Section 3.) Depreciation Methods and Calculations
One of the most important concepts to learn with fixed assets is that of depreciation. In accounting, depreciation reflects a way to allocate the cost of an asset over its useful life. This is not an attempt to measure a decline in value, as the term is commonly used outside of accounting. In fact, the very fact that it doesn’t match up with a decline in fair market value is what gives rise to gains and losses on the sale of assets, which will be discussed more in later sections.
Most assets are eventually “used up” in the process of generating revenues. As we have previously discussed, this “using up of assets” is known as an expense. With long term assets that we are going to be talking about in this chapter the issue becomes timing. When do we convert something from an asset to an expense?
Certain types of assets are used over several periods of time, rather than being used up within one period. When these assets are long term, the expense must be recognized over the life of the asset as well. This process is known as depreciation.
Land is generally the exception to depreciation as it is not really “used up” over time. The land has a virtually infinite life (as long as the planet itself exists.) There are situations where the land contains minerals, oil, etc. that will be mined. In these cases, we deplete the minerals, but that does not deplete the land itself. The topic of depletion is a separate issue that will be discussed later in this chapter.
There are a variety of different depreciation methods that a company can use, but we are going to discuss the four most common ones. These include the straight-line method, units of production method, double-declining balance, and sum of the years’ digits.
The first two methods (straight line and units of production) are often referred to as “straight line” methods in general because they have each have an element that remains constant throughout the entire life of the company. For the actual straight-line method, it is the depreciation expense itself that remains constant. In other words, every year will have the exact same amount of depreciation. For the units of production method, it is the depreciation rate per unit that remains constant, even though the number of units may not be.
The second two units (double-declining balance and sum of the years’ digits) are referred to as accelerated methods due to the fact that the expense is accelerated so that more is recognized earlier on and less later.
In addition to knowing what method the company has selected, we also need to know what the original cost was, what the estimated salvage value (aka scrap or residual value) is, and what the estimated life of the asset is.
Terminology (Repeated from the earlier section):
Salvage Value/Residual Value/Scrap Value - All three of these terms mean the exact same thing. These all reflect a portion of the historical cost of the asset that we do not plan to depreciate. This is an estimated amount reflecting how much the asset is expected to be worth after it has been used for its full useful life. We only want to depreciate the portion of the asset that is going to be used up over time.
You can think of a piece of equipment that is made of some sort of metal. Even after it is completely used up it is still worth some sort of scrap value for its scrap metal. Since this amount is not expected to be used up throughout the life of the asset, we want to ensure NOT to depreciate this portion of it.
Depreciable Cost - This is the historical cost minus the salvage value. This is the portion of the asset that we DO want to depreciate and expense over time.
Estimated Useful Life - As the name implies this is the length of time in months, years, or simply units that the asset is expected to last for. If the units of production method is being used, we would need to know the total number of units that can be produced by the product throughout its entire life. Sometimes these units are measured in “machine hours”, but they could also be actual physical production units.
Depreciation Journal Entry:
Regardless of the depreciation method we use, the journal entry to record it will always be a debit to depreciation expense (to increase it) and a credit to accumulated depreciation (increasing that contra asset account.)
Remember that increasing a contra asset account offsets the value of the asset itself. This ends up looking like this on the balance sheet:
As the accumulated depreciation balance increases over the years, the net book value of the asset decreases. This is all done without touching the original equipment asset account balance. In fact, that asset balance will generally remain the same until we dispose of the asset later.
Depreciation Methods:
In order to determine the depreciation expense entry amount, we must know what method we are using. The below discussion goes through each of the methods.
Straight Line
Annual Depreciation Expense = Historical Cost – Salvage Value (if any)
Estimated Useful Life (Years)
The result of this calculation is a dollar amount of depreciation that will be allowed in each year of the asset’s useful life. This means that we only want to depreciate the portion that will be used up throughout the asset’s life and will not remain as a salvage value at the end. In fact, the numerator to the above calculation (cost minus salvage value) is referred to as “depreciable cost” (i.e., the amount of cost that we want to depreciate.)
Generally, the amount of depreciation will remain constant from year to year. This is where the name “straight line” comes from. However, there are situations where one of the estimates (depreciable life or salvage value) is changed, or the depreciable is revised due to a betterment or improvement that is capitalized as part of the asset. More discussion on this topic can be found in a later section.
Note that any change to these estimates is NOT treated as an error that requires retrospective correction to prior year financial statements. Instead, revisions will be handled on a prospective basis.
