Depreciation

Study
Study Objectives
Objectives
1. Describe how the cost principle applies to plant assets.
2. Explain the concept of depreciation.
3. Compute periodic depreciation using the straight-line method, and
contrast its expense pattern with those of other methods.
Reporting
Reporting and
and Analyzing
Analyzing Long-Lived
Long-Lived Assets
Assets

Plant Assets Intangible Assets

Determining the cost of Accounting for

plant assets intangibles assets
Accounting for plant Types of intangibles
assets assets
Analyzing plant assets Financial statement
presentation of long-lived
assets
Plant
Plant Assets
Assets Section One

Plant assets are resources that have

 physical substance (a definite size and shape),
 are used in the operations of a business,
 are not intended for sale to customers,
 are expected to provide service to the company for a
number of years, except for land.

Referred to as property, plant, and equipment; plant and

equipment; and fixed assets.
Determining
Determining the
the Cost
Cost of
of Plant
Plant Assets
Assets

Cost Principle - requires that companies record plant

assets at cost.
Cost consists of all expenditures necessary to
acquire an asset and make it ready for its intended use.

Revenue expenditure – costs incurred to acquire a plant

asset that are expensed immediately.

Capital expenditures - costs included in a plant asset

account.
Determining
Determining the
the Cost
Cost of
of Plant
Plant Assets
Assets

Cost - cash paid in a cash transaction or the cash

equivalent price paid.
Cash equivalent price is the
 fair value of the asset given up or
 fair value of the asset received,
whichever is more clearly determinable.
Determining
Determining the
the Cost
Cost of
of Plant
Plant Assets
Assets

Land
All necessary costs incurred in making land ready for its
intended use increase (debit) the Land account.

Costs typically include:

1) cash purchase price,
2) closing costs such as title and attorney’s fees,
3) real estate brokers’ commissions, and
4) accrued property taxes and other liens on the land
assumed by the purchaser.
Determining
Determining the
the Cost
Cost of
of Plant
Plant Assets
Assets

Buildings
Includes all costs related directly to purchase or construction.

Purchase costs:
 Purchase price, closing costs (attorney’s fees, title insurance,
etc.) and real estate broker’s commission.
 Remodeling and replacing or repairing the roof, floors,
electrical wiring, and plumbing.

Construction costs:
 Contract price plus payments for architects’ fees, building
permits, and excavation costs.
Determining
Determining the
the Cost
Cost of
of Plant
Plant Assets
Assets

Equipment
Include all costs incurred in acquiring the equipment and
preparing it for use.
Costs typically include:
 Cash purchase price.
 Sales taxes.
 Freight charges.
 Insurance during transit paid by the purchaser.
 Expenditures required in assembling, installing, and testing
the unit.
Accounting
Accounting for
for Plant
Plant Assets
Assets

Depreciation
Process of allocating to expense the cost of a plant asset
over its useful (service) life in a rational and systematic
manner.
 Process of cost allocation, not asset valuation.
 Applies to land improvements, buildings, and equipment,
not land.
 Depreciable, because the revenue-producing ability of
asset will decline over the asset’s useful life.
Accounting
Accounting for
for Plant
Plant Assets
Assets

Factors in Computing Depreciation

Cost Useful Life Salvage Value

Accounting
Accounting for
for Plant
Plant Assets
Assets

Depreciation Methods
Management selects the method it believes best measures an
asset’s contribution to revenue over its useful life.

Examples include:
(1) Straight-line method.
(2) Declining-balance method.
(3) Units-of-activity method.
Accounting
Accounting for
for Plant
Plant Assets
Assets

Illustration: Bill’s Pizzas purchased a small delivery truck on

January 1, 2012.

Required: Compute depreciation using the following.

(a) Straight-Line. (b) Units-of-Activity. (c) Declining Balance.
Accounting
Accounting for
for Plant
Plant Assets
Assets

Straight-Line
 Expense is same amount for each year.
 Depreciable cost = Cost less salvage value.
 Accounting
Accounting for
for Plant
Plant Assets
Assets
Illustration: (Straight-Line Method)
Depreciable Annual Accum. Book
Year Cost x Rate = Expense Deprec. Value
2012 $ 12,000 20% $ 2,400 $ 2,400 $ 10,600
2013 12,000 20 2,400 4,800 8,200
2014 12,000 20 2,400 7,200 5,800
2015 12,000 20 2,400 9,600 3,400
2016 12,000 20 2,400 12,000 1,000

