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Calculate Double Declining Balance Depreciation Cost - PowerPoint

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					     Chapter 8




    Operating Assets:
Property, Plant & Equipment,
      Natural Resources,
       & Intangibles
                               1
       Basic Objectives and Concepts

   What is included in the cost of an asset?
   What is Depreciation?
   Three GAAP methods: Definition & Example
    » Straight Line
    » Units of Production
    » Accelerated Method (Double Declining Balance)
   Change(s) in Method
   Disposal of Asset (Gain or Loss)
   Other L-T Assets: Natural Resources & Intangibles
   Financial Statement Analyses: Key Ratios          2
Balance Sheet Presentation of Mattel
           A Refresher
Property, Plant and Equipment:
  Land                             $ 30,864
  Buildings          record all at  207,382
                      Acquisition
  Machinery              Cost       409,675
 Capitalized leases                  24,271
  Leasehold improvements             59,908
                                    732,100
  Less: Accumulated depreciation 293,160
            Book Value             $438,940
                                              3
        Acquisition Cost of P,P&E:
          The Depreciation Base
   DEFN: All costs necessary to acquire asset
    and prepare it for its intended use

                         +
        Invoice
                                Freight Charges
         Price
           +
         Taxes
                       +             Installation
                                        Costs
                                                    4
Group Asset (Lump Sum) Purchases:
       How to Assign Costs
Assign cost of lump-sum purchase based upon
 pro rata estimated fair market values.
   (e.g., Purchase factory (including land) for $500,000)

METHOD:           Fair Market Pro-Rata            Assigned
   Cost               Value       %                Cost
  $500,000
                    Building =        77%         $385,000
                                                  ($500K X 77%)
                     $400,000       ($400/$520)


                      Land =          23%         $115,000
                     $120,000       ($120/$520)   ($500K X 23%)
                                                              5
          What is Depreciation?
COST ALLOCATION NOT VALUATION
Depreciation is:
 An allocation of the acquisition cost of a long-
  term asset over the useful (economic) life of that
  asset.
 A non-cash expense (cost allocation) associated
  with a given time period.
Depreciation is not:
 A method of reflecting market value of the asset
  (in Balance Sheet).
 A source of cash (in Cash Flow Statement)
                                                  6
Depreciation of Plant & Equipment

   GOAL:                                              1    2    3



   Match        with periods
                                  4


                                  11
                                       5


                                       12
                                            6


                                            13
                                                 7


                                                 14
                                                      8


                                                      15
                                                           9


                                                           16
                                                                10


                                                                17




   Cost of       benefited
                                  18


                                  25
                                       19


                                       26
                                            20


                                            27
                                                 21


                                                 28
                                                      22


                                                      29
                                                           23


                                                           30
                                                                24


                                                                31




   Assets

                      How?
Straight-Line         Units of                        Accelerated
                     Production                        Methods
                                                                     7
 Depreciation Example Facts

   Calculate Checker’s depreciation on a new
    taxicab for years 1 - 3 using: (a) straight-
    line, (b) units-of-production and (c) double
    declining balance depreciation methods.
Defn: Depreciable base is the amount to be depreciated
after reflecting estimated salvage (residual) value.

Depreciable Base = Cost – Estimated Salvage Value

Checker’s base = $20,000 cost - $2,000 residual value
                = $18,000 to be depreciated              8
          Straight-Line Method

   Concept: Allocate original cost of the
    asset equally over its estimated useful life
    – e.g.,
                     $18,000
                     3 yr. life


            $6,000     $6,000     $6,000
            Year 1     Year 2     Year 3

                                                   9
          Straight-Line Depreciation
FORMULA

 Annual Depreciation =       Cost - Residual Value
                                   Useful Life
                             = $20,000 - $2,000
           $18,000                 3 years
           3 yr. life
                             = $6,000 per year
 $6,000     $6,000      $6,000
 Year 1     Year 2      Year 3
                                                     10
      Units-of-Production Method


   Concept: Allocate asset cost based upon
    estimated number of units produced over
    its useful life

                          depreciation =

                                  per unit
                                              11
    Depreciation Example Facts
              (same as before)

On January 1, Checker Cab Company
 purchases a new taxi for $20,000. The
 useful life of the cab is estimated at three
 years, after which time it is expected to be
 sold for $2,000.




