Accounting for Long-term Assets
8.3 Changes in estimates related to depreciation of fixed assets
Sometimes there are revisions of salvage value, useful life, or asset total projected output. In such situations nothing should be done to correct the previously reported financial statements. However, the new information is taken into calculations of the present and future depreciation expenses.
Let us look at an example. A company bought a tool that cost $12,000 and has a salvage value of $3,000. The useful life is expected to be 3 years. Therefore, depreciation expense for the first year under straight-line method is $3,000 ([$12,000 - $3,000] / 3 years).
8.3.1 Change in estimate from revision of useful life
Assume that the company obtained new information about the asset useful life after the asset first year of operation. It was determined that the useful life will be 6 years. So, as the tool has already been in use for one year, there is 5 more years during which depreciation will be charged. The salvage value remains the same, and the new depreciation expense is computed as follows:
Illustration 8-15: Change in depreciation from revision of useful life
| (Hist. Cost - Accum. Depreciation) - Salvage Value |
= |
Depreciation Expense |
| Useful Life |
||
|
|
|
|
| $9,000 book value - $3,000 salvage |
= |
$1,200 |
| 5 years |
8.3.2 Change in estimate from revision of salvage value
Now assume that the company got new information about the salvage value (the estimated useful life is not changed and remains 3 years). The new salvage value is considered to be $4,000 instead of $3,000. The useful life is the same:
Illustration 8-16: Change in depreciation from revision of salvage value
| (Hist. Cost - Accum. Depreciation) - Salvage Value |
= |
Depreciation Expense |
| Useful Life |
||
|
|
|
|
| $9,000 book value - $4,000 salvage |
= |
$4,500 |
| 2 years |
8.4 Depletion as a means of natural resources cost allocation
Natural resources are recorded on the books at their acquisition cost. The process of expense recognition for using natural resources is called depletion. Recall that depletion is allocation of a natural resource cost to expense in a rational and systematic manner over the resource useful life.
The units-of-production is the most common method to allocate the cost of natural resources. Suppose in 20X7 a mining company purchased a new mine for $6,700, plus real estate fees of $300 (totaling $7,000). No salvage value is expected. The mine is estimated to have approximately 14,000 tons of coal. So, the cost per ton is $0.5 (7,000 tons / $14,000). If the company extracts 4,000 tons in the first year, the depletion cost will be $2,000 (4,000 x $0.5). The depletion of a natural resource has the same effects on the accounting equation as depreciation of fixed assets has. Assets (Coal Mine) and equity (by increasing Depletion Expense) decrease.
Illustration 8-17: Effect of natural resources depletion on the horizontal model
| Assets |
= |
Equity |
Rev. |
- |
Exp. |
= |
Net |
Cash Flow |
|||||
| Cash |
+ |
Coal Mine |
= |
Con. Cap. |
+ |
Ret. Earn. |
|||||||
| (7,000) |
+ |
7,000 |
= |
n/a |
+ |
n/a |
n/a |
- |
n/a |
= |
n/a |
(7,000) |
IA |
| n/a |
+ |
(2,000) |
= |
n/a |
+ |
(2,000) |
n/a |
- |
(2,000) |
= |
(2,000) |
n/a |
|
The journal entries are shown below:
Illustration 8-18: Journal entries for mine acquisition and depletion expense
| Event No |
Account titles |
Debit |
Credit |
| 1 |
Coal Mine |
7,000 |
|
|
|
Cash |
|
7,000 |
| 2 |
Depletion Expense |
2,000 |
|
|
|
Coal Mine |
|
2,000 |
To show the decrease in assets, a contra asset account titled Allowance for Depletion could have been used instead of directly affecting the Coal Mine account. In such a case, Allowance for Depletion has the same relationship with natural recourses as Accumulated Depreciation has with property, plant, and equipment. Both decrease the historical cost of assets to their book value.
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