UNIT 5: PLANT ASSETS: DEPRECIATION AND DEPLETION

Contents
5.0 Aims and Objectives
5.1 Introduction
5.2 Depreciation
5.3 Factors in the Estimation of Periodic depreciation
5.3.1 Depreciation Base for the Asset
5.3.2 Estimate of Economic Life
5.3.3 Depreciation Methods
5.3.3.1 Straight-line Method
5.3.3.2 Accelerated Methods
5.3.3.2.1 Declining-Balance method
5.3.3.2.2 Sum-of-the-years’-Digits method.
5.3.3.3 Units-of-Output Method
5.3.3.4 Special Depreciation Methods
5.3.3.4.1 Inventory Method
5.3.3.4.2 Retirement and Replacement Methods
5.3.3.4.3 Group and Composite Methods
5.3.3.4.4 Interest Method of Depreciation
5.4 Depreciation Methods and Management Decisions
5.5 Depletion of Natural Resources
5.6 Summary
5.7 Answers to Check Your Progress
5.8 Model Examination Questions
5.9 Glossary

5.0 AIMS AND OBJECTIVES

This unit aims at discussing the factors involved in the accounting and recording of
depreciation and depletion. In addition to a thorough discussion of the accounting

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problems, the unit presents a detailed analysis and explanation of the various depreciation
methods used in practice.

After you have studied this unit, you will:

 understand the concept of depreciation;
 be abele to apply several depreciation methods and understand the incentives for
choosing them;
 appreciate the relationship among depreciation, taxes and cash flows ;
 understand the concept of depletion.

5.1 INTRODUCTION

Accountants, engineers, appraisers, and economists all define depreciation differently,

and they probably will continue to do so because each group uses depreciation in a
different context. All agree, however, that most assets are on an inevitable “March to the
rubbish heap”, and some type of write down or write off of cost is needed to indicate that
the usefulness of an asset has declined. Depreciation is the term most often employed to
indicate that tangible plant assets have declined in service potential. Where natural
resources, such as timber, gravel, oil, and coal, are involved, the term depletion is
employed. The expiration of intangible assets, such as patents, or goodwill, is called
amortization.

5.2 DEPRECIATION

The concept of depreciation is linked closely to the measurement of net income. Because
part of the service potential of depreciable plant assets is exhausted in the revenue
generating process each accounting period, the cost of these services must be deducted
from revenue in the measurement of net income; the expired cost must be recovered
before a business enterprise is considered “as well off” as at the beginning of the period.
Depreciation is the measurement of this expired cost.

To accountants, depreciation is not a matter of valuation but a means of cost allocation.

Assets are not depreciated on the basis of a decline in their fair market value, but on the
basis of systematic charges to expense. Depreciation is defined as the accounting process

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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.

5.3 FACTORS IN THE ESTIMATION OF PERIODIC DEPRECIATION

Before a pattern of charges to revenue can be established, three basic questions must be
answered:
1. What depreciable basis is to be used for the asset?
2. What is the asset’s useful life (Economic life)?
3. What method of cost allocation is best for this asset?

5.3.1 Depreciable Base for the Asset

The base established for depreciation is a function of two factors: the original cost and
salvage or disposal value. We discussed historical cost in unit 4. Salvage value is the
estimated amount that will be received at the time the asset is sold or removed from
service. It is the amount to which the asset must be written down or depreciated during its
useful life. To illustrate, if an asset has a cost of Br. 10, 000 and a salvage value of Br. 1,
000, its depreciable base or depreciable cost is Br. 9, 000 (Br. 10, 000 – Br. 1, 000). From
a practical standpoint, salvage value is often considered to be zero because its valuation is
small. Some long-lived assets, however, has substantial values.

The scrapping or removal of plant assets such as buildings, structures, and heavy
equipment may involve substantial costs in the year of retirement. Theoretically, removal
costs should be estimated and included in the depreciation base. The inclusion of removal
costs in the depreciation base means that the entire cost involved in obtaining services
from plant assets will be allocated to the revenue generated by the assets, without regard
to the timing of the expenditure. In practice, however, removal costs may be either
disregarded or netted against the estimated residual value of the assets. The depreciable
base for a plant asset thus becomes:

Depreciable base = Cost – Estimated salvage value (net)

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5.3.2 Estimate of Economic Life

The economic life of a plant asset is the total units of service expected to be derived from
the asset. Accountants commonly measure economic life of a plant asset in terms of time
units, for example, months or years. Economic life of a plant asset also may be measured
in terms of output or activity, expressed in such physical units as miles, or machine-
hours. Forces that tend to limit the economic life of a plant asset should be considered in
the determination of the type of unit of service to use for a specific asset or group of
assets. The cause of a decrease in economic life may be divided into physical
deterioration (including causalities), and functional or economic factors.