                                                12
 Units-of-Production Depreciation
   Step 1: Estimate Total Units

 Checker’s estimated annual usage:
         Yr. 1         20,000 miles
         Yr. 2         40,000 miles
         Yr. 3         30,000 miles
         Total         90,000 miles

After which:

                                      13
  Units-of-Production Depreciation
 Step 2: Calculate Depreciation Rate
FORMULA
  Depreciation   = Cost - Residual Value
    per unit        Total Units in Life

                     = $20,000 - $2,000
                        90,000 miles

                      = $ .20 per mile

                                           14
Units-of-Production (UOP) Depreciation
Step 3: Calculate Depreciation Expense
   UOP’s annual depreciation expense formula:
    Actual Output X Pre-determined Rate = EXPENSE

 Yr. 1 40,000 miles x $.20/mile =          $8,000   (Est. was 20K miles)

 Yr. 2 30,000 miles x $.20/mile =           6,000   (Est. was 40K miles)

 Yr. 3 20,000 miles x $.20/mile =           4,000   (Est. was 30K miles)

                      TOTAL               $18,000
Notice that:
1. Actual mileage per year differed from estimate (but total was same).
                                                                   15
2. The actual mileage declined each year. Does that make sense? Why?
      Double Declining-Balance (DDB)
                  Method
   Concept: “Accelerated” method with higher
    amount of depreciation expense in early years
    » Why would you want more expense at beginning?
   Method: Double the straight-line rate and
    multiply it by a declining balance (book value)


         Straight-line
             Rate
                                                      16
Double Declining-Balance (DDB) Depreciation
       Step 1: Calculate DDB Rate

    DDB rate = 2 / (useful life)     Formula

   Example  2 / (3 years)

                = 66.7%
  Or:
  3 year life => Straight line rate = 1/3
  Formula: Straight Line Rate X 2
              (1/3) X 2 = 66.7%
                                               17
Double Declining-Balance Depreciation
   Step 2: Determine the Amount
Formula      Depreciation = Beg. Book Value x Rate

                Example        $20,000 x 66.7%   Rate never
                                                   changes
                               = $13,333

 Year     Rate  Beg. B.V. Deprec. End B.V. *
   1      66.7% $20,000 $13,333      $6,667
                            * Cost – Accum. Deprec.
               NOTE:
          Initially ignores
           residual value
                                                          18
Double Declining-Balance Depreciation
Step 3: Determine the 2nd Year Amount
Year 2 Depreciation = Beg. Book Value x Rate
(same formula with new book value)   Declines   Constant


             Example  $6,667 x 66.7%
                         = $4,444

Year    Rate  Beg. B.V. Deprec. End B.V.
  1     66.7% $20,000 $13,333 $6,667
  2     66.7% $ 6,667    $4,444 $2,222
                                                      19
 Double Declining-Balance Depreciation
Step 4: Determine the Last Year’s Amount
 Year      Rate  Beg. B.V.                Deprec.         End B.V.
   1       66.7% $20,000                  $13,333         $6,667
   2       66.7% $ 6,667                  $4,444          $2,222          Remember
                                                                          est. salvage
  33       66.7% $ 2,222                     222*
                                          $ 1,481*        $2,000
                                                          $ 741*            value =
                                                                            $2,000 !
          NOTE:
 Final year’s depreciation =
  Amount needed to equate                                  = Residual
book value with salvage value                                Value

* If we had followed formula, then 3rd year’s Depreciation would have been:
($2,222 X 66.7%) = $1,481, and a Book Value of $741. BUT. . . that is less than the
estimated salvage value. So we “plug” (work backwards) for Yr. 3 Depreciation.
                                                                                 20
Straight-line vs. DDB vs. UOP Depreciation
      Annual Depreciation Expense

 $14,000

 $12,000

 $10,000

  $8,000                              Straight-line
                                      DDB
  $6,000
                                      UOP
  $4,000

  $2,000

     $0
           Year 1   Year 2   Year 3
                                                      21
 Comparative Summary of Methods
and Tax/Cash Implications (Year #1)
          Method Straight      Units of      DDB
    Component      Line       Production
Revenues (assumed) $20,000     $20,000     $20,000
Depreciation       ($3,000)    ($8,000)    ($13,333)
Operating Profit   $17,000     $12,000      $6,667
Income Tax (40%)   ($6,800)    ($4,800)    ($2,667)
NET INCOME         $10,200      $7,200      $4,000
CASH FLOW          $13,200     $15,200     $17,333
(Rev. – Taxes)                                       22
   Reasons for Choosing
Straight-Line Depreciation
     Simplicity & comparability
     Assumes constant asset
      productivity & profits
     Management bonus plans
     Reporting to stockholders in
      Annual Report




