Noncurrent Assets: Depreciation and Exchange

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 1 Depreciation of Tangible Assets 8 Impairment of Long-Lived Assets 2 Straight-Line Method 9 Disposal of Assets 3 Declining Balance Method 10 Nonmonetary Asset Exchanges 4 Sum-of-the-Years'-Digits Method 11 Dissimilar Asset Exchanges 5 Use-Factor Methods 12 Similar Asset Exchanges in Same Line of Business 6 Amortization of Intangible Assets 13 Glossary 7 Change in Estimates Related to Depreciation

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:

• Ensure that the book value of assets equals their market value
• Accumulate cash to replace noncurrent tangible assets.
Depreciation is recorded as follows:
Debit Depreciation Expense
Credit Accumulated Depreciation
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.

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:
• Cost, which is the price at which the asset was purchased.
• Estimated useful life, which is the length of service the business expects from an asset. For example, the useful life of a computer is the number of years it is expected to be used.
• Salvage value, which is the expected cash value of the asset at the end of its useful life. (The cost of the asset minus the salvage value is called depreciable cost.)
Many methods are used to calculate depreciation expense:
• Straight-Line Method.
• Accelerated Methods.
• Declining-Balance Method.
• Sum-of-the-Years' Digits Method.
• Use Factor Methods.
• Service Hours Method.
• Units of Production Method.
• Group/Composite Methods.

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Straight-Line Method

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

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Declining Balance Method

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.

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

Step 2:
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.

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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
N years, the denominator equals (1 + 2 + 3 . . . + N-1 + N). The shortcut to calculate this is as follows:

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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Use-Factor Methods

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.

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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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Change in Estimates Related to Depreciation

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).

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).

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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:

 Debit Loss on Impairment (step 1) \$ 140,000 Debit Accumulated Depreciation (step 2) 150,000 Credit Building (step 3) \$ 290,000
Note:
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.

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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:

Step 1:
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) \$ 6,000 Debit Accumulated Depreciation (step 2) 15,000 Debit Loss on Disposal (step 4) 2,000 Credit Machine (step 1) \$ 23,000

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Nonmonetary Asset Exchanges

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.

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

Step 1:
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.

• If the FMV of the asset given up is less than its book value, a loss occurs. Losses on exchanges are always recognized.
• If the FMV of the asset given up is more than its book value, then a gain occurs. Gains on exchanges are sometimes recognized, depending on the type of exchange. The details are discussed later.

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).

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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) \$ 62,000 Debit Accumulated Depreciation (building) (step 2) 20,000 Credit Building (step 1) \$ 70,000 Credit Gain on Exchange (step 4) 12,000

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) \$ 44,000 Debit Cash (step 3) 10,000 Debit Accumulated Depreciation (building) (step 2) 15,000 Credit Building (step 1) \$ 45,000 Credit Gain on Exchange (step 4) 24,000

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

If the assets exchanged are considered similar, but are used in different lines of business, they are accounted for as if they were dissimilar assets. That is, if two similar machines used in different lines of business are exchanged, they are accounted for exactly as noted here. Both gains and losses are fully recognized.

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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).

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Glossary