Challenging Issues Under Accrual Accounting: Longlived Depreciable Assets A Closer Look

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CHAPTER F8

• Challenging Issues Under Accrual
  AccountingLong-lived DepreciableAssets -- A
  Closer Look

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Depreciation

• Recall the basic definition of depreciation (from
  Chapter 6)
  
• Depreciation is a systematic and rational
  allocation of the cost of a long-lived item from
  asset to expense.

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Effect of Estimates

• Estimated useful life of the asset and the
  estimated disposal value at the end of that
  useful life each play a large role in determining
  the amount of depreciation to be recognized in
  each year that we use the long-lived asset.

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Discussion Questions

• Think about your most recent purchase of a
  long-lived asset. Maybe you bought a computer, a
  car, or a TV.
  
• How long do you expect to keep it and use it?
• What do you think it will be worth when you are
  through with it?
  
• How certain are you of these answers?

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Effect of Estimates

• Example Assume that we buy a new 6,000 computer
  system. We are unsure whether to use a
  three-year life or a five-year life, and some of
  our experts think that it could be worth as
  little as 0 after three years or as much as
  1,000 after five years.

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Effect of Estimates
Using 5 years and 1,000 disposal value, you
depreciate 1,000 each year.
Using 3 years and 0 disposal value, you would de
preciate 2,000 each year.
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Effect of Different Methods

• When preparing the depreciation schedule for a
  newly purchased long-lived asset, an accountant
  has a choice of several different depreciation
  methods.
• By choosing one method over another, the
  accountant has an impact on the amount of expense
  that will be reported in any given year, and,
  therefore, also the net income.

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Straight-line Depreciation

• In Chapter 6, the Straight-line method of
  depreciation was illustrated. It is probably the
  easiest method, and it is definitely the most
  heavily used method in the U.S.A.
• Approximately 95 of major corporations in
  America use straight-line for some or all of
  their long-lived assets.

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Straight-line Alternatives

• The straight-line method could be calculated on
  the basis of time, with an equal amount of
  depreciation being allocated to each time
  period.
• Alternatively, the straight-line measure could be
  units of production or some other measure of
  usage, such as miles driven for a vehicle or
  hours flown for an airplane.

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Straight-line Based on Time

• The basic premise is that the same amount of
  depreciation will be recognized in each year of
  the useful life of a long-lived asset.
  
• The computer system (5-year or 3-year)
  depreciation schedules given previously are
  examples of the straight-line method based on the
  passage of time.

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Straight-line Based on Usage

• The other variation of the straight-line method
  is often called the Production Depreciation
  method.
  
• Instead of estimating the number of years of
  useful life, we will instead estimate the amount
  of usage that we expect from the asset.

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Production Depreciation Method

• Assume that a pizza parlor buys a delivery truck.
  Rather than drive the truck into the ground,
  they decide that they should sell it after it has
  75,000 miles on it. The original cost is 20,000
  and they estimate that the disposal value will be
  5,000 at that time.

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Production Depreciation Method

• Step One Calculate the depreciation charge per
  mile driven Depreciable Base 15,000
  Estimated Miles 75,000 .20
  
• Step Two Calculate depreciation each year (or
  interim period) by multiplying actual miles
  driven by the per mile depreciation Year 1
  30,000 miles X .20 6,000

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Effect of Different Methods

• There are several other depreciation methods that
  are considered acceptable and are used by some
  companies.
  
• Most of these other methods are called
  accelerated depreciation methods. They are
  accelerated in that a larger amount of expense is
  taken in the early years, and less in later years.

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Double-Declining-Balance Method

• The most heavily used accelerated method is the
  Double-Declining-Balance method.
  
• The main features of this method are
• (1) it depreciates at a rate () equal to double
  the straight-line rate, and
  
• (2) you do not consider the estimated disposal
  value during the early years of depreciation.

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Double-Declining-Balance Method

• First step determine the DDB rate. The DDB rate
  is equal to twice the annual straight-line rate.
  
• For a five-year asset, the annual straight-line
  rate is 1/5 or 20. The DDB rate is 40.
  
• For an three-year asset, the annual straight-line
  rate is 1/3 or 33.3. The DDB rate is 66.7.

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Double-Declining-Balance Method

• Second step Multiply the DDB rate by the book
  value at the beginning of the year.
  
• You will use the same rate () each year,
  however, the amount of depreciation will decrease
  each year because the beginning book value also
  decreases each year.
• NOTE Be careful in the later years, dont
  depreciate the asset below salvage value.

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Double-Declining-Balance Method

• Lets prepare double-declining-balance
  depreciation schedules for the computer system
  mentioned in an earlier slide.
  
