Noncurrent Assets: Depreciation and Exchange
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Depreciation of Tangible Assets
Depreciation
is the systematic and rational allocation of the cost of noncurrent, tangible, fixed assets over their estimated
useful lives. When a fixed asset is purchased, it is recorded as an asset. The amount of the asset's cost that
is allocated to an expense account in every period is called depreciation
expense.
Depreciation does not do the following:
Depreciation is recorded as follows:
Debit Depreciation Expense
The Accumulated Depreciation account is a contra-asset account and represents the value
of the asset allocated to depreciation from the time the asset was acquired. The term accumulated depreciation
refers to the amount in the Accumulated Depreciation account.
Credit Accumulated Depreciation
The book value
of an asset, at any time, is the original cost minus the amount in the Accumulated Depreciation account up to that
point in time.
In calculating the amount of depreciation per period, the following factors are relevant:
depreciable
cost.)
Many methods are used to calculate depreciation expense:
The straight-line
method allocates an equal amount of depreciation
expense to each period of the asset's useful life. Depreciation expense each period is calculated as follows:
Depreciation expense = Depreciable cost/Useful life = (Cost - Salvage value)/ Useful life
At the end of each period, the depreciation for that period is added to the Accumulated Depreciation account. Thus,
the Accumulated Depreciation account includes the total depreciation from the date the asset was purchased to the
current date. The difference between the cost and the accumulated depreciation amount is called the book value of the asset
as noted earlier.
Example:
Marks Company purchased a machine for $41,000 on January 1, 2002. The machine's salvage value is $5,000 and its
useful life is 4 years. Calculate the depreciation expense, accumulated depreciation at the end of the year, and
the book value at the end of the year for each year of the useful life of the asset, when depreciation expense
is calculated using the straight-line method.
Depreciation expense each year = ($41,000 - $5,000)/4 = $9,000 per year
Year ending Book value at year beginning
Depreciation expense
Accumulated depreciation
Book value at end of year
12/31/2002 $ 41,000
$ 9,000
$ 9,000
$ 32,000
12/31/2003 32,000
9,000
18,000
23,000
12/31/2004 23,000
9,000
27,000
14,000
12/31/2005 14,000
9,000
36,000
5,000
Accelerated Depreciation methods allocate larger amounts to depreciation expense in the earlier
periods of the assets' useful life than in later periods. The declining-balance method is an accelerated method.
Step 2:
We discuss the double-declining-balance method in detail. As noted later, the other declining-balance
methods are substantially similar; they differ from the double-declining balance method only in the multiplication
factor used to multiply the straight-line rate. In the double-declining-balance method, depreciation expense is
calculated as follows:
Step 1:
Calculate the straight-line depreciation rate.
Straight-line depreciation rate = 1/Useful life
Step 2:
Calculate the double-declining-balance (DDB) rate.
DDB rate = 2 x Straight-line rate
Step 3:
Calculate depreciation expense.
Depreciation expense = DDB rate x Book value at the beginning of the period
Note 1:
For the first period, the book value equals the cost of the asset. For each subsequent period, the book value is
the difference between the asset's cost and the amount of accumulated depreciation.
Note 2:
The asset must not be depreciated below its salvage value. If the amount of depreciation expense for a year calculated
using the preceding formula reduces the book value below salvage, the amount of depreciation expense for that year
is the amount needed to reduce the asset's book value to its salvage value.
Example:
Spencer Company purchased a machine for $25,000 on January 1, 2002. The machine's salvage value is $3,000, and
its useful life is 4 years. Calculate the depreciation expense, accumulated depreciation at the end of the year,
and the book value at the end of the year for each year of the asset's useful life, when depreciation expense is
calculated using the double-declining balance method.
Step 1:
Straight line rate = 1/Useful life = ¼ = 0.25
DDB rate = 2 x Straight-line rate = 2 x 0.25 = 0.50
Year ending Book value at year beginning
Depreciation expense
Accumulated depreciation
Book value at end of year
A B
C = B x 0.50
D
E = B - C
12/31/2002 $ 25,000
$ 12,500
$ 12,500
$ 12,500
12/31/2003 12,500
6,250
18,750
6,250
12/31/2004 6,250
3,125
21,875
3,125
12/31/2005 3,125
125*
22,000
3,000
Note:
For the final year, depreciation expense is the "plug" number. Because the salvage value given is $3,000,
the book value at the end of 2005 must equal $3,000. Because the book value at the beginning of 2005 is $3,125,
the depreciation expense for the year must be $125 so that the book value becomes equal to $3,000.
