Depreciation - Method of Cost Allocation

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.

Allocating costs of long-term assets:

Long-lived assets = Depreciation expense
Intangibles = Amortization expense
Mineral resources = Depletion expense
Depreciation - Method of Cost Allocation

Factors Involved in the Depreciation Process

Three basic questions:
(1) What depreciable base is to be used?

(2) What is the asset’s useful life?

(3) What method of cost apportionment is best?

Depreciation - Method of Cost Allocation

Factors Involved in the Depreciation Process

Depreciable Base
Illustration 11-1
Depreciation - Method of Cost Allocation

Factors Involved in the Depreciation Process

Estimation of Service Lifes
 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).
Depreciation - Method of Cost Allocation

Methods of Depreciation
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) Diminishing (accelerated)-charge methods:

a) Sum-of-the-years’-digits.

b) Declining-balance method.
 Depreciation - Method of Cost Allocation

Activity Method
Illustration 11-2

Stanley Coal
Mines Facts

Illustration: If Stanley uses the crane for 4,000 hours the first
year, the depreciation charge is:
Illustration 11-3
 Depreciation - Method of Cost Allocation

Straight-Line Method
Illustration 11-2

Stanley Coal
Mines Facts

Illustration: Stanley computes depreciation as follows:

Illustration 11-4
 Depreciation - Method of Cost Allocation

Diminishing-Charge Methods
Illustration 11-2

Stanley Coal
Mines Facts

Sum-of-the-Years’-Digits. Each fraction uses the sum of the

years as a denominator (5 + 4 + 3 + 2 + 1 = 15). The
numerator is the number of years of estimated life remaining
as of the beginning of the year.

Alternate sum-of-the- n(n+1) 5(5+1)

= = 15
years’ calculation 2 2
 Depreciation - Method of Cost Allocation

Sum-of-the-Years’-Digits
Illustration 11-6
 Depreciation - Method of Cost Allocation

Diminishing-Charge Methods
Illustration 11-2

Stanley Coal
Mines Facts

Declining-Balance Method.
► Utilizes a depreciation rate (%) that is some multiple of
the straight-line method.

► Does not deduct the residual value in computing the

depreciation base.
 Depreciation - Method of Cost Allocation

Declining-Balance Method
Illustration 11-7
Depreciation - Method of Cost Allocation

Component Depreciation
IFRS requires that each part of an item of property, plant,
and equipment that is significant to the total cost of the
asset must be depreciated separately.
Depreciation - Method of Cost Allocation

Component Depreciation
Illustration: EuroAsia Airlines purchases an airplane for
€100,000,000 on January 1, 2011. The airplane has a useful
life of 20 years and a residual value of €0. EuroAsia uses the
straight-line method of depreciation for all its airplanes.
EuroAsia identifies the following components, amounts, and
useful lives.
Illustration 11-8
Depreciation - Method of Cost Allocation

Computation of depreciation expense for EuroAsia for 2011.

Illustration 11-9

Depreciation journal entry for 2011.

Depreciation Expense 8,600,000

Accumulated Depreciation—Airplane 8,600,000
Depreciation - Method of Cost Allocation

Special Depreciation Issues

(1) How should companies compute depreciation for
partial periods?

(2) Does depreciation provide for the replacement of

assets?

(3) How should companies handle revisions in

depreciation rates?
 Depreciation - Method of Cost Allocation
E11-5 (Depreciation Computations—Four Methods): Maserati
Corporation purchased a new machine for its assembly process on
August 1, 2010. The cost of this machine was €150,000. The
company estimated that the machine would have a salvage value of
€24,000 at the end of its service life. Its life is estimated
at 5 years and its working hours are estimated at 21,000 hours. Year-
end is December 31.

