The life cycle of an operational asset includes (1) acquisition of funds to acquire the asset, (2) acquisition of the asset, (3) use of the asset, and (4) retirement (disposition of) the asset. The company expects to use the asset for 5 years (estimated useful life) and then sell it for $1,000 (salvage value). Therefore, the recognition of expenses for the cost of equipment is spread over the useful life of the asset.
Instead, they are included in the total amount of cash collected from the sale of the asset. The amount of depreciation expense ($5,000) reported on the income statement is constant each year from 2010 to 2013. Multiply the double-declining balance rate by the asset's book value at the beginning of the period (remember that book value is historical cost minus accumulated depreciation).
The following table shows the amount of depreciation expense that Dryden will recognize over the van's useful life. Exhibit 6.4 shows financial statements for the life of the asset, assuming that Dryden uses double-declining-balance depreciation. Reported depreciation expense is larger in the earlier years and smaller in the later years of the asset's life.
The double-declining balance method smooths out the amount of net income reported over the useful life of the asset.
DRYDEN ENTERPRISES
In the early years, when the use of heavy assets produces higher income, depreciation expenses are also higher. Similarly, in later years, lower levels of income are matched by lower levels of depreciation expense. The depreciation method a company uses does not affect how it obtains financing, invests funds, and retires assets.
Different depreciation methods only affect the amount of depreciation expense recorded each year, not which accounts are used.
Units-of-Production Depreciation
Salvage value Units of production Annual 3 in current 5 depreciation
Depreciation expense is greater in years when the van is driven more and less in years when the van is driven less, ensuring a reasonable match of depreciation expense to revenue produced.
Comparing the Depreciation Methods
REVISION OF ESTIMATES
To report useful financial information in a timely manner, accountants must make many estimates of future outcomes, such as the salvage value and useful life of depreciable assets and the expense of uncollectible accounts. Because revisions to estimates are common, generally accepted accounting principles require the inclusion of revised information in current and future calculations. At this point, what happens if McGraw changes his estimates of useful life or salvage value.
Revision of Life
Revision of Salvage
CONTINUING EXPENDITURES FOR PLANT ASSETS
Costs That Are Expensed
Costs That Are Capitalized
The event is still an asset exchange; cash decreases and the car's book value increases. However, the increase in the book value of the machinery results from the decrease in the balance in the account against the assets, Accumulated Depreciation.
CHECK YOURSELF 6.3
The $1,200 cost was incurred to repair damage resulting from an accident
The $1,200 cost would be capitalized in the asset account, increasing both the book value of the asset and the annual depreciation expense
NATURAL RESOURCES
INTANGIBLE ASSETS
Trademarks
Patents
Copyrights
Franchises
FOCUS ON INTERNATIONAL ISSUES
Companies want their brands to be known, but they also face the risk of the brand being used as a generic name for a product. On March 9, 2009, Merck & Company (Merck), one of the world's largest pharmaceutical companies, agreed to pay $41.1 billion to acquire Schering-Plough Corporation (S-P), another pharmaceutical company. Why would Merck pay the S-P owners nearly four times the net asset value shown on the company's balance sheet.
Merck was willing to pay four times the book value of the assets for three reasons. First, the value of the assets on S-P's balance sheet represented the historical cost of the assets. The current market value of these assets was likely higher than their historical cost, especially for assets such as S-P's drug patents.
Second, Merck believed that the two companies together could operate at a lower cost than the two could as separate companies, thus increasing the overall earnings they could. Finally, Merck likely believed that S-P had goodwill that enables a company to use its assets in a way that will generate above-average earnings.
REALITY BYTES
Goodwill
Assets 5 Liabilities 1 Stockholders’ Equity
The fair market value of the restaurant's assets represents the historical cost to the new owner.
EXPENSE RECOGNITION FOR INTANGIBLE ASSETS
Expensing Intangible Assets with Identifiable Useful Lives
Impairment Losses for Intangible Assets with Indefinite Useful Lives
BALANCE SHEET PRESENTATION
EFFECT OF JUDGMENT AND ESTIMATION
The depreciation method is not the only aspect of expense recognition that can differ between companies. Companies may also make different assumptions about the useful lives and salvage values of long-lived operating assets. Because the depreciation method and the underlying assumptions regarding useful life and salvage value affect the determination of depreciation expense, it also affects the amounts of net income, retained earnings and total assets.
To promote meaningful analysis, publicly traded companies are required to disclose all significant accounting policies they use in preparing their financial statements.
