BUS103: Introduction to Financial Accounting

Companies record depreciation on all plant assets except land. Since the amount of depreciation may be relatively large, depreciation expense is often a significant factor in determining net income. For this reason, most financial statement users are interested in the amount of, and the methods used to compute, a company's depreciation expense.

Depreciation is the amount of plant asset cost allocated to each accounting period benefiting from the plant asset's use. Depreciation is a process of allocation, not valuation. Eventually, all assets except land wear out or become so inadequate or outmoded that they are sold or discarded; therefore, firms must record depreciation on every plant asset except land. They record depreciation even when the market value of a plant asset temporarily rises above its original cost because eventually the asset is no longer useful to its current owner.

Exhibit 5: Factors affecting depreciation

Major causes of depreciation are (1) physical deterioration, (2) inadequacy future needs, and (3) obsolescence. Physical deterioration results from the use of asset - wear and tear - and the action of the elements. For example, an automobile

may have to be replaced after a time because its body rusted out. The inadequacy asset is its inability to produce enough products or provide enough services to meet current demands. For example, an airline cannot provide air service for 125 passengers using a plane that seats 90. The obsolescence of an asset is its decline in usefulness brought about by inventions and technological progress. For example, the development of the xerographic process of reproducing printed matter rendered almost all previous methods of duplication obsolete.

The use of a plant asset in business operations transforms a plant asset cost into an operating expense. Depreciation, then, is an operating expense resulting from the use of a depreciable plant asset. Because depreciation expense does not require a current cash outlay, it is often called a noncash expense. The purchaser gave up cash in the period when the asset was acquired, not during the periods when depreciation expense is recorded.

To compute depreciation expense, accountants consider four major factors:

• Cost of the asset.
• Estimated salvage value of the asset. Salvage value (or scrap value) is the amount of money the company expects to recover, less disposal costs, on the date a plant asset is scrapped, sold, or traded in.
• Estimated useful life of the asset. Useful life refers to the time the company owning the asset intends to use it; useful life is not necessarily the same as either economic life or physical life. The economic life of a car may be 7 years and its physical life may be 10 years, but if a company has a policy of trading cars every 3 years, the useful life for depreciation purposes is 3 years. Various firms express useful life in years, months, working hours, or units of production. Obsolescence also affects useful life. For example, a machine capable of producing units for 20 years, may be expected to be obsolete in 6 years. Thus, its estimated useful life is 6 years - not 20. Another example, on TV you may have seen a demolition crew setting off explosives in a huge building (e.g. The Dunes Hotel and Casino in Las Vegas, Nevada, USA) and wondering why the owners decided to destroy what looked like a perfectly good building. The building was destroyed because it had reached the end of its economic life. The land on which the building stood could be put to better use, possibly by constructing a new building.
• Depreciation method used in depreciating the asset. We describe the four common depreciation methods in the next section.

Exhibit 6: Depreciation method used

In Exhibit 5, note the relationship among these factors. Assume Ace Company purchased an office building for USD 100,000. The building has an estimated salvage value of USD 15,000 and a useful life of 20 years. The depreciable cost of the building is USD 85,000 (cost less estimated salvage value). Ace would allocate this depreciable base over the useful life of the building using the proper depreciation method under the circumstances.

Today, companies can use many different methods to calculate depreciation on assets. This section discusses and illustrates the most common methods - straight line, units-of-production, and accelerated depreciation method (double-declining balance).

As is true for inventory methods, normally a company is free to adopt the most appropriate depreciation method for its business operations. According to accounting theory, companies should use a depreciation method that reflects most closely their underlying economic circumstances. Thus, companies should adopt the depreciation method that allocates plant asset cost to accounting periods according to the benefits received from the use of the asset. Exhibit 6 shows the frequency of use of these methods for 600 companies. You can see that most companies use the straight-line method for financial reporting purposes. Note that some companies use one method for certain assets and another method for other assets. In practice, measuring the benefits from the use of a plant asset is impractical and often not possible. As a result, a depreciation method must meet only one standard: the depreciation method must allocate plant asset cost to accounting periods in a systematic and rational manner. The following four methods meet this requirement.

An accounting perspective:
Business insight

Regardless of the method or methods of depreciation chosen, companies must disclose their depreciation methods in the footnotes to their financial statements. They include this information in the first footnote, which summarizes significant accounting policies.