                                     23
          Reasons for Choosing
          Accelerated Methods

 Reflects high technological
  rate of change and
  competitiveness
 Declining asset productivity
 Minimizes taxable income
  and taxes                      Income Taxes
 Maximizes Cash
 Cash   is King!
                                          24
    Other Depreciation-Related Topics

 Tax Return vs. Financial Statements  Use
  different depreciation methods for each
 Change in Estimate  Adjust remaining
  Depreciation Expense
 Capital vs. Revenue Expenditures  When
  should the expense be recognized?
 Asset Disposal  Recognize Gain (Loss) on
  Asset Disposal
                                              25
     Tax Return vs. Financial Statements
   Companies are permitted to “keep two sets of books”
   Tax Purposes  Accelerated depreciation is used to
    minimize tax payments in early years.
   Book (F/S) Purposes  Straight line depreciation
    generally represents best matching on I/S.
   Deferred Income Taxes  Represents future tax
    liability when companies choose this approach.
   Benefit/Risk  Tax rates can change!
    » Decrease  Company wins since it applies lower rate in future
      when taxable income increases (e.g., in later years when DDB
      expense is small and taxable profits are higher)
    » Increase  Company could “lose” since it is paying taxes
      using higher rate. BUT remember it had extra CASH in earlier
      years that it would have invested!                         26
    Changes in Depreciation Estimates

 Concept: Recompute remaining depreciation
  schedule using new estimates
 Method: Record prospectively (i.e. change
  should affect current and future years only)

                       Useful life is
                       4 years vs. 3?


                                                 27
      Change in Useful Life Estimate
Example:
  An $18,000 truck was originally expected to
   be depreciated over 3 years (straight line).
   After 2 years, management determines the
   useful life is increased to total of 4 years.
                                             planned
  Depreciation          $6,000*    $6,000*   $6,000*

                           Yr. 1     Yr. 2    Yr. 3

* $18,000 / 3 = $6,000 per year               revise
                                             estimate   28
     Change in Useful Life Estimate
Example:
  Remaining book value ($6,000*) is depreciated
   prospectively over remaining life (2 years)
  Depreciation  $6,000 / 2 = $3,000 per year

               $6,000   $6,000    $3,000   $3,000
Depreciation

               Yr. 1     Yr. 2    Yr. 3     Yr. 4

* $6,000 = $18K less          Revise
   (2 years prior
depreciation @ $6K)
                                life
                             estimate               29
     Capital vs. Revenue Expenditures
                  Concepts

   Capital Expenditure
                                          Balance
    »   Treat as asset addition (Long-
                                           Sheet
        Term Assets) to be depreciated
        over a future period of time


   Revenue Expenditure
    »   Expense immediately           Income
                                     Statement

                                                    30
 Capital vs. Revenue Expenditures
      Accounting Treatment

                                   Capitalize or
General Guidelines:                 Expense?

» Increase asset life            Capitalize
» Increase asset productivity    Capitalize
» Normal maintenance             Expense
                                                   31
              Capital Expenditures
              Increase Useful Life
Example:
$18,000 truck originally expected to be depreciated
  over 3 years.
After 2nd year, company replaced engine at cost of
  $4,000. Truck life is increased by 2 years because of
  new engine.
                                     planned
Depreciation $6,000        $6,000     $6,000

                  Yr. 1     Yr. 2     Yr. 3

                               replace
                               engine                     32
                      Capital Expenditures
Example:              Increase Useful Life
   Calculate new book value ($10,000)  $6,000
    remaining book value plus $4,000 capital expenditure.
   Depreciate new book value prospectively over
    remaining (2 year) life.

               $6,000     $6,000    $5,000* $5,000*
Depreciation
                Yr. 1      Yr. 2     Yr. 3   Yr. 4

    ($6K+$4K) / 2 =            Replace       Why do we make
                                engine       this adjustment?
      $5K per year             & extend
                                  life
                                             Proper matching!
                                                            33
    Disposal of Operating Assets

 Concept: Upon asset disposal, the company
  should record any resulting gain or loss.
 Procedure:
    » Step 1: Record depreciation up to date of
      disposal
    » Step 2: Compute gain or loss on disposal by
      comparing proceeds to book value


      Proceeds > Book Value = Gain
      Proceeds < Book Value = Loss                  34
         Disposal of Operating Assets
      Example:

   Company sells pick-up truck (cost $20,000 with
    accumulated depreciation $12,000) for $7,000

      Sales price (cash proceeds)      $ 7,000
      Less: Book value
        Asset cost             $20,000
        Less: Accumulated
          depreciation          12,000 8,000
       = Loss on sale                  ($ 1,000)
                                                     35
       Disposal of Operating Assets -
       Effect on Accounting Equation