EFFECT OF INDUSTRY CHARACTERISTICS
The table shows that for every $1.00 invested in property, plant and equipment, Kelly Services generated $31.91 in sales. In contrast, Cox Communications and United Airlines produced only $0.73 and $1.31, respectively, for every $1.00 they invested in operational assets. Does that mean Kelly management is doing a better job than Cox Communications or United Airlines management.
This chapter explains that the primary purpose of recording depreciation is to match the cost of a long-lived property, plant and equipment with the income the asset is expected to generate. The chapter explains how alternative methods can be used to account for the same event (eg straight-line versus double-declining balance depreciation). The alternative accounting methods for depreciating, depreciating, or amortizing assets include (1) straight-line, (2) double-declining balance, and (3) units of production.
The amount of recognized expense is determined using the formula [(cost 2 salvage) 4 number of years of useful life]. The double-declining balance method produces proportionally larger amounts of expense in the early years of an asset's useful life and progressively smaller amounts of expense in the later years of the asset's useful life. The formula for calculating double-declining balance depreciation is [book value at beginning of period 3 (2 3 straight-line rate)].
The units of production method generates costs in direct proportion to the number of units produced in an accounting period. The formula for the amount of expense recognized each period is [(cost 2 salvage) 4 total estimated production units 5 distribution rate 3 production units in the current accounting period]. This chapter showed how to account for changes in estimates, such as the useful life or salvage value of a depreciable asset.
Instead, the remaining book value of the asset over its remaining useful life is expensed. After an asset is put into service, companies usually incur further costs for maintenance, quality improvement and extension of useful life. Costs that improve the quality of an asset are added to the cost of the asset, increasing the book value and the amount of future depreciation charges.
A Look Forward >>
- What is a basket purchase of assets? When a basket purchase is made, how is cost as-
- What are the stages in the life cycle of a long-term operational asset?
- What effect does the recognition of depre- ciation expense have on total assets? On
- Does the recognition of depreciation ex- pense affect cash fl ows? Why or why not?
- MalMax purchased a depreciable asset
- John Smith mistakenly expensed the cost of a long-term tangible fixed asset
- What is salvage value?
- What type of account (classifi cation) is Accumulated Depreciation?
- Why is depreciation that has been recog- nized over the life of an asset shown in a
- Assume that a piece of equipment cost
- Why would a company choose to depreciate one piece of equipment using the double-
- Why may it be necessary to revise the esti- mated life of a plant asset? When the esti-
- How are capital expenditures made to im- prove the quality of a capital asset ac-
- When a long-term operational asset is sold at a gain, how is the balance sheet affected?
- List several common intangible assets
- List some differences between U.S. GAAP and GAAP of other countries with respect to
- How can judgment and estimation affect information reported in the financial
- Purchased a new pizza oven that cost $15,000 cash
- Earned $26,000 in cash revenue
- Paid $13,000 cash for salaries expense
- Paid $6,000 cash for operating expenses
- Company 2
- Required
- CHECK FIGURES
- CHECK FIGURE
- CHECK FIGURE
- Business Applications Case Understanding real-world annual reports Required
- Group Assignment Different depreciation methods
- Research Assignment Comparing Microsoft’s and Intel’s operational assets Companies in different industries often use different proportions of current versus long-term as-
- Writing Assignment Impact of historical cost on asset presentation on the balance sheet
- Ethical Dilemma What’s an expense?
Why the asset's book value is likely to differ from the asset's current market value. Determine the amount that will be capitalized in the funds account for the purchase of the saw. Determine the amount of purchase costs to be attributed to the land and the amount to be attributed to the building.
Calculate the depreciation for each of the five years, assuming that the company uses ( 1) Straight-line depreciation. Calculate the depreciation expense for each of the five years using double-declining balance depreciation. Calculate the depreciation expense for each of the five years using units of production.
Calculate the amount of gain or loss on the sale of the asset under each of the depreciation methods. Record the acquisition of sand stock and the cost of depletion for years 1 and 2 in the financial statement model as before. Record the purchase of intangible assets and related depreciation expense for year 1 in a horizontal statement model like the previous one.
Calculate the depreciation expense for each of the five years assuming the use of straight-line depreciation. Calculate the depreciation expense for each of the five years, assuming the use of double-declining balance depreciation. Calculate the depreciation for each of the three years assuming the use of units of production depreciation.
Record the purchase of the van and the recognition of the income and the depreciation expense for the first year in a financial statement model like the previous one. Use a horizontal statement model such as the following one to show the effects of these transactions on the elements of the financial statements. Determine the book value (cost 2 accumulated depreciation) Big Sky will report on the balance sheets at the end of the years 2011 to 2015.
Determine the amount of the gain or loss Big Sky will report on the disposal of the equipment on July 1, 2016. How will these differences in the amount of depreciation expense change over the life of the equipment.