Note: Although the method shown above calculates a specific annual dollar amount, it is helpful to also realize what your percentage depreciation rate is. This is needed for the accelerated methods discussed later. This depreciation percentage is calculated by taking 1 divided by the number of years in the asset’s life. For example, if it is a 5-year life, 1 divided by 5 = 20%. If it is a 10-year life, 1/10 = 10% of the total depreciable cost that will be depreciated each year.
Below is an example of a “depreciation schedule”, which is a chart showing each year of the asset’s life, and how much depreciation expense will be recorded each year.
-First, it shows the net book value of the asset at the beginning of the year (i.e., cost minus the accumulated depreciation up to that point in time.)
-Next, it may show the depreciation percentage rate, even though that number is not necessarily needed to calculate depreciation for the straight-line method.
-Next, it will show the depreciation expense for the year. That amount represents the journal entry that will include a debit to depreciation expense and a credit to accumulated depreciation.
-Next, it will show the running balance of accumulated depreciation up to that point in time.
- Finally, it will show the ending net book value, which is the beginning net book value for the year minus that year’s depreciation amount.
Under the straight-line method, the final year’s net book value should equal the salvage value (with potential small rounding variances.) This is because we subtracted the salvage value out of the depreciable cost that we divided by the number of years.
Units of Production Depreciation
This method is useful when equipment can be measured either by a unit of output (i.e., a unit of product) or perhaps by a machine hour or by a mile. Machinery and vehicles are the most common assets that may use this particular depreciation method. This method most accurately matches the cost of an asset with its usage, and with the amount of revenue it helps to generate.
This method is still considered a “straight line” method, not because the same amount of depreciation is recorded per year, but because the same amount of depreciation is recorded per unit. This method requires a two-step process:
Step 1: Determine the depreciation rate per unit.
This step is similar to the straight-line calculation, with the difference being that we are not dividing the depreciable cost by the number of years in the asset’s life, but rather the number of units it can produce throughout its life.
Depreciation Rate Per Unit = Historical Cost – Salvage Value (if any)
Estimated Useful Life (In Units)
Step 2: Determine the depreciation amount per year
To complete this step, you need to know how many units are produced in each year.
Then you would multiply the number of units by the depreciation rate from step 1 to arrive at the total depreciation expense for that year.
Note: If your total estimate was off and in the final year it becomes apparent that you are going to produce more or fewer units than expected, an adjustment will be needed in that final year to ensure that total depreciation exactly equals the amount of depreciable cost (no more, no less.)
If this variance becomes apparent in years before the final year, an adjustment should be made to the depreciation rate in those earlier years going forward.
Note in the below depreciation schedule how the depreciation expense can vary widely from year to next, even being zero in some years. This is all based on the amount of activity each year. In total, the depreciation cannot exceed the depreciable cost, and the final net book value will equal the salvage value, as it did in the straight-line method.
Sum of the Years’ Digits (Accelerated Method)
This method is rarely used accelerated method that provides for a larger percentage of the depreciation to be recorded up front and less down the road.
The first step in calculating the “sum of the years’ digits” depreciation is to…sum the years’ digits. What this means is that we add the 1 from year 1, the 2 from year 2, the 3 from year 3, etc. all the way until we reach our final year.
If we have five years, this means we sum up all of the individual years.
1 + 2 + 3 + 4 + 5 = 15
This “sum of the years’ digits” will become the denominator of our depreciation rate calculation.
The numerator for each year will be one of the digits above, starting with the last year (the largest number) and moving backward to the lowest number. (See example below)
Year 1 Depreciation = 5/15 of the depreciable amount (i.e., historical cost less salvage value)
Year 2 Depreciation = 4/15 of the depreciable amount
Year 3 Depreciation = 3/15 of the depreciable amount
Year 4 Depreciation = 2/15 of the depreciable amount
Year 5 Depreciation = 1/15 of the depreciable amount
Note in the below depreciation schedule how the depreciation expense starts off high and then becomes much smaller each year. In total, the depreciation cannot exceed the depreciable cost, and the final net book value will equal the salvage value, as it did in the straight-line method.
Declining Balance Methods
Like the “sum of the years’ digits” method above, this method is an accelerated method that provides for a larger percentage of the depreciation to be recorded up front and less down the road.
There are a variety of declining balances that could be used, including the 150% declining balance method, the 200% declining balance method (i.e., aka double-declining balance.) The one we will learn about in this text is the double-declining balance (DDB) method.
To begin the 200% declining balance method, we first have to go back and recalculate what the straight line “percentage rate” would have been given the depreciable life of the asset.