Instructions: Compute the depreciation expense for 2010 under the

following methods.
(a) Straight-line depreciation. (c) Sum-of-the-years’-digits.
(b) Activity method (d) Double-declining balance.
 Depreciation - Method of Cost Allocation

Straight-line Method
Current
Depreciable Annual Partial Year Accum.
Year Base Years Expense Year Expense Deprec.
2010 $ 126,000 / 5 = $ 25,200 x 5/12 = $ 10,500 $ 10,500
2011 126,000 / 5 = 25,200 25,200 35,700
2012 126,000 / 5 = 25,200 25,200 60,900
2013 126,000 / 5 = 25,200 25,200 86,100
2014 126,000 / 5 = 25,200 25,200 111,300
2015 126,000 / 5 = 25,200 x 7/12 = 14,700 126,000
$ 126,000
Journal entry:

2010 Depreciation expense 10,500

Accumultated depreciation 10,500
 Depreciation - Method of Cost Allocation

Activity Method (Assume 800 hours used in 2010)

($126,000 / 21,000 hours = $6 per hour)
(Given) Current
Hours Rate per Annual Partial Year Accum.
Year Used Hours Expense Year Expense Deprec.
2010 800 x $6 = $ 4,800 $ 4,800 $ 4,800
2011 x =
2012 x =
2013 x =
2014 x =
800 $ 4,800

Journal entry:
2010 Depreciation expense 4,800
Accumultated depreciation 4,800
 Depreciation - Method of Cost Allocation
5/12 = .416667
Sum-of-the-Years’-Digits Method 7/12 = .583333
Current
Depreciable Annual Partial Year Accum.
Year Base Years Expense Year Expense Deprec.

2010 $ 126,000 x 5/15 = 42,000 x 5/12 $ 17,500 $ 17,500

2011 126,000 x 4.58/15 = 38,500 38,500 56,000

2012 126,000 x 3.58/15 = 30,100 30,100 86,100

2013 126,000 x 2.58/15 = 21,700 21,700 107,800

2014 126,000 x 1.58/15 = 13,300 13,300 121,100

2015 126,000 x .58/15 = 4,900 4,900 126,000

$ 126,000
Journal entry:
2010 Depreciation expense 17,500
Accumultated depreciation 17,500
 Depreciation - Method of Cost Allocation
Sum-of-the-Years’-Digits Method
Year Calculation Depreciation Accumulation
2010 $17,500 $17,500

2011

$ 38,500 $56,000
2012

$ 30,100 $86,100
2013

$ 21,700 $107,800
2014

$ 13,300 $121,100
2015 $ 4,900 $126,000
 Depreciation - Method of Cost Allocation

Double-Declining Balance Method

Current
Depreciable Rate Annual Partial Year
Year Base per Year Expense Year Expense

2010 $ 150,000 x 40% = $ 60,000 x 5/12 = $ 25,000

2011 125,000 x 40% = 50,000 50,000

2012 75,000 x 40% = 30,000 30,000

2013 45,000 x 40% = 18,000 18,000

2014 27,000 x 40% = 10,800 Plug 3,000

$ 126,000
Journal entry:
2010 Depreciation expense 25,000
Accumultated depreciation 25,000
Depreciation - Method of Cost Allocation

Depreciation and Replacement of PP&E

Depreciation

► Does not involve a current cash outflow.

► Funds for the replacement of the assets come from

the revenues.
Depreciation - Method of Cost Allocation

Revision of Depreciation Rates

 Accounted for in the current and prospective periods.

 Not handled retrospectively

 Not considered errors or extraordinary items

 Change in Estimate Example

Arcadia HS, purchased equipment for $510,000 which was

estimated to have a useful life of 10 years with a residual value
of $10,000 at the end of that time. Depreciation has been
recorded for 7 years on a straight-line basis. In 2010 (year 8), it
is determined that the total estimated life should be 15 years
with a residual value of $5,000 at the end of that time.

Questions:
 What is the journal entry to correct No Entry
the prior years’ depreciation? Required

 Calculate the depreciation expense

for 2010.
Change in Estimate Example After 7 years

Equipment cost $510,000 First, establish NBV

Salvage value - 10,000 at date of change in
Depreciable base 500,000 estimate.
Useful life (original) 10 years
Annual depreciation $ 50,000 x 7 years = $350,000

Balance Sheet (Dec. 31, 2009)

Equipment $510,000
Accumulated depreciation 350,000
Net book value (NBV) $160,000
Change in Estimate Example After 7 years

Net book value $160,000 Depreciation

Salvage value (new) 5,000 Expense calculation
Depreciable base 155,000 for 2010.
Useful life remaining 8 years
Annual depreciation $ 19,375

Journal entry for 2010

Depreciation expense 19,375

Accumulated depreciation 19,375