Physical deterioration results largely from wear and tear from use and the forces of
nature. These physical forces terminate the usefulness of plant assets by rendering them
incapable of performing the service for which they were intended and thus set the
maximum limit on economic life. Unusual events such as accidents, floods, and
earthquakes also serve to terminate or reduce the economic life of plant assets.

Functional or economic factors may render a plant asset that is in good physical condition
no longer useful because it is not economical to keep the asset in service, or because of
legal or income tax considerations related to the use of the asset. Two primary causes of
functional depreciation are obsolescence and inadequacy obsolescence refers to the effect
of innovations and technological improvements on the economic life of a plant assets.
Inadequacy refers to the effect of growth and changes in the scale of a business operation
in terminating the economic life of plant assets.

The choice of an appropriate unit of economic life of a plant asset also requires a
determination of the causes of depreciation. The objective is to choose the unit most
closely related to the cause of service exhaustion. When the economic life of a plant asset
is limited largely by the effect of physical deterioration, a unit that reflects physical use of
the asset is appropriate. For example, hours of service might be chosen as the unit of
economic life of an electric motor; or miles of service for a truck. In contrast, the physical
deterioration that limits the economic life of buildings probably is related more closely to

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the passage of time than to usage. Thus, an estimated economic life in terms of years is
more appropriate for buildings.

5.3.3 Depreciation Methods

When the economic life of a plant asset has been estimated, and its depreciation base
established, there remains the problem of determining the portion of cost that will expire
with each unit of economic life. There are two major variables to be considered in
reaching a solution to this problem:
1. The quality of services used may be equal or may differ during each accounting
period of economic life.
2. The cost of various units of service may be equal or may differ during each
accounting period of economic life.

There are several depreciation methods that attempt to recognize those factors in varying
degrees. They may be classified as follows:
1. Straight-line method
2. Accelerated methods
a. Declining-balance method
b. Sum-of-the-years’-digits method
3. Units-of-output method
4. Special depreciation methods
- Inventory method
- Retirement and replacement method
- Group and composite method
- Compound interest method

5.3.3.1 Straight-line Method

The straight-line method is based on the assumption that a plant asset declines in
usefulness at a constant rate. The straight-line method relates depreciation directly to the
passage of time rather than to the asset’s use, resulting in a constant amount of
depreciation recognized per time period.

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The formula for computing periodic straight-line depreciation is:
Cost  Re sidual Value  net 
Annual straight-line depreciation = Years of estimated Economic Life

To illustrate the straight-line method of depreciation, assume that a machine is acquired

on January 2, 1990 for Br. 7, 000 and that the net residual value of the machine at the end
of four years of economic life is estimated at Br. 1, 000. The depreciation expense of the
machine over its economic life is:
Br.7,000  Br.1,000 Br.6,000
Annual depreciation expense =  = Br. 1, 500
4 4
At the end of each year, depreciation expense of this machine is recorded as follows:
Depreciation Expense……………………….1, 500
Accumulated depreciation-machine…………….1, 500

Check Your Progress –1

1. Given the following data for Jupiter Company for equipment.

Acquisition cost, January 1, 1995………………Br. 6, 600
Residual value…………………………………...……600
Estimated Economic life…………………….……5 years
Compute depreciation expense for 1995 using straight-line method?
________________________________________________________________________
________________________________________________________________________
_________________________________.

5.3.3.2 Accelerated Method

The assumption that plant assets yield either a greater quantity of service or more
valuable service in early years of their economic life has led accountants to devise
methods of depreciation that result in larger amounts of depreciation in early years of
economic life, and smaller amounts in later years. The three most widely used accelerated
methods of depreciation are.

5.3.3.2.1 Declining-Balance Method

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This method utilizes a depreciation rate (expressed as a percentage) that is some multiple
of the straight-line method. For example, the double declining rate for a 10-year asset
would be 20% (double the straight line rate, which is 10%). The declining-balance rate
remains constant and is applied to the reducing book value each year. Unlike other
methods, in the declining-balance method the salvage value is not deducted in computing
the depreciation base.

