Video Transcript: Depreciation of Plant Assets
Hello and welcome back. Now we're going to discuss the depreciation of assets. Companies record depreciation on all plant assets, except for 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 statements 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 assets 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. This description shows a cost for the building and $100,000 it has a useful life of 20 years, with an estimated depreciable base of $85,000 less a salvage value of $15,000 the salvage value is not depreciable. Major causes of depreciation are physical deterioration, inadequate inadequacy for future needs and obsoletion. Physical deterioration results from the use of the asset, wear and tear and the action of the elements. For example, an automobile may have to be replaced after a time because of its bodies rusted out. The inadequacy of a plant asset is its inability to produce enough products or produce enough services to meet current demands. For example, an airline cannot provide air service for 125 passengers using the plane that seats 90. The obsolution of an asset is its decline in usefulness, brought about by inventions and technological progress. For example, the development of a zero graphic process of reproducing printed material 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 non cash expense. The purchaser gave up cash in the period when the asset was acquired, not during the periods when the depreciation expense is recorded. To compute depreciation expense, accountants considered four major factors consider the cost of the asset, the estimated salvage value of the asset. Salvage value, or is called scrap value, is the amount of money the company expects to recover less disposable costs on the date a plant asset is scrapped, sold or traded in estimated 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 seven years and its physical life may be 10 years. But if a company has a policy of trading cars every three years, the useful life for depreciation purposes is three years. Various firms Express useful life in years, months, working hours or units of production. Obsolution also affects useful life.
Remember that in recording the life history of an asset, accountants match expenses related to the asset with the revenues generated by it. Because measuring the periodic expense of plant assets affects net income. Accounting for property, plant and equipment is important to financial statement users. Depreciation method used in depreciating the asset we describe in four common methods. The method the four common methods. Is a straight line method, a decline balance method, some of years digits and accelerate. Units of production are the four common note the relationship among these factors, assume ace company purchased an office building for $100,000 the building has an estimated salvage value of $15,000 and a useful life of 20 years. The depreciable cost of this building is $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, this section discusses and illustrates the most common methods, straight line, units of production and accelerated depreciation, or the 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, a company 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 six 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 costs to the accounting period in a systematic and rational manner, the following four methods meet this requirement. In the illustration of four depreciation methods that follow, we assume the following, on January one, 2010 a company purchased a machine for $54,000 with an estimated useful life of 10 years, or 50,000 units of output and an estimated salvage value of 4000 straight line depreciation has been the most widely used depreciation method in the United States for many years, because 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 appreciation under straight line is as follows, excuse me, so you have your asset cost and you're going to subtract off the salvage cost, which is the cost you expect to receive from the asset if you were to scrap it or sell it, divided by the number of accounting periods of its useful life. Okay. So for instance, the machine that was purchased, you purchased it for 40, $54,000, you're going to
subtract the $4,000 salvage value and divided by the 10 years of its useful life, which will give you a $5,000 depreciation expense per year. Here we present a schedule of annual depreciation entries, cumulative balances in the accumulated depreciation account and the book values of the $54,000 machine using the straight line method for assets is appropriate, where time, rather than obsoletion, is the major factor limiting the asset's life, and the asset produces relatively consistent amounts of periodic services. Assets that possess these features include items such as pipelines, fencing and storage tanks, 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 obsolution leads to the demise of the asset. Under this method, you would compare. Cube 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. So to illustrate that, again, your asset cost minus the salvage value, and here you're going to divide it by the estimated total units of production during its useful life. Okay, so you purchased the equipment for $54,000 minus the salvage value of four and you're going to produce 50,000 units of its useful life. And that equates to $1 per unit. Okay, so at the end of year one depreciation will be $5,000 for a total accumulation of $5,000 for this for the year. And then each year thereafter, you're going to deduct the $5,000 per year. And finally, you will come to at the end of the 10 years, you will after deducting 5000 for each year, the remaining balance is going to be the $4,000 of which equates to your salvage value. If it does not equate to the salvage value the ending balance, then somewhere along the line, your calculations are incorrect, and you should go back and figure where you went wrong in deducting them. If the machine produced 1000 units in 2010 and 2500 units in 2011 depreciation expense for those years would be $1,000 and $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, an office building the asset is a higher technologically asset subject to rapid up solution, repairs increase substantially in the Assets later years. Under this method, the depre depreciation and repair and repairs together remain fairly consistent over the assets life, to demonstrate the double declining balance. If you remember, in the straight line, we started the first year with $5,000 so in essence, you're, in essence, you are doubling the amount of depreciation for the year from what you would have deducted if it were the straight line method. So this just shows you that 20% instead of 10% you're going to deduct 20% of 54,000, and so on and so forth, until the 10 years is up. To apply the double declining balance
