Depreciation and Depletion

Applying PHILIPPINE ACCOUNTING STANDARD (PAS) 16 Property, Plant and

Equipment on depreciation and depletion

Depreciation refers to the decline in value of tangible plant assets.

Depletion is the term used to describe the decline in natural resources such as
timber, oil, or coal.

Amortization is the term used to describe the expiration of intangible assets

Depreciation Process

1. Depreciation 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. The cost allocation
approach is justified because it matches costs with revenues and because
fluctuation in market values is difficult to determine.

2. To compute depreciation, the following must be established:

(a) the depreciable base to be used for the asset,

(b) the asset's useful life, and
(c) the depreciation method to be used.

Determination of the first two factors requires the use of estimates.

3. The depreciable base is the difference between an asset's cost and its
salvage value. Salvage value is the estimated amount that will be received
at the time the asset is sold or removed from service.

4. The estimate of an asset's service life is dependent upon both the economic
factors and the physical factors related to its use.

a) Economic factors are characterized by inadequacy,

supersession, and obsolescence.
b) Physical factors relate to wear and tear, decay, and casualties
that prevent the asset from performing indefinitely.

Depreciation Methods

PAS 16 Paragraph 16 provides that the depreciation method used shall reflect
the pattern in which the asset’s future economic benefits are expected to be
consumed by the entity. This means that depreciation method selected for a
particular asset should be systematic and rational.

Depreciation methods may be classified as:

A. Units of production method (Activity method).

B. Straight-line method.

C. Diminishing balance method (Decreasing charge methods).

a. Sum-of-the-years'-digits.
b. Declining-balance method.
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A. 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 based on units produced or miles driven. One problem
associated with the use of this method concerns a before-the-fact estimation of
the total output the asset will achieve during its useful life.

B. 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 method is easy to use, it rests on an
assumption that, in most situations, is not realistic.

C.The diminishing balance method (decreasing charge) or (accelerated depreciation)

methods result in a higher depreciation cost during the early years of an asset's service
life and lower charges in later years. This approach is justified on the basis that assets
lose a greater amount of service potential in earlier years and thus depreciation should be
higher.

The sum-of-the-years'-digits method and the declining-balance method are

the two most often used decreasing 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 use of a constant percentage applied to an asset's cost less
accumulated depreciation. Salvage value is initially ignored under the
declining-balance method.

Depreciation expense reduces net income for the accounting period in which it
is recorded even though a current cash outflow is not involved. However,
depreciation should not be considered a source of cash. Cash is generated by
revenues, not accounting procedures.

The estimates involved in the depreciation process are sometimes subject to

revision as a result of unanticipated occurrences. Such revisions are classified
as changes in accounting estimates and should be handled in the current and
prospective periods rather than changing previously reported results.

Depletion

Depletion refers to the process of recording the consumption of natural

resources (wasting assets). The depletion base for natural resources includes
acquisition costs, exploration costs, intangible development costs, and
restoration costs reduced by any residual value related to the land.

Tangible assets used in extracting natural resources are normally set up in a

separate account and depreciated individually.

Depletion is normally based on the number of units extracted during the period,
which corresponds to the activity depreciation method discussed earlier. A
major problem one faces when computing depletion is estimating recoverable
reserves.

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Disclosures

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 in a productive capacity (held for future use or as an
investment) should be segregated from assets used in operations and classified
as "Other Assets." Financial statement disclosures related to depreciation
include:

a. Depreciation expense for the period.

b. Balances of major classes of depreciable assets, by nature and

function.

c. Accumulated depreciation, either by major classes of

depreciable assets or in total.

d. A general description of the method or methods used in

computing depreciation with respect to major classes of
depreciable assets.

Special Depreciation Issues.

1. Depreciation for partial periods. Many methods are applied and are
acceptable as long as they are used consistently.

a. Conceptually it is necessary to determine the depreciation expense

for the full year and then prorate it between the two periods involved.

b. As a practical matter many companies use arbitrary fractional-year

depreciation policies (such as a full year's depreciation in the year
of acquisition and none in the year of disposal). These policies are
acceptable as long as they are applied 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 retained
earnings available for dividends.

3. Revision of estimates. Changes in estimates of salvage value or

service life are shown in current and prospective (future) periods as
required by PAS 8 (see change in accounting estimates).

a. Point out the difference between a change of accounting principle, a

correction of an error, and a change of accounting estimate.

b. In a change of accounting estimate, no retroactive adjustment of

opening balances is made and no journal entry is required.

c. When the straight-line method is used, the subsequent depreciation

expense is equal to

EXERCISE

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Depreciation methods.
Each of the statements appearing below is descriptive of one or more of the following
depreciation methods. In the spaces below, place the letter(s) belonging to the
method(s) to which the statement best applies.
a. Declining-balance e. Sum-of-the-years'-digits
b. Group f. Units of output
c. Composite g. Working hours
d. Straight-line

______ 1. The depreciation charged by this method decreases by the same amount each
year. C

______ 2. These methods are used for depreciating multiple-asset accounts. B,C

______ 3. These methods allocate larger shares of the cost of a plant asset to expense
during the years in which the greatest use is made of the asset. F,G

______ 4. These methods always allocate larger shares of the cost of a plant asset to
expense during the earlier years of its life. A,E

______ 5. Once the depreciable base, scrap value, and life of a plant asset are
determined, the annual charges to operations under this method will be the
same. D

MODIFIED TRUE or FALSE

A. Only Statement 1 is True

B. Only Statement 2 is True
C. Both Statements are True
D. Both Statements are False

1. 1. The straight-line method of depreciation is based on the assumption that

depreciation expense can be regarded as a constant function of time.