The declining-balance rate is multiplied by the book value of the asset is reduced each
period. Since the book value of the asset is reduced each period by the depreciation
charge, the constant declining-balance rate is applied to a successively lower book value
that results in lower depreciation charges each year. This process continues until the book
value of the asset is reduced to its estimated salvage value, at which time depreciation is
discontinued. As indicated above, various multiples are used in practice, such as twice
(200%) the straight-line rate (double-declining-balance method) and 150% of the
straight-line rate etc.

To illustrate, assume that Famine Company recently purchased crane for digging
purposes. Pertinent data concerning the purchase of the crane are:
Cost of crane……………………..Br. 500, 000
Estimated Economic life…………………5 years
Estimated salvage value………………..Br. 50, 000
Productive life in hours………………………30, 000 hours.
Using the doubles declining approach the depreciation expense per year is as follow:
Book value of Accumulated Book value
Year Asset at beginning of year Rate Depn. Expense Depn. End of year
1 Br. 500, 000 40% Br. 200, 000 Br. 200, 000 Br. 300, 000
2 300, 000 40% 120, 000 320, 000 180, 000
3 180, 000 40% 72, 000 392, 000 108, 000
4 108, 000 40% 43, 200 435, 200 64, 800
5 64, 800 40% 14, 800* 450, 000 50, 000

*
Limited to Br. 14, 800 because book value should not be less than salvage value.
5.3.3.2.2 Sum-of-the-years’-Digits Method

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This method results in a decreasing depreciation charges based on a decreasing fraction
of depreciable cost (original cost less salvage value). Each fraction uses the sum of the
years as a denominator and the number of years of estimated life remaining as of the

n( n  1)
beginning of the year as a numerator. The denominator is calculated as where n
2
is the economic life of the asset.

In this method, the numerator decreases year by year although the denominator remains
constant. At the end of the asset’s useful life, the balance remaining should be equal to
the salvage value. Using the data for Famine Company above, the depreciation expense
per year is calculated as follows:
Depreciation Remaining life Depreciation Depreciation Book value
Year Base in year Fraction Expense End of year
1 Br. 450, 000 5 5/15* Br. 150, 000 Br. 350, 000
2 450, 000 4 4/15 120, 000 230, 000
3 450, 000 3 3/15 90, 000 140, 000
4 450, 000 2 2/15 60, 000 80, 000
5 450, 000 1 1/15 30, 000 50, 000

* n( n  1) 5(5  1) 5(6)
= = 15
2 2 2
N.B The depreciation rate under the sum-of-years’-digits-method should be used for one
full year (12 months)

Check Your Progress –2

1. A plant asset Cost Br. 56, 000, had an economic life of 8 years, and an estimated net
residual value of Br. 2, 000.
a. Compute depreciation Expense for the first year of economic life under the sum-of-
the-years’-digits method of depreciation
b. Assume that this asset was acquired on April 1, 1990. Compute depreciation
expense for the full year ended Dec. 31, 1991, under the sum-of-the-years’-digits
method of depreciation.

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5.3.3.3 Units-of-output method

This method assumes that depreciation is a function of use or productivity instead of the
passage of time. The life of the asset is considered in terms of either the output it provides
(units it produces), or an input measure such as the number of hours it works.
Conceptually, the proper cost association is established in terms of output instead of
hours used, but often the output is not easily measurable. In such cases, an input measure
such as machine hours is a more appropriate method of measuring the birr amount of
depreciation charges for a given accounting period.

For Famine Company above, if the crane is used 4, 000 hours the first year, the
depreciation charge is
 Cost less salvage value 
Depreciation expense = Total estimated hours x Hours this year

Br.500,000  Br.50,000
= 30,000
x 4, 000

= Br. 60, 000

The major limitation of this method is that it is not appropriate in situations in which
depreciation is a function of time instead of usage. For example, a building is subject to a
great deal of steady deterioration from the elements (time) regardless of its use. In
addition, where an asset is subject to economic or functional factors, independent of its
use, the units-of-output method losses much of its significance. For example, if a
company is expanding rapidly, a particular building may soon become obsolete for its
intended purposes (function).

Check Your Progress –3

1. Describe a situation in which the use of the output method of depreciation is

appropriate.
__________________________________________________________________
____________________________.