The approach for other declining-balance methods is very similar. The only difference is in step 2. For the DDB method, step 2 is as follows:
DDB rate = 2 x Straight-line rate
If we use the 150% declining-balance (as opposed to DDB) method, step 2 is as follows:
150% declining-balance rate = 1.5 x Straight-line rate
If we use the 125% declining-balance (as opposed to DDB) method, step 2 is as follows:
125% declining balance rate = 1.25 x Straight-line rate
In other words, the only change is in the multiplication factor used to multiply the straight-line rate, as noted
earlier.
Sum-of-the-Years'-Digits Method
The sum-of-the-years'-digits method is another accelerated method. Under this method, the depreciation
expense is calculated as follows.
Assume that a machine has an estimated useful life of 4 years. The sum-of-the-years'-digits
equals 10 (1 + 2 + 3 + 4). In the first year, the depreciation expense is 4/10 of the total depreciable cost. In the second year, the depreciation expense is 3/10 of the total depreciable cost, and so on. In the fourth and final year, the depreciation expense is 1/10 of the depreciable cost.
Thus, under this method, the denominator equals the sum of the years involved. If an asset has a useful life of
1 + 2 + 3 . . . +
N-1 + N = N x (N+1)/2
The numerator for the first year is N, for the second year is N-1, for the third year is N-2, and so on. For the final year, the numerator is 1.
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Under use-factor methods, depreciation is viewed as being related to the
extent to which an asset is used. Thus, the more an asset is used in a given period, the higher is its depreciation
expense for that period.
Example:
Williams Company purchased a truck on January 1, 2002, for $35,000 and estimated that it would be driven for 200,000
miles, after which it would be sold for $5,000. The actual number of miles driven in the first three years of the
truck's life was as follows: 30,000 miles in 2002; 45,000 miles in 2003; 37,000 miles in 2004. What is the depreciation
expense in each of the first three years?
The total depreciable cost = $30,000 ($35,000 cost - $5,000 salvage value)
Total use factor = 200,000 miles
Depreciation per use-factor unit = $30,000/200,000 miles = $0.15 per mile
Thus, depreciation in each year is as follows:
Year Use factor (miles)
Depreciation expense
2002 30,000
$4,500 (30,000 x 0.15)
2003 45,000
$6,750 (45,000 x 0.15)
2004 37,000
$5,550 (37,000 x 0.15)
In this example, depreciation was calculated based
on the input factor (miles driven). Other examples of input factors include machine
hours, service hours, and labor hours. In other situations, it may be more appropriate to calculate depreciation
based on the output factor, such as the number of units produced or the number of customers served.
Note that when depreciation expense is calculated based on the output (for example, when using the units-of-production method),
depreciation is a variable expense in the income statement. In contrast, when depreciation is calculated using
the time-factor methods (such as straight line, declining balance, or sum of the years' digits), the expense is
fixed in the income statement.
Amortization of Intangible
Assets
Noncurrent intangible assets are amortized
over their estimated useful lives, just as noncurrent tangible assets are depreciated over their estimated useful
lives. Thus, amortization is similar to depreciation, except that the word "amortization"
is used only in the context of intangible assets, while depreciation is used for tangible assets. (A similar word is depletion,
which is used only in the context of natural resources, such as oil and gas wells.)
Some differences exist between the amortization of intangible assets and the depreciation of tangible assets. First,
intangible assets are amortized by directly crediting (that is, reducing the balance of) the intangible asset.
Thus, intangible assets have no Accumulated Amortization account. Second, intangible assets must be amortized according
to the straight-line method unless compelling reason exists to use another method.
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Depreciation calculations are based on estimates,
such as the estimated salvage value, estimated useful life, or estimated output. Estimates are not precise and may
change over time. Any change in an estimate impacts the depreciation for only the current and future periods; past
periods' depreciation remains unchanged (companies do not go back and correct prior periods' depreciation).
Change in Estimates Related
to Depreciation
Example:
Cabrero Company bought a machine on January 1, 2002, for $24,000 and estimated its useful life to be eight years.
On January 1, 2005, the company revised the estimated useful life to be only seven years. Calculate the depreciation
expense for each year using the straight-line method.
Depreciation expense for each of the years 2002, 2003, and 2004 equals $3,000 per year ($24,000/8).
As of December 31, 2004, accumulated depreciation equals $9,000 ($3,000 multiplied by 3).
Thus, as of January 1, 2005, the book value of the machine equals $15,000 ($24,000 minus $9,000).
Therefore, the amount left to be depreciated as of January 1, 2005, equals $15,000.
This $15,000 must be depreciated over the next four years (because the revised estimated useful life is seven years,
and the machine has already been used for three years).
Hence, the revised depreciation expense (for each of the years 2005 through 2008) equals $3,750 per year ($15,000/4).
