Depreciation and Amortization. IS NOT Accumulation of a cash fund for asset replacement A determination of an asset’s current value IS The systematic

Depreciation andAmortization

IS NOT• Accumulation of

a cash fund for asset replacement

• A determination of an asset’s current value

IS• The systematic

allocation of an asset’s cost to the periods of benefit

Financial Accounting, 7e Stice/Stice, 2006 © Thomson

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Causes of depreciation:◦ Physical deterioration

Due to use, passage of time, and exposure to the elements

◦ Obsolescence Outdated, outmoded, or inadequate


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Residual value (salvage value)◦ An estimate of the asset’s worth at the time of

its disposal Depreciable cost

◦ The original cost minus the residual value Estimated useful life

◦ A measure of the service potential in terms of years or units produced


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Straight-line◦ Allocates an equal amount of asset cost per

year Units-of-production

◦ Allocates cost based on the productive output of the asset

Declining balance◦ An accelerated method which allocates more

cost to depreciation in the early years than the later years


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Assume the following information:Equipment purchase date January 1, 2006Acquisition cost $40,000Estimated residual value $4,000Depreciable cost $36,000Estimated useful life 5 years


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Cost - Residual Value = Annual Depreciation

Useful Life

$40,000 - $4,000 = $7,200

5 years

Year Depreciation Accum Dep Book Value

2006 7,200 7,200 32,800 2007 7,200 14,400 25,600 2008 7,200 21,600 18,400 2009 7,200 28,800 11,200 2010 7,200 36,000 4,000


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An equal amount of depreciation expense is allocated to each period

Straight-line Depreciation

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

1 2 3 4 5

Year

Annual Depreciation End of Year Book Value


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Annual depreciation is determined by applying a fixed percentage to the remaining book value at the beginning of each year

1 rate = percentage rate

life

1 2 = 40%

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‘rate’ is the multiple of straight-line(double is 2 times the straight-line rate)


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40% remaining book value40% (cost - accum dep)Year 1: 40% ($40,000 - 0) = $16,000Year 2: 40% ($40,000 - $16,000) = $9,600

YearBeginning

Book Value Depreciation Accum Dep

Ending Book Value

2006 40,000 16,000 16,000 24,000 2007 24,000 9,600 25,600 14,400 2008 14,400 5,760 31,360 8,640 2009 8,640 3,456 34,816 5,184 2010 5,184 1,184 36,000 4,000

2010’s expense is adjusted so that ending book value is not less than established residual value


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Double Declining-Balance Depreciation

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

1 2 3 4 5

Year

Annual Depreciation End of Year Book Value

Accelerated methods allocate a greater portion of cost to the earlier years of the asset’s life

Both methods allocate a depreciable cost of $36,000 over a five-year period


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$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

1 2 3 4 5

YearStraight-Line Method Declining Balance Method

Management may choose any GAAP-based method for financial reporting

Theoretically, best to use a method that reflects the pattern of the asset’s revenues or benefits◦ The straight-line method is appropriate for assets whose

benefits diminish on a fairly uniform basis

◦ The double-declining-balance method is appropriate for assets that give up a greater portion of their benefits in the early years

Most companies use the straight-line method due to its simplicity


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Salvage value is ignored for tax purposes The half-year convention is used

◦ Property is depreciated for half the taxable year in which it is placed in service, regardless of when use actually begins

Deferred tax liability arises◦ Accelerated depreciation for tax purpose vs straight-line depreciation for

financial purpose◦ Earlier years have higher tax deductions◦ Later years have higher taxable income


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Depreciation is not a source of cash; it is a noncash expense

Depreciation indirectly affects cash flow◦ depreciation reduces taxable income◦ results in lower income taxes being paid


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Finite life intangibles:◦ Amortize over the economic useful life or legal

life, whichever is shorter◦ Not to exceed 40 years◦ Direct subtraction from the asset account

Indefinite life intangibles:◦ No amortization


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Depreciation and Amortization. IS NOT Accumulation of a cash fund for asset replacement A determination of an asset’s current value IS The systematic