BAF 3M: CHAPTER 6 DEPRECIATION

AUTOMOBILE EXAMPLE Imagine a contracting company purchases a brand new work truck: Will this truck stay new: NO!

FIXED ASSETS BECOME USED The brand new truck is going to become used very quickly. Mileage, dirt, scratches, stains, etc all decrease the value of the truck This decrease in value is called depreciation and is a direct result of using this vehicle to conduct the business and earn revenue. This decrease in value applies to fixed assets that lose value when used or as they age – automobiles, machinery, equipment, etc

DEPRECTIATION: WHAT IS IT Definition: Allocation of the cost of a fixed asset to the fiscal period in which it was used. Depreciation is an expense and appears on the income statement. The decrease in value of the fixed asset will be shown on the balance sheet through a contra account (an account that reduces the value of another account) Asset account – asset contra account = book value

CALCULATING DEPRECTIAION 2 methods: Straight Line and Declining Balance Straight Line – same amount of depreciation over recorded each fiscal period. Use the rate of depreciation and calculate the depreciation amount in year 1. Depreciate the asset this same amount each of the subsequent years. Declining Balance – allocates greater amount of depreciation to early years. Use the rate of depreciation and calculate the depreciation amount for each year based on the book value.

STRAIGHT LINE EXAMPLE Our pick up truck cost $50,000 and in 5 years we feel there will be no salvage value. The rate of depreciation is 20% per year. Original Cost x rate = depreciation expense $50,000 x 20% = $10,000 Therefor the truck will depreciate $10,000/year till it is worthless in 5 years Journalized: DateDepreciation expense – truck $10,000 Accumulated Depreciation – Truck$10,000

DECLINING BALANCE EXAMPLE Same truck Yr 1 – Original Cost x rate = depreciation expense Yr 2 – Book Value x rate = depreciation expense Yr 3 – Book Value x rate = depreciation expense Yr1 - $50,000 x 20% = $10,000 Yr 2 - $40,000 x 20% = $8000 Yr 3 - $32,000 x 20% = $6400

WHICH METHOD DO I USE? In Canada – declining balance method is used when reporting income tax and it is referred to as the capital cost allowance or CCA. The CCA sets maximum rates in which classes of assets can depreciate in any given year. NOTE: A company must use the CCA when reporting income tax to the government. The company does NOT have to use the CCA (declining balance) method when preparing their own books. Straight line may be more accurate.

PRINCIPLES TO FOLLOW Principle of Materiality – information that can affect the decisions of the users of the financial statements must be included when statements are prepared. Principle of Conservatism – where there are acceptable alternatives (ex. depreciation methods), the one that results in the lower net income and net assets be chosen.