To find the straight-line rate, you simply take 1 divided by the asset’s life in years. For example, a 10-year life would yield a 10% straight line depreciation rate. We then plug that straight-line rate, and all of the other date, into the below calculation.
Annual 200% DDB Depreciation = Net Book Value at the Beginning of the year * 200% of the Straight-Line Percentage
NBV (Net Book Value) is defined by the historical cost of the asset, less any accumulated depreciation up to that point. It is important to note that we are ignoring any salvage value in the beginning calculations. This is different than the other methods that subtracted it out before beginning the calculations. However, the same basic rule applies that we cannot depreciate below the salvage value. This rule is applied on the back end, by reviewing the final years of the asset’s life to ensure that we didn’t take too much or too little depreciation. If so, an adjustment would be needed to the depreciation expense entry in those final years, rather than relying on the calculation in the depreciation schedule. This generally takes place in the last year or two.
This is similar to what we did with the units of production method when our actual production varied from the expected life.
Notice that each year the beginning net book value will be less, (due to prior year depreciation), thus current year depreciation will “decline.” This is where the method gets its name from.
The below videos go through the topics in more detail.
Depreciation Expense Exercise
Straight Line Depreciation Practice Exercise
Units of Production Depreciation Practice Exercise
Double Declining Balance Depreciation Practice Exercise
Section 4:) Revenue and Capital Expenditures
Depreciation is the expensing of the cost related to the asset’s initial purchase. However, there are other expenses that relate to the asset throughout its life. These include repairs or maintenance type expenses, as well as betterments, additions, and improvements. Generally, if a maintenance or repair expense is routine and necessary to keep the asset going for its originally estimated life, then it should be counted as a regular expense in the period in which it was incurred. Such expenses are not added to the asset and depreciated over the life of the asset.
However, if a maintenance activity extends the useful life of the asset, increases the asset’s benefit for its originally estimated life, or if it increases the salvage value of the asset, then it may need to be capitalized and depreciated over the life of the asset, as the original cost was.
For example, if a vehicle is purchased, it regularly requires new tires, a new battery, oil changes, etc. However, it may also require an engine or transmission overhaul that extends the life of the asset or increases its utility. The question here is how that cost should be handled.
There are two options.
1.) If it is considered an “ordinary” repair and maintenance item, it falls under the category of revenue expenditures. This basically means it is going to have an expense recorded immediately, with no impact to the asset’s cost or future depreciation. Some examples of this include basic repairs for vehicles, minor repairs in a building, etc. The journal entry in this case will simply be a debit to sort of repair expense account and a credit to cash or accounts payable (i.e., the method of payment.)
2.) If it is considered an “extraordinary” expense that increases the asset’s life or extends its utility, the cost will be added to the historical cost basis of the asset. From that point on, the depreciation will be calculated using that higher cost. Some examples of this include completely renovating an existing building, adding on a new wing to a building, overhauling a vehicle’s engine or transmission, etc.
The journal entry in this case will be a debit to the equipment asset and a credit to cash or accounts payable (i.e., the method of payment.) Future depreciation calculations will have to be revised based on the revised cost, with the remaining useful life of the asset and salvage value estimate being used in the recalculation as well.
Section 5.) Disposition of Assets
When selling an asset, you need to compare the current book value of the asset (historical cost less accumulated depreciation) with the amount the asset is being sold for. If it is sold for more than its book value, the difference is considered a gain on sale of the asset. If it is sold for less than the book value, it is a loss on sale.
In any case, when an asset is disposed of or sold, the asset and the related accumulated depreciation account must be closed out to a zero balance on the books. This is not a normal annual closing entry, but instead a closing entry once the asset has been disposed of.
Example to record gain on sale of equipment
Cash $xxxx
Accumulated Depreciation $xxxx
Equipment $xxxx
Gain on Sale of Equipment $xxxx
In the above entry we debited cash to increase it (assuming that we received money when selling the asset.) We also debited accumulated depreciation for whatever its final balance was. That balance was a credit, so to close it we have to debit it. We are crediting equipment for its original cost, to close out the debit balance of that account. Finally, to make the journal entry balance, we either need to credit a gain or debit a loss, depending on what is needed.