method of calculating periodic depreciation charges, you begin by calculating the straight line depreciation rate. To do this, divide the 100% by the number of years of useful life, then multiply this rate by two Next, apply the resulting double declining rate to the declining book value of the asset, ignore the salvage value in making the calculations at the point where book value is equal to salvage value, no more depreciation is taken. So the formula for the double declining balance depreciation would be two times the straight line method, times the asset cost minus the accumulated depreciation. Look at the calculations for the 54,000 machine using the double declining method in Exhibit eight, the straight line rate is 10% which, when doubled, yields a double declining balance rate of 20% express this fraction. The straight line rate is one and 1/10 or 1/10 and the double declining is 210 since at the beginning of the year, no accumulated depreciation had been recorded. Cost is the basis of the calculation in each of the following years, book value is the basis. The calculation, at the beginning of the year, in the 10th year, you could increase depreciation to $3,247 if the asset is to be retired and its salvage value is still $4,000 this higher depreciation amount for the last year would reduce the book value of $7,247 down to the salvage value of 4000 if an asset is continued in service, depreciation should only be recorded until the asset's book value equals its estimated salvage value. 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, firm 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 first day of the month, and they treat an asset purchased after the 15th as if it were required on the first day of the following month to compare the calculation of a partial year, we use the machine purchased for $7,600 on September 1 of 2010 with an estimated salvage value of 400 and an estimated useful life of five years, and estimated total units of production of 25,000 units. This demonstration shows the straight line method and the double declining balance method, just how it declines each year. Straight line method, partially year depreciation calculations for the straight line depreciation method are relatively easy, beginning 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 $7,600 machine purchased on September 1 of 2010 with an estimated salvage value of 400 and a useful life of five years, the annual straight line depreciation is $1,440 the machine would operate for four months prior to the end of the accounting year, December 31 or 1/3 of a year, the depreciation for 2010 is $480 the units of production method requires no unusual computations to record depreciation for a particular year. For a partial
year, excuse me 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 a full year because fewer units of goods or services are produced double declining method, it is relatively easy to determine depreciation for 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, double declining depreciation on the $7,600 asset for 2010 is $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 $2,635 and 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 the 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 costs $30,000 has an estimated salvage value of 3000 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 was $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 $2,700 to determine the revised depreciation per period you're okay. So you start off with your original cost of 30,000 and at the end of the fourth year, you've already accumulated $13,500 depreciation with a book value beginning at the fifth year of $16,500 there you determine that the equipment has a longer life value. So you're going to revise that salvage value for the asset, which is now $2,700 and you're going to determine that the remaining depreciable cost is going to be $13,800 so therefore you must revise the depreciation to extend the new life value, and you're going to divide that by the six years that you have decided that it's going to be used for. And therefore, with a new depreciation value for the remainder of the six years of $2,300 had this company used the units of production method, its revision of the life estimate, 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 five year five would be $9,492.19 depreciation expense for year five would be twice the new straight line times book value. The straight line rate is 100% divided by six,
which gives you 16.67% so twice the straight line rate is 33.33% or 1/3 thus 1/3 times 9004. 9219, would equal 3001 64, and six cents depreciation. APB option number 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 the financial statements major classes of plant assets and their related accumulated depreciation amounts are reported showing cost less accumulated depreciation in the balance sheet gives statement users a better understanding of the percentages of a company's plant asset than have been used up than reporting only the Book value. For example, reporting buildings at $75,000 less $45,000 of accumulated depreciation, resulting in the net amount of $30,000 is quite different from merely reporting buildings at $30,000 in the first case, the statement user can see that the assets are about 60% used up. So as you can see, if an investor is looking at a balance sheet, it can see that you have a building that is worth even though the net realized value is 30 because you've listed the building at its original cost less than depreciation, they can see that you didn't pay $30,000 for the building to begin with. It was actually cost at 75,000 and the same with the equipment. You can see the actual cost left the usage, which is a depreciation for a net realized value of what it is valued at the time of. Of the balance sheet. So if you were to look at a balance sheet that consisted of two years, you could see that in 1999 the cost is more than the following year because of the depreciation. Some mistaken financial statements. 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 the data on the total original acquisition cost and accumulated depreciation are readily available to meet reporting requirements in the balance sheet. Firms report plant assets and original costs, less accumulated depreciation. One of the justifications for reporting the remaining undepreciable cost of the asset, rather than market values, is the going concept concern. The going concept of the going concern concept, excuse me, 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.