 ---------Balance Sheet-------------- ---Income Statement---
     Assets        = Liab. + OE + Rev. - Expenses

CA: Accumulated                                     E: Loss
Depreciation 12,000                                 on sale
A: Cash        7,000                                of asset
A: Truck     (20,000)                                (1,000)

        Approach: Remove asset and related contra-asset
        accounts, record cash received and recognize G/L
                                                               36
    Other Long-Term Asset Topics

 Natural Resources: Cost and Depletion
 Intangible Assets: Cost and Amortization
 R&D costs: Accounting Treatment
 Financial Statement analysis via ratios:
  » Average Life of L-T Assets
  » Average Age of L-T Assets
  » Long-Term Asset Turnover

                                         37
    Natural Resources

 DEFN: Resource consumed as it is used
 Concept: Allocate cost to the time period
  when asset is “depleted” (used up)
 Approach: Depletion method similar to
  Units of Production
 Expense called Depletion vs. Depreciation




                                              38
                Intangible Assets

   Defn: Long-term assets with no physical properties


                         Organization
       Patents              Costs
     Trademarks
     Copyrights

                                             Software
              Goodwill
                                                         39
          Other Long-Term Assets
             Intangible Assets
   Cost: Includes cost to acquire and prepare for
    intended use
         Purchase Price               Other
                                  Acquisition
                          +           Costs
                                (i.e. legal fees,
                                 registration
                                   fees, etc.)


                                                    40
    Amortization of Intangible Assets

   Concept: Allocate cost of intangible asset as an
    expense, same as depreciation for tangible assets
   Method: Normally recorded using straight-line
    method
   Life: Amortized over legal or useful life,
    whichever is shorter
   B/S presentation: Reported net of accumulated
    amortization (i.e., NO contra-asset account)


                                                        41
    Amortization of Intangibles:
   Amortization Expense Example
Example:
   Discovery Corporation purchases a
   patent for $270,000 and incurs $30,000 in
   legal and registration fees.
   The patent’s remaining legal life is 12
   years, but its anticipated useful
   (economic) life is only 5 years.


                                               42
      Amortization of Intangibles
 Calculate Annual Amortization Expense

Discovery’s Annual Amortization:
Purchase price                      $ 270,000
Plus: Acquisition costs                30,000
  Total Intangible Asset Cost (B/S) $ 300,000
Divide by:
  lesser of legal or useful life       5 years
Equals: Annual Amortization Expens $60,000
                                                 43
       Amortization of Intangibles
       Balance Sheet Presentation

 Discovery’s Balance Sheet Presentation:

                        Upon       End of
                       Purchase Yr. 1     Yr. 5
 Long-term Assets:
  Intangible Assets,
   (net of Accum.
   Amortization) $300,000           $240,000       $ 0
NOTE: (CA): Accumulated Amortization is NOT shown on B/S 44
          Research & Development
               Expenditures

   GAAP: Must be expensed in
    period incurred

   Rationale: Difficult to identify
    or measure future benefits (just
    like Advertising expenditures)

   Conservatism principle applies

                                       45
    Analyzing Long-Term Assets
         AVERAGE LIFE

Average Life =   Property, Plant & Equipment
                     Depreciation Expense



                            Answers: What is
                                the average
                            depreciable period
                             of the company’s
                                  assets?
                                                 46
   Analyzing Long-term Assets
        AVERAGE AGE

Average Age = Accumulated Depreciation
                Depreciation Expense



                          Answers:
                       Are assets old or
                            new?


                                           47
   Analyzing Long-term Assets
     ASSET TURNOVER

Asset Turnover =        Net Sales
                   Average Total Assets


                          Answers: How
                         productive are the
                         company’s assets?



                                              48
      Basic Objectives and Concepts:
               A Summary
   What is included in the cost of an asset?
   What is Depreciation?
   Three GAAP methods: Definition & Example
    » Straight Line
    » Units of Production
    » Accelerated Method (Double Declining Balance)
   Change(s) in Method
   Disposal of Asset (Gain or Loss)
   Other L-T Assets: Natural Resources & Intangibles
   Financial Statement Analyses: Key Ratios          49
Exhibit 8-8
              Long-term Assets and the
              Statement of Cash Flows
Operating Activities
Net income                       xxxx
 Depreciation and Amortization    +
 Gain on sale of asset            -
 Loss on sale of asset            +
Investing Activities
 Purchase of asset                -
 Sale of asset                    +
Financing Activities

				
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