2012 Depreciation expense 2,400

Journal
Accumulated depreciation 2,400
Entry
 Partial
Accounting
Accounting for
for Plant
Plant Assets
Assets Year
Illustration: (Straight-Line Method)
Assume the delivery truck was purchased on April 1, 2010.
Current
Depreciable Annual Partial Year Accum.
Year Cost Rate Expense Year Expense Deprec.
2012 $ 12,000 x 20% = $ 2,400 x 9/12 = $ 1,800 $ 1,800
2013 12,000 x 20% = 2,400 2,400 4,200
2014 12,000 x 20% = 2,400 2,400 6,600
2015 12,000 x 20% = 2,400 2,400 9,000
2016 12,000 x 20% = 2,400 2,400 11,400
2017 12,000 x 20% = 2,400 x 3/12 = 600 12,000
$ 12,000
Journal entry:
2012 Depreciation expense 1,800
Accumultated depreciation 1,800
Accounting
Accounting for
for Plant
Plant Assets
Assets

Declining-Balance
 Accelerated method.
 Decreasing annual depreciation expense over the
asset’s useful life.
 Double declining-balance rate is double the straight-line
rate.
 Rate applied to book value.
 Accounting
Accounting for
for Plant
Plant Assets
Assets
Illustration: (Declining-Balance Method)
Declining
Beginning Balance Annual Accum. Book
Year Book value x Rate = Expense Deprec. Value

2012 13,000 40% $ 5,200 $ 5,200 $ 7,800

2013 7,800 40 3,120 8,320 4,680
2014 4,680 40 1,872 10,192 2,808
2015 2,808 40 1,123 11,315 1,685
2016 1,685 40 685* 12,000 1,000

2012 Depreciation expense 5,200

Journal
Accumulated depreciation 5,200
Entry

* Computation of $674 ($1,685 x 40%) is adjusted to $685.

Accounting
Accounting for
for Plant
Plant Assets
Assets

Units-of-Activity
 Companies estimate total units of activity to calculate
depreciation cost per unit. Illustration 9A-3

 Expense varies based on

units of activity.
 Depreciable cost is cost
less salvage value.
Accounting
Accounting for
for Plant
Plant Assets
Assets

Illustration: (Units-of-Activity Method)

Hours Rate per Annual Accum. Book
Year Used x Hour = Expense Deprec. Value
2012 15,000 $ 0.12 $ 1,800 $ 1,800 $ 11,200
2013 30,000 0.12 3,600 5,400 7,600
2014 20,000 0.12 2,400 7,800 5,200
2015 25,000 0.12 3,000 10,800 2,200
2016 10,000 0.12 1,200 12,000 1,000

2012 Depreciation expense 1,800

Journal
Accumulated depreciation 1,800
Entry
Accounting
Accounting for
for Plant
Plant Assets
Assets

Comparison of
Depreciation
Methods
Illustration 9-13

Each method is
acceptable because
each recognizes the
decline in service
potential of the asset
in a rational and
systematic manner.
Accounting
Accounting for
for Plant
Plant Assets
Assets

Impairments
Permanent decline in the fair value of an asset.
So as not to overstate the asset on the books, the
company writes the asset down to its new fair value
during the year in which the decline in value occurs.
Inventory
 Study
Study Objectives
Objectives
1. Describe the steps in determining inventory quantities.
2. Explain the basis of accounting for inventories and apply the
inventory cost flow methods under a periodic inventory system.
3. Explain the financial statement and tax effects of each of the
inventory cost flow assumptions.
 Reporting
Reporting and
and Analyzing
Analyzing Inventory
Inventory

Determining
Classifying Inventory Analysis of
Inventory
Inventory Costing Inventory
Quantities

Merchandising Taking a Specific Inventory

Manufacturing physical identification turnover ratio
Just-in-time inventory Cost flow LIFO reserve
Determining assumptions
ownership of Financial
goods statement and
tax effects
Consistent use
Lower-of-cost-
or-market
Classifying
Classifying Inventory
Inventory

Merchandising Manufacturing
Company Company

One Classification: Three Classifications:

 Merchandise  Raw Materials
Inventory  Work in Process
 Finished Goods

Regardless of the classification, companies report all inventories

under Current Assets on the balance sheet.
Determining
Determining Inventory
Inventory Quantities
Quantities

Taking a Physical Inventory

Involves counting, weighing, or measuring each kind
of inventory on hand.
Taken,
 when the business is closed or business is slow.
 at end of the accounting period.
Determining
Determining Inventory
Inventory Quantities
Quantities

Determining Ownership of Goods

Goods in Transit
 Purchased goods not yet received.
 Sold goods not yet delivered.