• First, lets assume a five-year life with 1,000
  disposal value, and
  
• Second, lets assume a three-year life with a 0
  disposal value.

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DDB Schedule, 5-Year Asset
Due to the accelerated amount of depreciation,
the asset is fully depreciated after four years.
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DDB Schedule, 3-Year Asset
Using the 3-year life with zero disposal value,
the amount of depreciation for year 3 is equal to
whatever amount remains.
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Understanding the Impact

• The choice of straight-line or an accelerated
  method affects all of the following
  
• Depreciation expense in each year.
• Net income in each year (because of 1).
• Accumulated depreciation in each year (except the
  last year when fully depreciated).
  
• Net book value in each year (because of 3,
  except the last year again).

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Understanding the Impact

• However, the choice of method does NOT affect the
  following
  
• The amount of depreciation taken over the entire
  useful life.
  
• The amount of net income reported over the entire
  useful life.
  
• The book value at the end of the useful life of
  the asset.

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Disposal of Assets

• At some point, a business will decide to dispose
  of a long-lived asset. This could happen at the
  end of the estimated useful life, or it could
  just as easily happen sooner or later than we
  originally estimated.
• Each time we dispose of an asset, we need to
  determine whether there is a gain or loss on
  disposal.

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Gains and Losses

• A gain is a net inflow resulting from a
  peripheral activity of the company, such as
  selling a long-lived asset for an amount greater
  than its net book value.
• A loss is a net outflow resulting from a
  peripheral activity of the company, such as
  selling a long-lived asset for an amount less
  than its net book value.

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Gains and Losses

• Gains and losses are important accounting
  elements. They are reported on the income
  statement along with revenues and expenses.
  
• Thus, the income statement equation is now
  expanded toNet income Revenue Gains -
  Expenses - Losses

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Determining Gains and Losses

• Consider these various examples of the disposal
  of a depreciable asset
  
• 1. A fully depreciated delivery truck (with
  220,000 miles on it) is hauled off to the junk
  yard.
  
• 2. A delivery van with a net book value of 8,000
  is traded in on a company car for the
  salespeople.
  
• 3. A one-year-old rental car with a net book
  value of 15,000 is sold at auction to a car
  dealership. Lets explore this third example a
  bit further.

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Calculating Gain on Disposal

• A gain on disposal of a depreciable asset will
  occur when the asset is sold for an amount in
  excess of the ending book value.
  
• Example The Car Rental Company sells a
  one-year-old car to a car dealership. The Car
  Rental Company has depreciated the asset to a
  book value of 15,000. The car dealership pays
  16,500 to buy the car. The Car Rental Company
  records a gain on disposal of 1,500.

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Calculating Loss on Disposal

• A loss on disposal of a depreciable asset will
  occur when the asset is sold for an amount less
  than the ending book value.
  
• Example The same situation with the Car Rental
  Company selling a car (book value of 15,000) to
  a dealership. The car dealership pays 14,500 to
  buy the car. The Car Rental Company records a
  loss on disposal of 500.

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Disposal with No Gain or Loss

• There will be no gain or loss on the disposal of
  a depreciable asset when the asset is sold (or
  traded) for an amount equal to the recorded book
  value.
• Example The same situation with the Car Rental
  Company selling a car (book value of 15,000) to
  a dealership. The car dealership pays 15,000 to
  buy the car. No gain or loss.

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True Meaning of Gains/Losses

• Remember that net book value is the end result of
  the depreciation amounts that have been charged
  against a particular asset.
  
• Therefore, if book value doesnt equal the
  disposal value of an asset, one can assume that
  we simply took too much or too little
  depreciation for that asset.
• The gain or loss is just an adjustment at the end
  of the process.

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True Meaning of Gains/Losses

• Case 1 You bought an asset at a cost of
  9,000. You have been depreciating this asset at
  a straight-line rate of 1,000 per year for 4
  years.
• The net book value at this time is 5,000 and you
  sell it for 4,000.
  
• You will record a loss on sale of 1,000.

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True Meaning of Gains/Losses

• Case 2 Same asset, 9,000 original cost and
  depreciated for the past four years.
  
• If you had depreciated 1,250 each year (total of
  5,000), the book value would have been equal to
  4,000.
  
• When the asset was sold for 4,000, there would
  be no gain or loss.

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True Meaning of Gains/Losses

• In case 1, you have 4,000 depreciation and a
  1,000 loss on sale. This reduces net income by
  5,000 over the life of the asset.
  
• In case 2, you have 5,000 depreciation and no
  gain or loss on sale. Again, net income has been
  reduced by 5,000.
  
• Either way, total net income is the same over the
  life of the asset.

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THE END

• Up Next Challenging Issues Under Accrual
  Accounting Merchandise Inventory and Cost of
  Goods Sold