Hi all…in the last post we covered tangible and intangible long-lived assets. In this post we will cover the depreciation method and amortization methods of those assets.
Depreciation expense is the capitalized cost of an asset allocated to the income statement in subsequent periods. Capitalized cost net of accumulated depreciation appears as ‘carrying value’ of the asset on the balance sheet.
Depreciation Methods for Tangible Long-lived Assets
Depreciation of assets may be calculated using straight line method, declining balance method, accelerated depreciation method or units of production method.
There are four methods for calculating depreciation expense. The first method is the Straight-line method. The straight line method recognizes an equal amount of depreciation expense in each period of the asset’s useful life. Straight-line method calculates depreciation as,
Cost – Residual value / useful life
Cost – Residual value is the total depreciation in the asset’s value over its useful life which is divided by the no. of years of useful life to get an equal amount of depreciation for each year. In reality, assets generate more economic benefits (revenue) in the earlier part of their life than in the later part of their life. Straight-line method deducts less depreciation in proportion to the revenue generated in the earlier years of the asset’s life and more depreciation in the later years when the revenue generated from the asset is less. This leads to lower net income and higher expenses in the later part of the assets life.
Accelerated Depreciation method
Therefore, to better match expenses to revenue, the second depreciation method, i.e. accelerated depreciation method is used. Under the accelerated depreciation method, depreciation expense recognition is systematically accelerated to recognize more depreciation in the earlier part of the asset’s life and less depreciation in the later part of its life. Total depreciation under both the straight line method and accelerated depreciation method remains the same.
Declining balance method
The third method is the declining balance method, which applies a constant rate of depreciation to an asset’s declining book value each year. Most common declining balance method is the double declining balance method, which applies two times the straight line rate to the declining balance. Depreciation expense is calculated under this method as follows;
2/useful life × (cost – accumulated depreciation)
Depreciation ends once the residual value is reached. If the asset is not expected to have any residual value, declining balance method will never fully depreciate it. Therefore, at some point in the asset’s life a switch is made to straight line method of depreciation.
Let’s take an example of double declining balance method. Let’s suppose the asset’s value is $14000 and it is expected to have a residual value of $4000 at the end of 5 years. Therefore depreciation will be calculated as follows;
2/5 × 14000 = 5600
2/5 × (14000 – 5600) = 3360
The accumulated depreciation in the third year will be 5600 + 3360 = 8960
2/5 × (14000 – 8960) = 2016
Since the total accumulated depreciation cannot exceed $10,000 ($14000 – $4000), the depreciation for the third year is restricted to $10,000 – $8960 = $1040 and not $2016 and with this, the asset is fully depreciated.
The fourth depreciation method is the units-of-production method, which is based on usage rather than time. Under this method, depreciation expense is higher in periods of higher usage. The formula is given as follows;
Depreciation = (original cost – residual value / useful life) * output units in the period
Useful lives and Salvage value assumption
Firms can manipulate the depreciation expense and therefore the net income through their estimation of useful life and salvage value of an asset. For example, longer useful life leads to a lower depreciation in each year and therefore higher net income, while a shorter estimated useful life will have the opposite effect. Similarly, a higher estimate of salvage value will decrease depreciation and increase net income, while a lower estimate will have the opposite effect.
Amortization methods for intangible long-lived assets
Amortization is the appropriation of the cost of an intangible asset over its useful life. In most cases, straight line method is used to calculate amortization expense recognition of an intangible asset with a definite life. It is similar to that used for calculating depreciation in case of tangible assets.
Intangible assets with indefinite lives, like goodwill, trademarks are not amortized. They are however tested for impairment at least annually. If the asset is impaired, impairment expense is recognized on the income statement. Impairment is calculated as;
Carrying value – recoverable value
Under US GAAP and IFRS, assets are reported on the balance sheet at depreciated cost. However, IFRS gives firms a choice to use a revaluation model. Under the revaluation model, assets can be recorded at their fair value, provided there is an active market for the asset.
Revaluation can result from either increase or decrease in fair value. An initial revaluation of an asset to a fair value below the historical cost, is reported as a loss on the income statement. A subsequent increase in fair value is reported as a gain to the extent it reverses a previously reported loss only. Any increase in asset value above the historical cost is not reported as a gain on the income statement but Revaluation Surplus in Shareholder’s Equity on the balance sheet. Subsequent declines in asset value decrease this surplus. In the event the fair value subsequently further falls below the historical cost it is again reported as a loss on the income statement.
That’s all in this post guys…do share the article if you liked it….
In the next installment in the long-lived assets series we will cover impairment in detail…..stay tuned…
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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