If you would like to calculate the specific amount of gain or loss, instead of just using it as a plug to balance the entry, use the following calculation:
Cash Received $100,000
Minus Net Book Value of Asset
Original Equipment Cost $250,000
Minus Accumulated Depreciation $180,000
Net Book Value $70,000
Equals Gain (if positive) $30,000
or Loss (if negative)
Section 6.) Intangible Assets and Amortization
Intangible assets are those that have value to the company even though there is no physical, tangible asset that is used. Instead, it is often a piece of paper that represents legal benefits. Some examples of this are: patents, trademarks, copyrights, or leaseholds (i.e., a legal right to lease property for a specified number of years.) The value of these assets is used up over time just as with a fixed asset. The only difference is that instead of being called depreciation it is called amortization. Amortization is calculated under a process identical to the straight-line depreciation method.
Another difference is that intangible assets often have a specific legally stated life. However, that only serves as a maximum life to use. In reality, the “estimated useful life” of the intangible asset may be even less than that. Consider a patent, which currently has a 20-year legal life. If that patent is protecting an invention that is expected to be a fairly quick-lived fad or is expected to be replaced by a newer technology in five years, then that lower life would be used, instead of the full 20 years.
Another thing to consider is that generally intangible assets do not have a salvage value, because once the legal right expires, it is entirely worthless.
One thing to note with these intangible assets is that there are two ways they can be created:
1.) If a company purchases a patent from another entity, then the purchase price itself becomes the historical cost, just like with other assets.
2.) If the company researches and develops an idea that they patent, then ONLY the legal fees associated with the patent filing can be considered as the historical cost of the asset. Under US GAAP, all of the actual research and development costs would be expensed immediately in the year incurred, even though they may generate a product that lasts for years. This is an unusual aspect of US GAAP that is different from international standards.
Goodwill is a unique type of asset that is no longer amortized over a useful life. This asset is created when one company is purchased by another for a price that exceeds the fair value of all identifiable assets. The thought is that if a higher price is being paid, there must be something in the company that is valuable but can’t be separately identified as an asset. For example, a loyal customer base or a strong employee base, or even a strong set of business processes cannot be reported as separate assets on the balance sheet, but nonetheless are very valuable. Although this is an intangible asset, its value is no longer amortized over time. Instead, the only time an expense is taken against the goodwill asset is when an impairment test has deemed that value has been lost. This test is outside of the scope of introductory accounting courses.
Section 7.) Natural Resources and Depletion
Although land itself cannot be depreciated, there are often minerals or oil in the land, trees on the land, etc. that can and must be expensed over time. The goal is to match up the expense related to the use of those assets with the revenue generated from their sale. This process, similar to depreciation and amortization is known as depletion. Depletion is calculated under a process identical to the units of production depreciation method.
One thing to note is that it is important to separate the value of the actual land from the value of the minerals, etc. within the land. Furthermore, any equipment, etc. that is being used in the mining process must be depreciated separately, rather than being included in the depletion calculation.
The useful life of the natural resource is often measured in tons or gallons or barrels. Each year, the number of those units extracted and sold is used to determine the amount of depletion to report. There generally is not a salvage value associated with these natural resources.
Please refer back to the units of production depreciation section for details on how this would be calculated.
Wrap-Up
The main topic for this week is depreciation. We will deal with the depreciation schedules under three separate methods for our assignment. You should spend most of your time practicing and understanding these concepts and calculations. The only thing you need to remember from the intangible asset and natural resource sections is what depreciation method they most closely resemble.
Section 1.) Overview of Fixed Assets
Last week we discussed current assets, which have an estimated life of less than a year. This week we switch over to long term assets that have lives longer than a year. There are a variety of long-term assets that we talk about in this chapter. Some of them are fixed assets, which are the ones we generally use in the process of generating revenue. Others are intangible assets, which are most often legal rights that only exist on paper. The third type are natural resources that can be used up and sold.
Regardless of the type, we first have to determine how to record the purchase or acquisition of the asset. Then, we have to determine how to record the depreciation expense related to the usage of the asset over time. Next, we record additional expenses for things like repairs, maintenance, or more expansive overhauls. Finally, we have to record the disposition of the asset when the company is no longer using it.
Before we get too deep, there are some terms we need to discuss:
Fixed Asset/Property Plant and Equipment (PP&E) – These two terms are often used interchangeably, and they represent a type of long-term asset that is tangible (physical) and actively used in the company’s operations. This type of asset is depreciated to record the expenses related to the usage of the asset over time.
Historical Cost - This is the original purchase price of the asset, regardless of how much of it has been used or what the fair value currently is.
Salvage Value/Residual Value/Scrap Value - All three of these terms mean the exact same thing. These all reflect a portion of the historical cost of the asset that we do not plan to depreciate. This is an estimated amount reflecting how much the asset is expected to be worth after it has been used for its full useful life. We only want to depreciate the portion of the asset that is going to be used up over time.
