# 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

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5

12
6

13
7

14
8

15
9

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10

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Cost of       benefited
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25
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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
\$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

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

   Conservatism principle applies

45
Analyzing Long-Term Assets
AVERAGE LIFE

Average Life =   Property, Plant & Equipment
Depreciation Expense

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

Average Age = Accumulated Depreciation
Depreciation Expense

Are assets old or
new?

47
Analyzing Long-term Assets
ASSET TURNOVER

Asset Turnover =        Net Sales
Average Total Assets

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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