Goods in transit should be included in the inventory of the

company that has legal title to the goods. Legal title is
determined by the terms of sale.
Determining
Determining Inventory
Inventory Quantities
Quantities

Goods in Transit

Ownership of the goods

passes to the buyer when the
public carrier accepts the
goods from the seller.

Ownership of the goods

remains with the seller until
the goods reach the buyer.
Determining
Determining Inventory
Inventory Quantities
Quantities

Determining Ownership of Goods

Consigned Goods
Goods held for sale by one party although ownership
of the goods is retained by another party.
Inventory
Inventory Costing
Costing

Unit costs can be applied to quantities on hand

using the following costing methods:
Specific Identification
First-in, first-out (FIFO)
Cost Flow
Last-in, first-out (LIFO) Assumptions
Average-cost
Inventory
Inventory Costing
Costing
Illustration: Assume that Crivitz TV Company purchases
three identical 50-inch TVs on different dates at costs of $700,
$750, and $800. During the year Crivitz sold two sets at $1,200
each. These facts are summarized below.
Inventory
Inventory Costing
Costing

“Specific Identification”
If Crivitz sold the TVs it purchased on February 3 and May 22,
then its cost of goods sold is $1,500 ($700 + $800), and its
ending inventory is $750.
Inventory
Inventory Costing
Costing

“Specific Identification”
Actual physical flow costing method in which items still
in inventory are specifically costed to arrive at the total
cost of the ending inventory.

Practice is relatively rare.

Most companies make assumptions (Cost Flow

Assumptions) about which units were sold.
 Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions
Illustration: Data for Houston Electronics’ Astro
condensers.

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions

“First-In-First-Out (FIFO)”
 Earliest goods purchased are first to be sold.
 Often parallels actual physical flow of
merchandise.
 Generally good business practice to sell oldest
units first.
Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions

“First-In-First-Out (FIFO)”
Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions

“First-In-First-Out (FIFO)”
Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions

“Last-In-First-Out (LIFO)”
 Latest goods purchased are first to be sold.
 Seldom coincides with actual physical flow of
merchandise.
 Exceptions include goods stored in piles, such as
coal or hay.
Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions

“Last-In-First-Out (LIFO)”
Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions

“Last-In-First-Out (LIFO)”
Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions

“Average-Cost”
 Allocates cost of goods available for sale on the
basis of weighted-average unit cost incurred.
 Assumes goods are similar in nature.
 Applies weighted-average unit cost to the units
on hand to determine cost of the ending
inventory.
Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions

“Average-Cost”
Inventory
Inventory Cost
Cost Flow
Flow Assumptions
Assumptions

“Average-Cost”
Financial
Financial Statement
Statement and
and Tax
Tax Effects
Effects
Comparative Financial Statement Summary
FIFO Average LIFO
Sales $9,000 $9,000
$9,000
Cost of goods sold 6,200 6,600
7,000
Gross profit 2,800 2,400
2,000
Admin. & selling expense 330 330
330
Income before taxes 2,470 2,070
1,670
Income tax expense 140 120
110
 Financial
Financial Statement
Statement and
and Tax
Tax Effects
Effects
In Period of Rising Prices, FIFO Reports:
FIFO Average LIFO
Sales $9,000 $9,000
Lowest $9,000
Cost of goods sold 6,200 6,600
7,000
Gross profit 2,800 2,400
2,000
Admin. & selling expense 330 330
Highest 330
Income before taxes 2,470 2,070
1,670
Income tax expense 140 120
110
 Financial
Financial Statement
Statement and
and Tax
Tax Effects
Effects
In Period of Rising Prices, LIFO Reports:
FIFO Average LIFO
Sales $9,000 $9,000
Highest $9,000
Cost of goods sold 6,200 6,600
7,000
Gross profit 2,800 2,400
2,000
Admin. & selling expense 330 330
Lowest 330
Income before taxes 2,470 2,070
1,670
Income tax expense 140 120
110
Inventory
Inventory Costing
Costing

Lower-of-Cost-or-Market
When the value of inventory is lower than its cost
 Companies can “write down” the inventory to its
market value in the period in which the price decline
occurs.
 Market value = Replacement Cost
 Example of conservatism.