Depreciation, Impairment and Depletion

Depreciation, Impairment and Depletion

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Depreciation

Assets last for varied periods of time. Some have short lifespan while others including buildings, furniture, and cars among other assets may last for more than one year. However, they are all destined to lose value as a result of tear, wear, age, and decrease in their demand or obsolescence (Clyde, et al 2009). A fraction of the cost of such assets is utilized during every accounting period usually monthly, quarterly or annually. This fraction is usually reported in the income statement as depreciation expense. Basically, the annual transfer of a portion of the asset’s cost from balance sheet to the income statement constitutes the concept of depreciation in accounting. Depreciation generally involves the rational and systematic distribution of the cost of tangible assets over the life of the assets in question (Clyde, et al 2009). Depreciation methods may be based on either time or the activity. The former encompasses declining balance method, straight line method as well as sum-of-the-years’-digits method.

Straight line depreciation is calculated by subtracting residual value from the original cost of the asset followed by dividing the difference by the useful life of the asset i.e. Depreciation = (Cost – Residual value) / Useful life. For instance, company x purchased an equipment on 1st of July 2010 at a cost of 100000. This asset is estimated to have 3 year useful life.  At the end of the 3rd year, the residual value will be $30,000.  Company Y recognizes a monthly depreciation.  Depreciation expenses for 2010 and 2011 may be calculated using straight line depreciation method as follows:

Depreciation for 2010 = (100000-30000) x 1/3 x 6/12 = $ 11667

Depreciation for 2011 = (100000-30000) x 1/3 x 12/12 = $23333

On the other hand, depreciation may be calculated using declining balance method where;

Depreciation = Book value x Depreciation rate

       Book value = Cost – Accumulated depreciation

Depreciation rate for double declining balance method = Straight line depreciation rate x 200% and Depreciation rate for 150% declining balance method = Straight line depreciation rate x 150%

In the above mentioned scenario, Useful life is three years hence; 

Straight line depreciation rate = 1/3= 33.3% per year

Depreciation rate for double declining balance method = 33.3% x 200% = 33.3% x 2 = 66.6% per yearDepreciation for 2010 = $100,000 x 66.6% x 6/12 = $33300

Finally, depreciation is given by;

Depreciation expense = (Cost – Salvage value) x Fraction according to sum-of-the-years’-digits method.

Impairments

Assets may be revalued to establish the true value of the fixed assets that are owned by a business venture. In many instances, such values of the assets fluctuate due to a variety of reasons including decline in demand, wear and tear, age as well as obsolescence. However, it is always expected that the carrying amount of the assets are recovered during the process (Schueze, & Wolnizer, 2004). The projected cash flow from the use and discarding of the asset should equal or exceed the carrying amount failure of which impairment shall have occurred. In such situation, the asset’s carrying amount is not recoverable and a write-off is inevitable. Impairment may occur when assets are held for use as well as for resale. In the former, impairment loss equals carrying value less Fair value but the restoration of such loss is not permitted. Furthermore, the depreciation is taken on a cost basis unlike when the assets are held for resale. On the other hand, restoration of the impairment loss is permitted in cases where the assets are held for resale (Schueze, & Wolnizer, 2004). Here, the Impairment loss equals carrying value less fair value less cost of disposal. Generally, an asset impairment accounting entails the estimation of profit generated from capital assets over a period of time usually more than twenty years in comparison to the book value of the asset and the gains or loss posted in respect to the difference (Schueze, & Wolnizer, 2004).

Depletion

Just like depreciation, depletion involves the process of cost recovery through tax reporting as well as accounting. Depletion is generally applied in such industries as petroleum, HYPERLINK “http://en.wikipedia.org/wiki/Mining” o “Mining” mining, HYPERLINK “http://en.wikipedia.org/wiki/Timber” o “Timber” timber, among other similar firms. An operator or an owner of the asset in question can account for the decrease in the reserves of the product through the application of depletion deductions. Different types of depletion are utilized in respect to the kind of assets in question. For instance, cost depletion is necessary for standing timber while a method that gives a larger deduction is suitable for a mineral property (Eisen, 2003). The cost and percentage depletion types are generally used for the purpose of tax reporting. Generally, Depletion entails the writing off of natural resources through cost basis (Eisen, 2003). It is achieved through calculation of depletion expense of single units followed by multiplication by the total number of units extracted in a certain period. Therefore:

Depletion expense per unit = (Cost – Estimated Salvage Value)/Total Estimated Units Available

Despite the aforementioned advantage, cost recovery through depletion is characterized by a variety of problems including difficulties in the estimation of recoverable reserves, discovery values as well as justifying for the liquidating dividends.

Reference list:

Clyde, P. et al (2009). Financial Accounting: An Introduction to Concepts, Methods and Uses.

Florence: Cengage Learning.

Eisen, P. (2003). Accounting the Easy Way. 4th Ed. New York: Barron’s Educational Series.

Schueze, W. & Wolnizer, P. (2004). Mark-to-market accounting:”true north” in financial

reporting. New York: Routledge.

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