5.3.3.3 Special Depreciation Methods

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Sometimes an enterprise does not select one of the more popular depreciation methods
because the assets involved have unique characteristics, or the nature of the industry
dictates that a special depreciation method be adopted. Generally, these systems can be
classified into five groups:

5.3.3.3.1 Inventory methods

The inventory method is used to value small tangible assets such as hand tools or utensils.
A tool inventory, for example, might be taken at the beginning and at the end of the year;
the value of the beginning inventory plus the cost of tools acquired for the year less the
value of the ending inventory provides the amount of depreciation expense for the year.
This method is appealing because separate depreciation schedules for the assets in use are
impractical.

5.3.3.3.2 Retirement and Replacement Methods

The retirement and replacement methods are used principally by public utilities and
railroads that own many similar units of small value such as poles, conductors, and
telephones. The purpose of these approaches is to avoid elaborate depreciation schedules
for individual assets. The distinction between the two methods is that the retirement
method charges the cost of the retired asset (less salvage value) to depreciation expense;
the replacement method charges the cost of units purchased less salvage value from the
units replaced to depreciation expense. In the replacement method the original cost
(sometimes called aboriginal cost) of the old assets is maintained in the accounts
indefinitely.

To illustrate these two methods, let us assume that the transmission lines of DOF
Company originally cost Br. 1, 000, 000 and that 8 years later lines costing Br. 150, 000
are replaced with lines having a cost of Br. 200, 000. Any salvage value from the old
transmission lines is considered a reduction of the depreciation expense in the period of
retirement or replacement under both methods. Neither makes use of an accumulated
depreciation account.
Entries under Retirement and Replacement Methods

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 Retirement method Replacement method
Installation of lines – 1990
Plant assets-lines…………….1, 000, 000 Plant assets-lines –1, 000, 000
Cash……………………….1, 000, 000 Cash…………1, 000, 000
Retirement of old asset – 1998
Depreciation Expense 150, 000 no entry
Plant assets-lines…………...150, 000
Cost of new asset – 1998:
Plant assets-line………..200, 000 Depreciation Expense – 200, 000
Cash………………….200, 000 Cash…………..……200, 000

5.3.3.3.3 Group and Composite Method

Depreciation methods are usually applied to a single asset. In certain circumstances,

however, multiple-asset accounts are depreciated using one rate. Two methods of
depreciating multiple-asset accounts are employed: the group method and the composite
method. The term group refers to a collection of assets that are similar in nature;
composite refer to a collection of assets that are dissimilar in nature. The group method is
frequently used where the assets are fairly homogeneous and have approximately the
same useful lives. The composite approach is used when the assets are heterogeneous and
have different lives.

The average depreciation or composite rate is determined by dividing the depreciation per
year by the total cost of the assets.

5.3.3.3.4 Interest method of Depreciation

For many years the annuity and sinking fund methods of depreciation have received
attention from accounting theorists because of their focus on cost recovery and rate of
return on the investment in depreciable plant assets. A depreciable plant asset represents a
bundle of future services to be received periodically over the economic life of the asset.
The cost of such an asset may be viewed as the present value of the equal periodic rents
(services) discounted at a rate of interest consistent with the risk factors identified with
the investment in the plant asset.

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 Annuity method
This method is appropriate when the periodic cost (depreciable) of using a long-lived
plant asset is considered to be equal to the total of the expired cost of the asset and the
implicit interest on the un recovered investment in the asset. Depreciation expense is
debited and accumulated depreciation and interest revenue are credited periodically.

 Sinking-Fund Method
This method might be used when a fund is to be accumulated to replace a plant asset at
the end of its economic life. Under the sinking-fund method, the amount of annual
depreciation expense is equal to the increase in the asset replacement fund. The increase
in the fund consists of the equal periodic deposits (rents) plus the interest revenue
realized at the assumed rate on the sinking-fund balance.

To illustrate the annuity method and sinking-fund method of depreciation, assume that a
trunk with an economic life of five years and a net residual value of Br. 42, 117.50 is
acquired for Br. 500, 000 at beginning of year 1.

Assume also that the fair rate of interest for this type of investment is 10% compounded
annually.

Required: A) using annuity method

1. Compute the yearly depreciation expense using the annuity method.
2. Prepare a summary of annuity method of depreciation.
3. Present the journal entries to record depreciation at the end of year 1 using the
annuity method.
B) Using sinking-fund method
4. Compute the yearly sinking-fund deposit using the sinking fund method of
depreciation.
5. Prepare a summary of sinking-fund method of depreciation.
6. Present the journal entries to record depreciation using the sinking-fund method
of depreciation for years 1 and 2
Solution:
1. Annual depreciation expense under annuity method.

