Is Accounting Helpful for Valuation? Conceptual Framework (FASB) –Purpose of Accounting: “financial reporting should provide information to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.” –Caveat: Accounting information “may help those who desire to estimate the value of a business enterprise, but financial accounting is not designed to measure directly the value of an enterprise.”
Discussion Questions Q11–1 Distinguish among depreciation, depletion, and amortization.
Allocating costs of long-term assets: Fixed assets = Depreciation expense Intangibles = Amortization expense Natural resources = Depletion expense Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. Cost Allocation
Some of the cost is expensed each period. Cost Allocation – An Overview The matching principle requires that part of the acquisition cost of operational assets be expensed in periods when the future revenues are earned. Depreciation, depletion, and amortization are cost allocation processes used to help meet the matching principle requirements. Expense Acquisition Cost (Balance Sheet)(Income Statement)
Caution! Depreciation, depletion, and amortization are processes of cost allocation, not valuation! Cost Allocation – An Overview Depreciation on the Balance Sheet
Discussion Questions Q11–7 What basic questions must be answered before the amount of the depreciation charge can be computed?
Cost allocation requires three pieces of information for each asset: The estimated expected use from an asset. Total amount of cost to be allocated. Cost - Residual Value (at end of useful life) Total amount of cost to be allocated. Cost - Residual Value (at end of useful life) The systematic approach used for allocation. Depreciable Base Service Life Allocation Method Measuring Cost Allocation
Service life often differs from physical life. Companies retire assets for two reasons: 1.Physical factors (casualty or expiration of physical life). 2.Economic factors (inadequacy, supersession, and obsolescence). Estimation of Service Life
Depreciable Base How much is value going to decrease while company owns it? This amount has to be transferred to expense during the period that the company is using the item.
The profession requires the method employed be “systematic and rational.” Examples include: (1)Activity method (units of use or production). (2)Straight-line method. (3)Sum-of-the-years’-digits. (4)Declining-balance method. (5)Group and composite methods. (6)Hybrid or combination methods. Accelerated methods Special methods Methods of Depreciation
Straight-Line Time: Activity:
Example 1a: Straight Line Depreciation On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using: Straight line
Example 1b: Activity Based Depreciation On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using: Units of production using miles driven as a measure of output, and the following actual mileage: ($33,000 – $3,000) / 100,000 miles = $0.30 / mile deprec rate YearMiles Depreciation , , , , ,000
Sometimes called a Decreasing-Charge Method or an Accelerated Method Declining-Balance Method. Utilizes a depreciation rate (percentage) that is some multiple of the straight-line method. Does not deduct the salvage value in computing the depreciation base. Declining-Balance Method
Accelerated Methods Accelerated methods result in more depreciation in the early years of an asset’s useful life and less depreciation in later years of an asset’s useful life Note that total depreciation over the asset’s useful life is the same as the Straight-line Method Declining-Balance depreciation – Based on the straight-line rate multiplied by an acceleration factor Computations initially ignore residual value Stop depreciating when BV = Residual Value Note that the Book Value will get lower each year Acceleration Factor
Example 1c: Double-Declining Balance On January 1, 2011, the Excel Delivery Company purchased a delivery van for $33,000. At the end of its five-year service life, it is estimated that the van will be worth $3,000. During the five- year period, the company expects to drive the van 100,000 miles. Calculate annual depreciation for the five-year life of the van using: Double-declining balance Year Book Value Beg of Year X Rate per Year = Depreciation Book Value End of Year 2011$33,
Use of Various Depreciation Methods
Example 2: DDB to Straight Line On January 2, 2011, the Jackson Company purchased equipment to be used in its manufacturing process. The equipment has an estimated life of eight years and an estimated residual value of $30,625. The expenditures made to acquire the asset were as follows: Purchase price$154,000 Freight charges 2,000 Installation charges 4,000 Jackson’s policy is to use the double-declining-balance (DDB) method of depreciation in the early years of the equipment’s life and then switch to straight line halfway through the equipment’s life. Calculate depreciation for each year of the asset’s eight-year life. Year Book Value Beg of Year X Depreciation Rate per Year = Depreciation Book Value End of Year
Example 2: Continued Year Book Value Beg of Year X Depreciation Rate per Year = Depreciation Book Value End of Year 2011$160,000 2 / 8 $ 40,000$120, Total * Switch to straight-line in 2015:
Partial-Period Depreciation Pro-rating the depreciation based on the date of acquisition is time-consuming and costly. A commonly used alternative is the... Half-Year Convention Take ½ of a year of depreciation in the year of acquisition, and the other ½ in the year of disposal That said, unless told otherwise for class you calculate based on months!
Example 3: Partial-Period On October 1, 2011, the Allegheny Corporation purchased machinery for $115,000. The estimated service life of the machinery is 10 years and the estimated residual value is $5,000. The machine is expected to produce 220,000 units during its life. Calculate depreciation for 2011 and 2012 using each of the following methods. Partial-year depreciation is calculated based on the number of months the asset is in service. 1.Straight line. 2.Double-declining balance. 3.One hundred fifty percent declining balance. 4.Units of production (units produced in 2011, 10,000; units produced in 2012, 25,000).
Example 3: Continued Straight-line:
Example 3: Continued Units-of-production:
E11-6 Muggsy Bogues Company purchased equipment for $212,000 on October 1, It is estimated that the equipment will have a useful life of 8 years and a salvage value of $12,000. Estimated production is 40,000 units and estimated working hours are 20,000. During 2014, Bogues uses the equipment for 525 hours and the equipment produces 1,000 units. Compute depreciation expense under each of the following methods. Bogues is on a calendar-year basis ending December 31. a.Straight-line method for b.Activity method (units of output) for c.Activity method (working hours) for d.Sum-of-the-years’-digits method for e.Double-declining-balance method for 2015.