2. Plant assets should be written down (below cost) when their market value has
declined temporarily.

2. 1.The accounting profession has developed specifically recommended procedures for

recording appraisal increases with respect to plant assets.

___2. An asset's cost minus its accumulated depreciation equals its book value.

3. 1.The sum-of-the-years'-digits method of depreciation ignores salvage value in the

computation of an asset's depreciable base.

2. When using the double-declining-balance method of determining depreciation, a

declining percentage is applied to a constant book value.

4.__1.The book value of plant assets declines more rapidly under decreasing-charge
methods than under the straight-line method.

2._Accounting depreciation is computed by determining the change in the market value

of a company's plant assets during the period under review.

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MULTIPLE CHOICE:

1.The following is true of depreciation accounting.

a. It is not a matter of valuation.
b. It is part of the matching of revenues and expenses.
c. It retains funds by reducing income taxes and dividends.
d. All of these.

2. Which of the following principles best describes the conceptual rationale for the
methods of matching depreciation expense with revenues?
a. Associating cause and effect
b. Systematic and rational allocation
c. Immediate recognition
d. Partial recognition

3. Depreciation accounting
a. provides funds.
b. funds replacements.
c. retains funds.
d. all of these.

4. Economic factors that shorten the service life of an asset include

a. obsolescence.
b. supersession.
c. inadequacy.
d. all of these.

5. The activity method of depreciation

a. is a variable charge approach.
b. assumes that depreciation is a function of the passage of time.
c. conceptually associates cost in terms of input measures.
d. all of these.

6. For income statement purposes, depreciation is a variable expense if the

depreciation method used is
a. units-of-production.
b. straight-line.
c. sum-of-the-years'-digits.
d. declining-balance.

7. If an industrial firm uses the units-of-production method for computing

depreciation on its only plant asset, factory machinery, the credit to accumulated
depreciation from period to period during the life of the firm will
a. be constant.
b. vary with unit sales.
c. vary with sales revenue.
d. vary with production.

8. Use of the double-declining-balance method

a. results in a decreasing charge to depreciation expense.
b. means salvage value is not deducted in computing the depreciation base.
c. means the book value should not be reduced below salvage value.
d. all of these.

9. Use of the sum-of-the-years'-digits method

a. results in salvage value being ignored.

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b. means the denominator is the years remaining at the beginning of the year.
c. means the book value should not be reduced below salvage value.
d. all of these.

10. A graph is set up with "yearly depreciation expense" on the vertical axis and
"time" on the horizontal axis. Assuming linear relationships, how would the
graphs for straight-line and sum-of-the-years'-digits depreciation, respectively,
be drawn?
a. Vertically and sloping down to the right
b. Vertically and sloping up to the right
c. Horizontally and sloping down to the right
d. Horizontally and sloping up to the right

11. A principal objection to the straight-line method of depreciation is that it

a. provides for the declining productivity of an aging asset.
b. ignores variations in the rate of asset use.
c. tends to result in a constant rate of return on a diminishing investment base.
d. gives smaller periodic write-offs than decreasing charge methods.

12. Each year a company has been investing an increasingly greater amount in
machinery. Since there is a large number of small items with relatively similar
useful lives, the company has been applying straight-line depreciation at a
uniform rate to the machinery as a group. The ratio of this group's total
accumulated depreciation to the total cost of the machinery has been steadily
increasing and now stands at .75 to 1.00. The most likely explanation for this
increasing ratio is the
a. company should have been using one of the accelerated methods of
depreciation.
b. estimated average life of the machinery is less than the actual average useful
life.
c. estimated average life of the machinery is greater than the actual average
useful life.
d. company has been retiring fully depreciated machinery that should have
remained in service.

13. For the composite method, the composite

a. rate is the total cost divided by the total annual depreciation.
b. rate is the total annual depreciation divided by the total depreciable cost.
c. life is the total cost divided by the total annual depreciation.
d. life is the total depreciable cost divided by the total annual depreciation.

14. Depreciation is normally computed on the basis of the nearest

a. full month and to the nearest cent.
b. full month and to the nearest dollar.
c. day and to the nearest cent.
d. day and to the nearest dollar.

15. Quayle Company acquired machinery on January 1, 1999 which it depreciated

under the straight-line method with an estimated life of fifteen years and no
salvage value. On January 1, 2004, Quayle estimated that the remaining life of
this machinery was six years with no salvage value. How should this change be
accounted for by Quayle?
a. As a prior period adjustment
b. As the cumulative effect of a change in accounting principle in 2004
c. By setting future annual depreciation equal to one-sixth of the book value on
January 1, 2004
d. By continuing to depreciate the machinery over the original fifteen year life

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16. A change in estimate should

a. result in restatement of prior period statements.
b. be handled in current and future periods.
c. be handled in future periods only.
d. be handled retroactively.

17. White Printing Company determines that a printing press used in its operations
has suffered a permanent impairment in value because of technological changes.
An entry to record the impairment should
a. recognize an extraordinary loss for the period.
b. include a credit to the equipment accumulated depreciation account.
c. include a credit to the equipment account.
d. not be made if the equipment is still being used.

18. A general description of the depreciation methods applicable to major classes of

depreciable assets
a. is not a current practice in financial reporting.
b. is not essential to a fair presentation of financial position.
c. is needed in financial reporting when company policy differs from income tax
policy.
d. should be included in corporate financial statements or notes thereto.

19. Dividends representing a return of capital to stockholders are not uncommon

among companies which
a. use accelerated depreciation methods.
b. use straight-line depreciation methods.
c. recognize both functional and physical factors in depreciation.
d. none of these.

20. Depletion expense

a. is usually part of cost of goods sold.
b. includes tangible equipment costs in the depletion base.
c. excludes intangible development costs from the depletion base.
d. excludes restoration costs from the depletion base.

E N D

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