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 Cost of asset less present value of net residual value
Depreciation = Pr esent value of ordinary annuity of 5 rents of 1 at 10%

Br.500,000  ( Br.42,117 .50 x 0.620921)

=
3.790787
= Br. 125, 000
2. Summary of annuity method of depreciation.

Implicit interest Credit to Accumulated Balance of Carrying

Year Depn. Expense revenue Depn. Account accumulated amount of
n
Dep . Account Truck
____ ____________ ______________ _________ ________ ______
0 Br. 500, 000
1 125, 000 50, 000 Br. 75, 000 Br. 75, 000 425, 000
2 125, 000 42, 500 82, 000 157, 500 342, 500
3 125, 000 34, 250 90, 750 248, 250 251, 750
4 125, 000 25, 175 99, 825 348, 075 151, 750
5 125, 000 15, 192.50 109, 807.50 457, 882.50 42, 117.50
Total Br. 625, 000 Br. 167, 117.50 Br. 457, 882.50

3. Journal entries under the annuity method

Year 1: Depreciation expense……………..125, 000
Interest Revenue……………………50, 000
Accumulated depreciation………….75, 000
B. Sinking-fund method
4. Yearly sinking-fund deposit
Cost of asset less net residual value
= Amount of ordinary annuity of 5 rents of 1 at 10%

Br.500,000  Br.42,117 .50

=
6.1051
= Br. 75, 000

5. Summary of sinking-fund method of depreciation

Annual Interest Total fund Fund Depn. Balance of Carrying

n
Year Deposit revenue Increase Balance Expense Acc. Dep . amount

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 Of Truck
____ ______ ______ ______ ______ ______ _______ _____
0 Br. 500, 000
1 Br. 75, 000 - Br. 75, 000 Br. 75, 000 75, 000 Br. 75, 000 425, 000
2 75, 000 Br. 7, 500 82, 500 197, 500 82, 500 157, 500 342, 500
3 75, 000 15, 750 90, 750 248, 250 90, 750 248, 750 251, 750
4 75, 000 24, 825 99, 825 348, 075 98, 825 348, 075 151, 925
5 75, 000 34, 807.50 109, 807.50 457, 882.50 109, 807.50 457, 882.50 42, 117.50

6. Journal entries under the sinking fund method.

Year 1: Sinking fund…………………………..75, 000
Depreciation expense………………….75, 000
Cash…………………………………….…..75, 000
Accumulated Depreciation…………………75, 000
Year 2: Sinking fund………………………….82, 500
Depreciation Expense…………………82, 500
Cash……………………………………..….75, 000
Interest revenue……………………….……..7, 000
Accumulated Depreciation…………………82, 000

5.4 DEPRECIATION METHODS AND MANAGEMENT DECISIONS

Plant assets play a large part in the productive process. It is easy to see that the cost of
direct material and direct labor becomes a part of finished product. It is not always so
clearly recognized, however, that a business enterprise also sells the services of the plant
assets used to manufacture and market its products.

The importance of depreciation stems from the various management decision that are
affected by it. To the extent that depreciation is a significant part of operating costs, and
that operating costs are relevant in business decisions, the relative importance of various
depreciation methods are significant in decisions relating to measurement of net income
and impact of inflation, computation of income taxes payable, and investment capital.

The purpose of depreciation accounting is to measure the amount that must be recovered
from revenue to compensate for the portion of plant asset cost that has been used up. This

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idea is embodied in the phrase maintenance of capital, which often is used in relation to
income measurement. During an inflationary period, any depreciation method based on
historical cost tends to understate the amount of capital consumed (depreciation). Thus, a
part of reported net income essentially represents return of capital-users of financial
statements should consider this shortcoming in the traditional income measurement
model and should make appropriate adjustments to restate depreciation and net income in
terms of current cost of plant assets.

Probably the strongest influence on depreciation policy is the income tax law. The
direction of the influence is toward rapid depreciation deductions. Depreciation expense
reduces taxable income and income tax expense.

