obtain from the asset before disposing of it The allocation base is the difference between the cost of the asset and its anticipated residual value The allocation method used should be systematic and rational and correspond to the pattern of asset use DECISION MAKERS PERSPECTIVE SELECTING A DEPRECIATION METHOD All methods provide the same total depreciation over an asset s life Activity based methods are theoretically superior to timebased methods but often are infeasible or too costly to use Most companies use the straight line method A recent survey of 500 large companies Depreciation Method Straight line Declining balance Sum of the years digits Accelerated method not specified Units of production Group Composite Number of Companies 492 10 2 13 15 4 A company does not have to use the same depreciation method for both financial reporting and income tax purposes nor does it have to use the same depreciation method for different classes of assets 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 In the U S 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 over sized 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 trucks 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 Depreciation Methods IAS No 16 specifically mentions three depreciation methods straight line units of production and the diminishing balance method The diminishing balance method is similar to the declining balance method sometimes used by U S companies As in the U S the straight line method is used by most companies A recent survey of large companies that prepare their financial statements according to IFRS reports that in 2009 93 of the surveyed companies used the straight line method DEPLETION OF NATURAL RESOURCES The Jackson Mining Company paid 1 000 000 for the right to explore for a coal deposit on 500 acres of land in Pennsylvania Costs of exploring for the coal deposit totaled 800 000 and intangible development costs incurred in digging and erecting the mine shaft were 500 000 In addition the Jackson purchased new excavation equipment for the project at a cost of 600 000 After the coal is removed from the site the equipment will be sold for its anticipated residual value of 60 000 The company geologist estimates that 1 million tons of coal will be extracted over the three year period During 2013 300 000 tons were extracted Jackson is required by its contract to restore the land to a condition suitable for recreational use after it extracts the coal In Chapter 10 we determined that the capitalized cost of the natural resource coal deposit including restoration costs is 2 768 360 The depletion rate per ton is calculated as follows