$ 140,000
150,000
$ 290,000
Impairment of Long-Lived
Assets
Sometimes an asset may become impaired before
the end of its estimated useful life. SFAS
No. 121 provides guidance on accounting
for impairment of long-lived assets. Under SFAS
No. 121, an asset is considered to be impaired
when the undiscounted (without consideration of present value discounting) sum of estimated future cash
flows from the asset is less than the book value (the cost less accumulated depreciation) of the asset.
If the asset is considered impaired, another calculation is required to determine the difference between the fair
value of the asset and its book value. The fair value usually equals the discounted present value of the estimated
future cash flows from the asset.
Note that in the first step (to determine whether the asset is impaired), we use the undiscounted future cash flows,
but in the second step (to determine the amount of impairment), we use the discounted future cash flows. The book
value of the asset is brought down to its fair value by adjusting the original cost (and the related accumulated
depreciation account), and by recording a loss.
Example:
Jones Company purchased a building with an estimated useful life of 20 years for $500,000 on January 1, 2002.
On January 1, 2008, the company determined that the undiscounted sum of future cash flows from the building (asset)
was $340,000 but the discounted sum of future cash flows from the asset was $210,000. Prepare the necessary journal
entries.
Depreciation per year on the building equals $25,000 ($500,000/20).
Accumulated depreciation as of January 1, 2008 equals $150,000 ($25,000 multiplied by 6 years).
Book value of the building as of January 1, 2008 equals $350,000 ($500,000 minus $150,000).
Since the undiscounted sum of future cash flows ($340,000) is less than the building's book value ($350,000), the
building is considered impaired.
The amount of impairment equals $140,000 ($350,000 minus $210,000).
(Note:
To calculate the amount of impairment, we must use the discounted future cash flow amount).
Journal entry:
Note:
Debit Loss on Impairment (step 1)
Debit Accumulated Depreciation (step 2)
Credit Building (step 3)
After the journal entry, the new cost of the building is brought down to $210,000 ($500,000 minus $290,000), which
is its estimated fair value.
Step 1: $ 6,000
15,000
2,000
$ 23,000
Disposal of Assets
Businesses dispose of plant assets after the assets cease to meet their needs. Businesses may dispose of a plant asset by selling or exchanging it. If an asset cannot be sold or exchanged, it may be discarded.
When a noncurrent asset is sold, a gain or loss may occur. If the price at which the asset is sold is higher than
its book value at the time of the sale, a gain is recognized. If the sale price is less than its book value, a loss is recognized.
The journal entries for the disposal of an asset are as follows:
Since the asset is no longer with the company, it must be removed from the company's books. This means
that the old asset account must be credited for the (historical) cost of the asset.
Step 2:
Since the asset has been removed from the books, the accumulated depreciation associated with the asset
also must be removed. Hence, the Accumulated Depreciation account is debited for the amount of accumulated depreciation
associated with the old asset.
Step 3:
If the old asset is sold for cash, the Cash account is debited.
Step 4:
Based on these three entries, if some amount is needed on the debit side to make debits equal credits, a loss occurs. Conversely, if some amount is needed on the credit side to make debits equal credits, a gain is recognized.
Example:
David Company bought a machine on January 1, 2002, for $23,000. Its estimated useful life was four years, and its
estimated salvage value was $3,000. Assume that the business uses the straight-line method for calculating depreciation.
The company sold the machine on January 1, 2005, for $6,000. Prepare the necessary journal entries for the transaction.
Solution:
At the time of the sale, the business has used the machine (asset) for three years (2002, 2003, and 2004). In each
of these years, the depreciation expense was $5,000 per year ([$23,000 minus $3,000]/4). Thus at the time of the
sale, the amount in the Accumulated Depreciation account is $15,000, and the book value of the machine is $8,000
($23,000 minus $15,000). The price at which the machine is sold ($6,000) is less than its book value ($8,000).
Thus, a loss of $2,000 is recognized. The journal entry for the sale follows:
Debit Cash (step 3)
Debit Accumulated Depreciation (step 2)
Debit Loss on Disposal (step 4)
Credit Machine (step 1)
Nonmonetary asset exchanges involve exchanges of assets without paying the full market
price solely
in the form of cash. For example, a company may exchange a building for land, one machine for another, or a car
for a truck. Such exchanges are called nonmonetary because a company acquires the asset without paying the
full amount of its market price in the form of cash.