The two most important questions relating to the role of depreciation in a capital
investment decisions are: Is depreciation a relevant cost in the decision? How does
depreciation affect the cash flows from the investment? In essence, two kinds of costs are
relevant to the decision to invest capital in productive assets: future costs (costs that will
be incurred as the result of the decision) and incremental costs (costs that will change as
the result of the decision). The expense represented by depreciation on existing plant
assets is attributable to an investment mode at some time in the past. Except to the extent
that an existing plant asset may be sold and some portion of the past investment
recovered, no present decision can change the amount of cost that has been sunk into that
part. Thus depreciation often has been referred to as a sunk cost.

Investment decisions are frequently made on the basis of the expected rate of return on
the investment. In the computation of rate of return, net cash flow from the investment
generally is a more useful concept than net income from the investment. Depreciation
expense does not generate cash directly; it is an expense that does not reduce cash, but is
deducted to compute taxable income. Thus, depreciation expense indirectly generates
larger cash flows form operations by reducing income taxes. For this reason, depreciation
is viewed as a powerful instrument for increasing cash flows and reducing the pay back
period (the number of years required to recover on investment in a plant asset) on new
investments in plant assets.

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Check Your Progress –3

1. The composite depreciation method:

A) Is applied to a group of homogeneous plant assets?
B) Is an accelerated method of depreciation?
C) Disregard net residual value. In the computation of the depreciation base
D) Does not involve the recognition of a gain or loss on the retirement of an
individual plant asset of the group.

5.5 DEPLETION OF NATURAL RESOURCES

Depreciable plant assets usually retain their physical characteristics as they are used in
operations. In contrast, natural resources in essence are long-term inventories of material
that will be removed physically from their sources. In either case whether accountants are
dealing with a “bundle of services” or a “store of material” – the basic problem is to
determine the cost of the units of services or material that are consumed during each
accounting period. The portion of the cost (or other valuation) assigned to property
containing natural resources that is applicable to the units removed from the property is
known as depletion.

The Depletion Base

The depletion base of property containing natural resources is the acquisition cost less the
estimated net residual value of the property after the resource have been removed. The
estimated cost of dismantling, abandoning, or restoring the property is taken into account
in the determination of the net residual value of the property.

Acquisition cost of a natural resource includes the price paid for the property and legal
fees, broker’s fees, and other fees incurred to acquire the property.

Estimate of Recoverable Units

The estimate of economic lives for plant assets is a relatively simple undertaking
compared with the estimate of recoverable units of natural resources. The recoverable
deposit of a natural resource should be measured in units of desired product, such as an

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ounce of silver or a pound of copper rather than in units of mined product, such as a ton
of raw ore.

The most widely method of depletion for financial accounting is the output (units-of-
production) method, which produces a constant depletion charge per unit of the natural
resource removed. To illustrate, assume that early in year 7, Low Company acquired
mining property for Br. 720, 000. It is estimated that there are 1.2 million recoverable
units of the natural resource, and that the land will have a net residual value (after
restoration costs) of Br. 60, 000 when the resource is exhausted. The depletion per unit of
output is computed as follows:
Cost  net residual value
Depletion = Estimated total re cov erable units

Br .720,000  Br.60,000
= 1,200,000 units

= Br. 0.55 per unit

If Low Company removed 300, 000 units of the natural resources from the ground in year
7, the journal entry to record depletion is as follows:
Depletion (300, 000 x Br. 0.55)…………………….165, 000
Accumulated depletion of mining property……………165, 000
Buildings and equipment used to remove natural resources may have an economic life
shorter than the time required to complete the removal, in which case the depreciation of
these assets should be recorded over their economic lives. Otherwise, depreciation is
computed by the output method, similar to the computation of depletion.

The amount of cost depletion is included in the cost of the inventory of the natural
resource and is recognized as an expense (cost of goods sold) only when the inventory is
sold.
When additional costs are incurred in the development of mining properties or estimates
of recoverable units are revised, the depletion rate is computed by dividing the carrying
amount (cost less accumulated depletion, less net residual value) of the mining property
(including any additional development costs) by the new estimate of recoverable units.

Check Your Progress –5

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1. The cost of certain mineral rights is Br. 400, 000 and that the deposit is estimated at 1,
000, 000 tons of ore of uniform grade.
(i) What is the depletion rate?
__________________________________________________________________
_________________.
(ii) If 90, 000 tons are mined during the year, what is the amount of depletion expense
for the year?
__________________________________________________________________
__________________.