The disclosure is generally straightforward: Sears, Roebuck & Co. operates department stores, paint and hardware stores, auto supply stores, and eye wear stores. Its annual report states simply that "depreciation is provided principally by the straight-line method". Companies may use different depreciation methods for different assets. General Electric Company is a highly diversified multinational corporation that develops, manufactures, and markets aerospace products, major appliances, industrial products, and high-performance engineered plastics. It uses an accelerated method for most of its property, plant, and equipment; however, it depreciates some assets on a straight-line basis, while the company's mining properties are depreciated under the units-of-production method. 

In the illustrations of the four depreciation methods that follow, we assume the following: On 2010 January 1, a company purchased a machine for USD 54,000 with an estimated useful life of 10 years, or 50,000 units of output, and an estimated salvage value of USD 4,000.

Straight-line method Straight-line depreciation has been the most widely used depreciation method in the United States for many years because, as you saw in Chapter 3, it is easily applied. To apply the straight-line method, a firm charges an equal amount of plant asset cost to each accounting period. The formula for calculating depreciation under the straight-line method is:

$\text { Depreciation per period }=\frac{\text { Asset cost }-\text { Estimated salvage value }}{\text { Number of accounting periods for estimated useful life }}$

Using our example of a machine purchased for USD 54,000, the depreciation is:

$\frac{\$ 54,000-\$ 4,000}{10 \text { years }}=\$ 5,000 \text{per year}$

In Exhibit 7, we present a schedule of annual depreciation entries, cumulative balances in the accumulated depreciation account, and the book (or carrying) values of the USD 54,000 machine.

Using the straight-line method for assets is appropriate where (1) time rather than obsolescence is the major factor limiting the asset's life and (2) the asset produces relatively constant amounts of periodic services. Assets that possess these features include items such as pipelines, fencing, and storage tanks.

Units-of-production (output) method The units-of-production depreciation method assigns an equal amount of depreciation to each unit of product manufactured or service rendered by an asset. Since this method of depreciation is based on physical output, firms apply it in situations where usage rather than obsolescence leads to the demise of the asset. Under this method, you would compute the depreciation charge per unit of output. Then, multiply this figure by the number of units of goods or services produced during the accounting period to find the period's depreciation expense. The formula is:

$\text{Depreciation per unit} = \dfrac{\text{Asset cost-Estimated salvage value}}{\text{units of production (service) during useful life of asset}}$

$\text{Depreciation per period = Deprecation per unit} \times \text{Number of units of goods/services produced}$

You would determine the deprecation charge for the USD 54,000 machine as:

$\frac{\mathrm{USD} 54,000-\mathrm{USD} 4,000}{50,000 \text { units }}=\$1 \, \text{per unit}$ 

Exhibit 7: Straight-line depreciation schedule

If the machine produced 1,000 units in 2010 and 2,500 units in 2011, depreciation expense for those years would be USD 1,000 and USD 2,500, respectively.

Accelerated depreciation methods record higher amounts of depreciation during the early years of an asset's life and lower amounts in the asset's later years. A business might choose an accelerated depreciation method for the following reasons:

• The value of the benefits received from the asset decline with age (for example, office buildings).
• The asset is a high-technology asset subject to rapid obsolescence (for example, computers).
• Repairs increase substantially in the asset's later years; under this method, the depreciation and repairs together remain fairly constant over the asset's life (for example, automobiles).

The most common accelerated method of depreciation is the double-declining balance (DDB) method.

* This amount could be $3,247 to reduce the book value to the estimated salvage value of $4,000. Then, accumulated depreciation would be $50,000. 

Exhibit 8: Double-declining-balance (DDB) depreciation schedule

Double-declining-balance method To apply the double-declining-balance (DDB) method of computing periodic depreciation charges you begin by calculating the straight-line depreciation rate. To do this, divide 100 percent by the number of years of useful life of the asset. Then, multiply this rate by 2. Next, apply the resulting double-declining rate to the declining book value of the asset. Ignore salvage value in making the calculations. At the point where book value is equal to the salvage value, no more depreciation is taken. The formula for DDB depreciation is:

$\text { Deprecation per period }=2 \times(\text { Straight }-\text { line rate }) \times(\text { Asset cost }-\text { Accumulated depreciation })$

Exhibit 9: Summary of depreciation methods

Look at the calculations for the USD 54,000 machine using the DDB method in Exhibit 8. The straight-line rate is 10 percent (100 percent/10 years), which, when doubled, yields a DDB rate of 20 percent. (Expressed as fractions, the straight-line rate is 1/10, and the DDB rate is 2/10). Since at the beginning of year 1 no accumulated depreciation has been recorded, cost is the basis of the calculation. In each of the following years, book value is the basis of the calculation at the beginning of the year.