You can think of a piece of equipment that is made of some sort of metal. Even after it is completely used up it is still worth some sort of scrap value for its scrap metal. Since this amount is not expected to be used up throughout the life of the asset, we want to ensure NOT to depreciate this portion of it.
Depreciable Cost - This is the historical cost minus the salvage value. This is the portion of the asset that we DO want to depreciate and expense over time.
Estimated Useful Life - As the name implies this is the length of time in months, years, or simply units that the asset is expected to last for. If the units of production method is being used, we would need to know the total number of units that can be produced by the product throughout its entire life. Sometimes these units are measured in “machine hours”, but they could also be actual physical production units.
Accumulated Depreciation - This is the amount of depreciation that has been recorded for an asset up to this point in the asset’s life. This accumulated depreciation is a “contra-asset” account, which means that it offsets the asset on the balance sheet. This is similar to how the allowance for doubtful accounts offset accounts receivable in last week’s discussion. Assets have normal debit balances. Contra-Assets, like Accumulated Depreciation, have normal credit balances. This means they are increased by credits.
Capitalization - This is the term that reflects an asset that has its expense spread out over time, instead of being recorded as an expense in the short run. In other words, assets that are purchased and expected to last for multiple years are also called capital assets.
Net Book Value (NBV) – This term represents the amount of the asset’s cost that is still unused at this point in time. It is calculated by taking the cost of the asset minus the accumulated depreciation balance.
The below video goes through these terms and the basic depreciation concepts in more detail.
Depreciation Concepts
Section 2.) Fixed Asset Purchase and Acquisition
The first concern when dealing with Fixed Assets is how to record the initial purchase/acquisition transaction. Recall our week 1 discussion of the historical cost principle, which requires that an asset be recorded at the amount of cost incurred to purchase it. This ignores any revised fair market values or appraisals, etc.
Another question that arises is whether it makes sense to spread the cost of this asset out over its life. Generally speaking, if an asset is going to be used in operations, and helping to produce revenue for multiple years, then the cost should be spread out over that same time period as well. This is required by the matching principle. However, there are exceptions when an amount is so small that the difference between spreading the cost out over multiple years or expensing it all in the first year wouldn’t impact anyone’s decisions about the company. This reflects the concept of materiality.
GAAP allows companies some leeway in determining what that materiality threshold is, though ultimately it would be up to the auditors to agree. Different companies may have different criteria for determining when they will treat an asset as a capital asset (that they depreciate) versus an operating asset (that they expense immediately.) The expected life of the asset and the dollar value of the asset are both used in this determination. One classic example of this is a trash can in an office building. Although the trash can certainly last several periods, it is generally not worth it to depreciate it.
Once the company has decided to capitalize an asset (for later depreciation) they record the purchase as a debit to the asset and a credit to cash or whatever other asset was given up obtaining the new assets. In some cases, this credit may go to a liability (like accounts or notes payables) instead, stating that you owe the money in the future.
The journal entry would require a debit to the fixed asset (to increase it) and a credit to whatever payment method was used for the purchase (i.e., cash, notes payable, etc.)
This concept is pretty straight forward when one specific asset is purchased, but it gets more complicated when multiple assets are purchased at one time. This is sometimes referred to as a basket purchase.
In those cases, the total purchase price must be allocated out to the various pieces of equipment. This is done based on the percentage of each assets appraised value to the total value of all assets. Note that fair market value doesn’t always exactly equal cost for a variety of reasons.
This is best to explain through an example. Assume a piece of land, a building, and a piece of machinery were all purchased for the total cost of $400,000. We need to identify how much cost goes to each asset. To do this, we need some sort of information about a current appraised value, which in some cases may actually be more than the cost. This could exist in situations where the seller was offering a discount or was perhaps under some extreme financial need.
In this example, let’s assume the fair market value of each asset was as follows:
Note that I have also calculated a percentage of the total value that each asset represents. Note that this $500,000 is more than the $400,000 cost. As such, we would not be able to just take the value of each asset and create a journal entry. Instead, we would apply the percentages by the total cost of $400,000 to identify the amount of cost to be allocated to each asset. This is shown in the illustration below:
The journal entry for the asset purchase would then be as follows:
This is important to allow the company to separately depreciate the assets based on their original cost. Once an asset is reported on the company’s books, it will remain there until the company is no longer using it. This is even if the company is done depreciating it and the asset is lasting longer than expected.
Comments
Post a Comment