5.6 SUMMARY

Depreciation, as defined in accounting, is the systematic allocation of the cost of a plant

asset to expense. The cost allocation approach is justified because it matches costs with
revenues and because fluctuation in market values is difficult to determine. An entry for
depreciation is recorded during each year of the asset’s useful life. The entry includes a
debit to depreciation expense and a credit to accumulated depreciation.

To compute depreciation, an accountant must establish the depreciation base to be used

for the asset, the asset’s economic life, and the depreciation method to be used.
Determination of the first two factors requires the use of estimates.

The depreciation method selected for a particular asset should be systematic and rational.
In other words, the method selected should, to the extent possible, match the probable
pattern of decline in an asset’s services.

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

Depletion refers to the process of recording the consumption of natural resources

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

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to the land. Depletion is normally based on the number of units extracted during the
period, which corresponds the units of production method of depreciation.

5.7 ANSWERS TO CHECK YOUR PROGRESS

1. Annual depreciation expense under the straight line method is computed as:
Cost  Estimated Re sidual Value ( net )
= Estimated Economic Life

Br.6,600  600 Br.6,000

= = Br. 1, 200
5 5
2. Computation of depreciation expense under sum-of-the-years’ digits method:
a) (Br. 56, 000 – Br. 2, 000) x 8/36* = Br. 12, 000
b) (Br. 54, 000 x 8/36 x 3/12) + (Br. 54, 000 x 7/36 x 9/12) = Br. 10, 875
* (8 x 9)  2 = 36
3. The output method of depreciation is particularly appropriate when plant asset use
fluctuates widely from year to year, and depreciation is more closely related to
actual use than to functional obsolescence.
4. D
5. (i) The depletion rate is Br. 400, 000  1, 000, 000
= Br. 0.40/ton
(ii) Depletion expense for the current year is
= Br. 90, 000 x Br. 0.40/ton
= Br. 36, 000

5.8 MODEL EXAMINATION QUESTIONS

Part I: True/False
________1. The accounting concept of depreciation reflects the decline in value
associated with a plant asset.

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________2. Whenever the economic nature of the asset is the primary determinant of
economic life, maintenance plays an extremely vital role in prolonging
economic life.
________3. Because depreciation expense does not require the use of cash, it is
theoretically correct to consider depreciation as a source of fund for the
enterprise.
________4. The replacement depreciation method is used when a new asset is purchased
to replace an old asset.
________5. The computation of depletion is essentially the same as the units-of-output
method.

Part II:
________1. Which of the following most accurately reflects the concept of depreciation
as used in accounting?
A. The process of charging the decline in value of an economic resource to
income in the period in which the benefit occurred.
B. The process of allocating the cost of tangible asset to expense in a
systematic and rational manner to those periods expected to benefit from
the use of the asset.
C. A method of allocating asset cost to an expense account in a manner,
which closely matches the physical deterioration of the tangible asset
involved.
D. An accounting concept that allocates the portion of an asset used up
during the year to the contra asset account for the purpose of properly
recording the fair market value of tangible assets.

________2. Which of the following depreciation methods does not consider salvage
value in computing the depreciation base of the asset?
A. Straight-line
B. Sum-of-the-years’-digits

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 C. Declining balance
D. Units-of-output-method
________3. ABC Company purchased a machine with a cost of Br. 165, 000 and a
salvage value of Br. 9, 000 on April 1, 1993. The machine will be
depreciated over a 12 year useful life using the sum-of-the-year’-digits
method. The amount of depreciation ABC Company would record for the
year ended 12/31/94 would be:
A. Br. 22, 000
B. Br. 24, 000
C. Br. 16, 500
D. Br. 22, 500

________4. The economic factors related to an asset’s service life include:

A. Obsolescence
B. Wear and tear
C. Decay
D. Unexpected casualties

________5. Of the following costs related to the development of natural resources, which
one is not a part of depreciable cost?
A. Acquisition cost of the natural resource deposit.
B. Exploration costs
C. Tangible equipment costs associated with machinery used to extract the
natural resource
D. Intangible development costs such as drilling costs, tunnels, and shafts.

Part III: Exercises

1. Beckham Company purchased a mainframe computer on January 2, 1990, for Br. 1,

200, 000. The system has a useful life of six years, considering obsolescence. Its
residual value is Br. 20, 000. Beckham Company uses the straight-line method.