In the 10th year, you could increase depreciation to USD 3,247 if the asset is to be retired and its salvage value is still USD 4,000. This higher depreciation amount for the last year (USD 3,247) would reduce the book value of USD 7,247 down to the salvage value of USD 4,000. If an asset is continued in service, depreciation should only be recorded until the asset's book value equals its estimated salvage value.

For a summary of the three depreciation methods, see Exhibit 9.

In Exhibit 10, we compare two of the depreciation methods just discussed - straight line and double-declining balance - using the same example of a machine purchased on 2010 January 1, for USD 54,000. The machine has an estimated useful life of 10 years and an estimated salvage value of USD 4,000.

An accounting perspective:
Uses of technology

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So far we have assumed that the assets were put into service at the beginning of an accounting period and ignored the fact that often assets are put into service during an accounting period. When assets are acquired during an accounting period, the first recording of depreciation is for a partial year. Normally, firms calculate the depreciation for the partial year to the nearest full month the asset was in service. For example, they treat an asset purchased on or before the 15th day of the month as if it were purchased on the 1st day of the month. And they treat an asset purchased after the 15th of the month as if it were acquired on the 1st day of the following month.

To compare the calculation of partial-year depreciation, we use a machine purchased for USD 7,600 on 2010 September 1, with an estimated salvage value of USD 400, an estimated useful life of five years, and an estimated total units of production of 25,000 units.

Exhibit 10: Comparison of straight-line and double-declining-balance depreciation methods

Straight-line method Partial-year depreciation calculations for the straight-line depreciation method are relatively easy. Begin by finding the 12-month charge by the normal computation explained earlier. Then, multiply this annual amount by the fraction of the year for which the asset was in use. For example, for the USD 7,600 machine purchased 2010 September 1 (estimated salvage value, USD 400; and estimated useful life, five years), the annual straight-line depreciation is [(USD 7,600 - USD 400)/5 years] = USD 1,440. The machine would operate for four months prior to the end of the accounting year, December 31, or one-third of a year. The 2010 depreciation is (USD 1,440 X 1/3) = USD 480.

Units-of-production method The units-of-production method requires no unusual computations to record depreciation for a partial year. To compute the partial-year depreciation, multiply the depreciation charge per unit by the units produced. The charge for a partial year would be less than for a full year because fewer units of goods or services are produced.

Double-declining-balance method Under the double-declining-balance method, it is relatively easy to determine depreciation for a partial year and then for subsequent full years. For the partial year, simply multiply the fixed rate times the cost of the asset times the fraction of the partial year. For example, DDB depreciation on the USD 7,600 asset for 2010 is (USD 7,600 X 0.4 X 1/3) = USD 1,013. For subsequent years, compute the depreciation using the regular procedure of multiplying the book value at the beginning of the period by the fixed rate. The 2011 depreciation would be [(USD 7,600 - USD 1,013) X 0.4] = USD 2,635.

An accounting perspective:
Uses of technology

Most companies report property, plant, and equipment as one amount in the balance sheet in their annual report; however, that account is made up of many items. Computers and accounting software have simplified record keeping for all of a company's depreciable assets. When depreciable plant assets are purchased, employees enter in the computer the cost, estimated useful life, and estimated salvage value of the assets. In addition, they enter the method of depreciation that the company decides to use on the assets. After processing this information, the computer calculates the company's depreciation expense and accumulates depreciation for each type of asset and each individual asset (e.g. a machine).

After depreciating an asset down to its estimated salvage value, a firm records no more depreciation on the asset even if continuing to use it. At times, a firm finds the estimated useful life of an asset or its estimated salvage value is incorrect before the asset is depreciated down to its estimated salvage value; then, it computes revised depreciation charges for the remaining useful life. These revised charges do not correct past depreciation taken; they merely compensate for past incorrect charges through changed expense amounts in current and future periods. To compute the new depreciation charge per period, divide the book value less the newly estimated salvage value by the estimated periods of useful life remaining.

