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ACC 318 Chapter 11 Fall 2006


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What does depreciation account for?
Depreciation is not a matter of valuation but a means of cost allocation.
What are the major decreasing-charge methods?
1. Sum-of-the-years’ digits 2. Declining-balance method.
Define depreciation
Depreciation is defined as 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.
What three questions need to be answered to set up a depreciation cycle for an asset?
1. What depreciable base is to be used for the asset? 2. What is the asset’s useful life? 3. What method of cost apportionment is best for this asset?
Define the activity method of depreciation
The activity method (also called the variable charge approach) assumes that depreciation is a function of use or productivity instead of the passage of time. It considers either the input or the output measures.
Define salvage value
It is the estimated amount that will be received at the time the asset is sold or removed from service.
Assets are retired for what two reasons?
physical factors and economic factors
Define physical factors
Physical factors are the wear and tear, decay, and casualties that make it difficult for the asset to perform indefinitely.
What is the equation for the activity method?
[(Cost – salvage)*units] / total estimated units
What are the 3 categories of economic factors?
inadequacy, supersession, and obsolescence.
What is the recording of depreciation an attempt to do?
Depreciation is an attempt to match the cost of an asset to the periods that benefit from the use of that asset.
define inadequacy
It results when an asset ceases to be useful to a give enterprise because the demands of the firm have increased.
define supersession
Supersession is the replacement of one asset with another more efficient and economical asset.
What is the assumption of the straight-line method?
The straight-line method considers depreciation a function of time rather than a function of usage.
define obsolescence
Obsolescence is the catchall for situations not involving inadequacy and supersession.
What are the two special depreciation methods
(a) group and composite methods (b) hybrid or combination methods
A company may choose these methods because the assets have unique characteristics, or the industry dictates that a special depreciation method be adopted.
What are the 3 major methods of depreciation?
1. Activity method 2. Straight-line method 3. Decreasing-charge method
What is the equation for the straight-line method?
(Cost – salvage) / estimated service life
What is the assumption of the sum-of-the-year's-digits method?
depreciation occurs the most when the asset is the most new
What is the equation for the denominator in the sum-of-the-year's-digits method?
What is the equation for the double declining balance method?
depreciation = (book value)*[2*(1/estimated service life)]
How should you depreciate for partial periods?
In computing depreciation expense for partial periods, it is necessary to determine the depreciation expense for the full year and then to prorate this depreciation expense between the two periods involved. This process should continue throughout the useful life of the asset.
In what way must a company depreciate its assets?
A company is at liberty to adopt any one of these several factional-year policies in allocating cost to the first and last years of an asset’s life so long as the method is applied consistently. However, unless otherwise stipulated, depreciation is normally computed on the basis of the nearest full month.
How are changes in depreciation estimates handled?
Changes in estimate should be handled in the current and prospective periods. No entry is made at the time the change in estimate occurs, and charges for depreciation in subsequent periods (assuming use of the straight-line method) are based on dividing the remaining book value less any salvage value by the remaining estimated life.
How is the lower of cost or market rule applied to property, plant, and equipment?
It isn't.
What is an impairment?
Impairment occurs when the carrying amount of an asset is not recoverable, and therefore a write-off is needed.
What are some examples of events that might lead to an impairment?
1. A significant decrease in the market value of an asset. 2. A significant change in the extent or manner in which an asset is used. 3. A significant adverse change in legal factors or in the business climate that affects the value of an asset. 4. An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset. 5. A projection or forecast that demonstrates continuing losses associated with an asset.
Explain the "recoverability test"
It is used to determine whether an impairment has occurred. First, estimate the future net cash flows expected from the use of that asset and its eventual disposition. 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.
How is the "loss on impairment" measured?
The impairment loss is the amount by which the carrying amount of the asset exceeds its fair value. The fair value of an asset is measured by its market value if an active market for it exists. If no active market exists, the present value of expected future net cash flows should be used.
What is a common misconception about depreciation?
That it provides funds for replacement of fixed assets. It is similar to any other expense in that it reduces net income. It does not involve a current cash flow.
Where do the funds for the replacement of the fixed asset come from?
The revenues generated through the use of the asset
How is a loss on impairment recorded?
Debit "Loss on Impairment." Credit "Accumulated Depreciation."
How is impairment loss recorded in the income statement?
The impairment loss is reported as part of income from continuing operations, generally in the “other expenses and losses” section.
When does the lower of cost or market apply to an asset?
Assets held for disposal are like inventory and should be reported at the lower of cost or net realizable value.
What is the process of determining an impairment loss?
1. Review events or changes in circumstances for possible impairment
2. If the review indicates impairment, aplly the recoverability test. If the sum of the expected future net cash flows from the long lived asset is less than the carrying amount of the asset, an impairment has occurred.
3. Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset is greater than the fair value of the asset.
How should losses or gains related to impaired assets be recorded in the income statement?
continuing operations
What are restoration costs, and how should they be treated?
substantial costs to restore property to its natural state after extraction has occurred; should be added to the depletion base
Are assets being held for disposal depreciated?
No, not during the period they are being held. Assets held for disposal are like inventory and should be reported at the lower of cost or net realizable value
Can you restore an impairment loss on an asset held for use?
Once an impairment loss is recorded, the reduced carrying amount of an asset held for use becomes its new cost basis.
What happens if the impaired asset is intended to be disposed of instead of held for use?
The impaired asset is reported at the lower of cost or Net realizable value[fair value - cost to sell]
Can an asset being held for disposal be written up or down in future periods?
yes as long as the write-up is never to an amount greater than the carrying amount of the asset before the impairment. Losses or Gains should be reported as part of income from continuing operations.
The computation of the depletion base involves what four factors?
1. acquistion cost of the deposit 2. exploration cost 3. development costs 4. restoration costs

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