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 The following events took place in 1991.
a. March 1: peripheral equipment costing Br. 30, 000 was added to the
mainframe. This equipment can be used with several different mainframes.
Beckham Company may replace the mainframe before the disposal of the
equipment.
b. September 1: an additional memory device was added to the mainframe,
costing Br. 250, 000. This device has no utility apart from the mainframe but
will increase the total residual of the mainframe to Br. 40, 000.
Required:
Required: Provide the general journal entry to record depreciation expense
for 1991 on the mainframe and related equipment.
2. Mite Engineering Company acquired a large number of small tools at the beginning
of operations on January 1, 1990, for Br. 4, 000. During 1990 and 1991, Mite
disposed of several used tools, receiving cash salvage value of Br. 400 in 1990 and
Br. 500 in 1991. During 1991, Mite acquired additional tools at a cost of Br. 1, 600.
Inventories of tools on hand, valued at current acquisition cost adjusted for the
present condition of the tools, indicated a value of Br. 2, 800 on December, 1990,
and Br. 3, 600 on December 31, 1991. Mite uses the inventory method of
depreciation for small tools.
Required:
Required: Give the entries for the inventory system to record the above
transactions. Include adjusting entries and the related closing entries.
3. Quick producers acquired factory equipment on January 1, 1992, costing Br. 39,
000. In view of pending technological developments it is estimated that the machine
will have a resale value up on disposal in four years of Br. 8, 000 and that disposal
costs will be Br. 500.
Estimated Economic life:

Years………………………………….4
Service hours 20, 000
Actual operations: Service hours
1992 5, 700

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 1993 5, 000
2000 4, 800
2001 4, 400

Required:
Required: Round to the nearest birr and show computation:
1. Prepare a depreciation schedule for the service hour’s method assuming the
accounts are closed each December 31.
2. Compute depreciation expense for the first and second years assuming
a) Straight-line method
b) Sum-of-the-year’-digits method
c) Double-declining depreciation method

4. Arizona Mining Company acquired property with copper ore reserves estimated at 2
million pounds for Br. 1, 800, 000. The property will have an estimated value of Br.
1, 000,000 after the ore has been extracted. Before any ore could be removed, it was
necessary to incur Br. 500, 000 of developmental costs. In the first year, 200, 000
pounds were removed and 160, 000 pounds of ore were sold; in the second, 400,
000 pounds were removed and 410, 000 pounds were sold. In the course of the
second year’s production, discoveries were made that indicated that if an added Br.
1, 460, 000 is spent on developmental costs during the third year, futtock removable
ore will total 2.5 million pounds. After there added costs were incurred, production
for the third year amounted to 510, 000 pounds with sales of 450, 000 pounds.
Required:
1. Calculate the total depletion amount and the depletion expense that Arizona
should report on its income statement for each of the three years. Should
supporting computations and round units costs to the nearest three decimal
places (assume FIFO)
2. Give the journal entry to record depletion and depletion expense at the end
of each of the three years.
5. Manara Corporation purchased the following assets January 1, 1990
Quantity Type Unit Cost Estimated Unit Unit
_______ ____ _______ Salvage value Useful life

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 10 Truck Br. 6, 000 Br. 1, 000 5 years
5 Bus 12, 000 2, 000 8 years
Using the composite system of depreciation, what is the composite rate based on cost?

5.9 GLOSSARY

1. Accelerated Depreciation: Depreciation methods that produce larger depreciation

charges during the early years of an asset’s life and smaller charges in the
later years.
2. Depletion: The cost created by consuming the usefulness of natural resources.
3. Depreciation: The decrease in usefulness of all plant assets except land.
4. Declining balance method: A method of depreciation that provides declining
periodic depreciation charges to expense over the estimated life of an asset.
5. Inadequacy: A condition in which the capacity of plant assets becomes too small for
the productive demands of the business.
6. Obsolescence: A condition in which, because of new inventions and improvements,
a plant asset can no longer be used to produce goods or services with a
competitive advantage.
7. Salvage value: The amount that management predicts will be recovered at the end
of a plant assets service life through a sale or as a trade-in allowance on the
purchase of a new asset.
8. Straight-line method: A method that allocates an equal portion of the total
depreciation for a plant asset (cost minus salvage) to each accounting period
in its economic life.
9. Sum-of-the-years’-digits depreciation method: A method of depreciation that
provides for declining periodic depreciation at a constant amount over the
economic life of the asset.
10. Units-of-output method: A method of depreciation that provides for depreciation
expense based on the expected productive capacity of an asset.

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