For example, assume that a machine cost USD 30,000, has an estimated salvage value of USD 3,000, and originally had an estimated useful life of eight years. At the end of the fourth year of the machine's life, the balance in its accumulated depreciation account (assuming use of the straight-line method) was (USD 30,000 - USD 3,000) X /8 = USD 13,500. At the beginning of the fifth year, a manager estimates that the asset will last six more years. The newly estimated salvage value is USD 2,700. To determine the revised depreciation per period:

Had this company used the units-of-production method, its revision of the life estimate would have been in units. Thus, to determine depreciation expense, compute a new per-unit depreciation charge by dividing book value less revised salvage value by the estimated remaining units of production. Multiply this per unit charge by the periodic production to determine depreciation expense.

Using the double-declining-balance method, the book value at the beginning of year would be USD 9,492.19 (cost of USD 30,000 less accumulated depreciation of USD ,507.81). Depreciation expense for year 5 would be twice the new straight-line rate times book value. The straight-line rate is 100 percent/6 = 16.67 percent. So twice the straight-line rate is 33.33 percent, or 1/3. Thus, 1/3 X USD 9,492.19 = USD 3,164.06.

APB Opinion No. 12 requires that companies separately disclose the methods of depreciation they use and the amount of depreciation expense for the period in the body of the income statement or in the notes to the financial statements. Major classes of plant assets and their related accumulated depreciation amounts are reported as shown in Exhibit 11.

Showing cost less accumulated depreciation in the balance sheet gives statement users a better understanding of the percentages of a company's plant assets that have been used up than reporting only the book value (remaining undepreciated cost) of the assets. For example, reporting buildings at USD 75,000 less USD 45,000 of accumulated depreciation, resulting in a net amount of USD 30,000, is quite different from merely reporting buildings at USD 30,000. In the first case, the statement user can see that the assets are about 60 percent used up. In the latter case, the statement user has no way of knowing whether the assets are new or old.

Reed Company

Partial Balance Sheet

2010 June 30

Exhibit 11: Partial balance sheet

An accounting perspective:

Business insight

In their financial statements, companies often provide one amount for property, plant, and equipment that is net of accumulated depreciation. Nonetheless, notes (footnotes) actually provide the additional information regarding the separate types of assets. The Limited, Inc. is a world leader in the design and distribution of numerous lines of women's and men's clothing. For instance, its 2001 Feb 3, balance sheet showed property, plant, and equipment, net, equal to USD 1,394,619. In a note to the financial statements (slightly modified to clarify), management explained this amount as follows:

(Dollar amounts in thousands)

A misconception Some mistaken financial statement users believe that accumulated depreciation represents cash available for replacing old plant assets with new assets. However, the accumulated depreciation account balance does not represent cash; accumulated depreciation simply shows how much of an asset's cost has been charged to expense. Companies use the plant asset and its contra account, accumulated depreciation, so that data on the total original acquisition cost and accumulated depreciation are readily available to meet reporting requirements.

Costs or market values in the balance sheet In the balance sheet, firms report plant assets at original cost less accumulated depreciation. One of the justifications for reporting the remaining undepreciated costs of the asset rather than market values is the going-concern concept. As you recall from Chapter 5, the going-concern concept assumes that the company will remain in business indefinitely, which implies the company will use its plant assets rather than sell them. Generally, analysts do not consider market values relevant for plant assets in primary financial statements, although they may be reported in supplemental statements.

A broader perspective:
Wolverine World Wide, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1 (In Part): Summary of Significant Accounting Policies

Property, Plant, and Equipment

Property, plant, and equipment are stated on the basis of cost and include expenditures for new facilities, major renewals, betterment, and software. Normal repairs and maintenance are expensed as incurred.

Depreciation of plant, equipment, and software is computed using the straight-line method. The depreciable lives for buildings and improvements range from five to forty years; from three to ten years for machinery and equipment; and from three to ten years for software. As required, the Company adopted the American Institute of Certified Public Accountants Statement of Position (SoP) 98-1, Accounting for the Costs of Computer Software Developed and Obtained for Internal Use, in 1999. The SOP provides guidelines for determining whether costs should be expensed or capitalized for computer software developed or purchased for internal use. The Company's accounting policies for such items were already in substantial compliance with SOP 98-1 and, therefore, the adoption did not have a material effect on its 1999 consolidated financial position or results of operations.