Step 1:
Nonmonetary asset exchanges may involve similar assets (such as one car for another, or one building for another)
or dissimilar assets (such as land for building, a truck for a crane). In accounting for such exchanges, we assume
that the exchanges are arms-length transactions. This means that the fair market value (FMV) of the old asset(s)
given up must equal the FMV of the new asset(s) received. (Note: Total FMV of assets being given up includes both
the FMV of the asset being given up in the exchange plus any cash paid; similarly, the total FMV of any assets
received includes the FMV of the asset being received in exchange plus any cash received.)
When an exchange of nonmonetary assets occurs, the journal entries involve the following
Credit the book value of the asset being given up. Because the company no longer owns it, the asset must be removed from the books.
Step 2:
Debit the Accumulated Depreciation Account of the asset being given up. If the asset is removed from the books, the amount of the accumulated depreciation related to the asset also must be removed from the books.
Step 3:
Debit the Cash account if cash is being received, or credit the Cash account if cash is being paid.
Step 4:
Compare the book value of the old asset against its FMV.
Step 5:
If the exchange results in a loss, first debit the new asset received for its FMV, then debit the account Loss on Exchange.
If the exchange results in a gain, determine how much of the gain can be recognized based on rules discussed later.
First credit the account Gain on Exchange, and then debit the account for the new asset received (that is, the new
asset account is debited for the plug number that will make debits equal to credits).
$ 62,000
20,000
$ 70,000
12,000
$ 44,000
10,000
15,000
$ 45,000
24,000
Dissimilar Asset Exchanges
Accounting for dissimilar asset exchanges
are simple. In this case, the entire amount of gain from the exchange can be recognized. (Remember that losses
on exchange are always recognized).
Example 1:
Assume that a building with a book value of $50,000 (original cost $70,000) was exchanged for land with a market
value of $62,000. Because the original cost of the building was $70,000 but its book value is only $50,000, the mount
of accumulated depreciation on the building must be $20,000 ($70,000 minus $50,000). The journal entry for this
transaction follows:
Debit Land (step 3)
Debit Accumulated Depreciation (building) (step 2)
Credit Building (step 1)
Credit Gain on Exchange (step 4)
Example 2:
Assume that a building with a book value of $30,000 (original cost $45,000) was exchanged for land with a market
value of $44,000. In addition, cash of $10,000 was received in the exchange. The journal entry for this transaction
follows:
Debit Land (step 4)
Debit Cash (step 3)
Debit Accumulated Depreciation (building) (step 2)
Credit Building (step 1)
Credit Gain on Exchange (step 4)
Example 3:
Assume that a building with a book value of $80,000 (original cost $90,000) was exchanged for land with a market
value of $78,000. In addition, cash of $12,000 was paid in the exchange. The journal entry for this transaction
follows:
Debit Land (step 4) $ 78,000
Debit Accumulated Depreciation (building) (step 2) 10,000
Debit Loss on Exchange (step 5) 14,000
Credit Building (step 1)
$ 90,000
Credit Cash (step 3)
12,000
Similar Asset Exchanges
in Same Line of Business
Accounting for exchanges of similar assets
used in similar lines of business is different than exchanges for different lines of business because gains on
exchanges may not always be fully recognized. (As before, losses on exchange are always fully recognized.)
If it appears that gain on the exchange of similar assets may occur (that is, if the FMV of assets being given
up is higher than their book value), did the company receive any cash during the exchange? Note that the question
asks only if cash was received, not if it was paid. Of course, one company's cash receipt must mean that the other
company paid cash, but accounting by the cash-receiving company is unrelated to accounting by the cash-paying company.
If cash was not received, no gain is recognized on the exchange. In this case, the last step is to record the new
asset. The amount used is a plug number to make debits equal credits. Note that this means the new asset is recorded
for an amount less than its FMV. If no cash is paid or received, the new asset is recorded at the same value as
the book value of the old asset.
If cash was received and if it is at least 25% of the FMV of the assets received, the entire gain can be recognized
(that is, the accounting is just like that for dissimilar assets). In this case, after recording the removal of
the old asset and the receipt of cash, a credit for the gain must be recorded. The final step is recording a debit
for the new asset (a plug number to make debits equal credits).
If cash was received and is less than 25% of the FMV of the assets received, then a partial gain is recognized.
The amount of gain recognized is determined as follows:
(Cash received / Cash received + FMV of asset received) x Gain
In other words, the gain recognized is proportional to the cash portion of the overall assets received by the company.
In this case, after recording the removal of the old asset and the receipt of cash, record a credit for the partial
gain; the final step is a debit for the new asset (a plug number to make debits equal credits).
| Accelerated depreciation methods | Estimated useful life |
| Accumulated Depreciation | Nonmonetary asset exchanges |
| Amortization | Salvage value |
| Book value | Straight-line method |
| Depreciation | Sum-of-the-years'-digits |
| Double-declining-balance method | Use-factor methods |