1. 1 Challenging Issues Under Accrual Accounting: Long-lived Depreciable Assets – A Closer Look CHAPTER F8 © 2007 Pearson Custom Publishing

2. 2 Explain the process of depreciating long-lived assets as it pertains to accrual accounting. Learning Objective 1: © 2007 Pearson Custom Publishing

3. 3 Depreciation Recall the basic definition of depreciation (from Chapter 6): Recall the basic definition of depreciation (from Chapter 6): Depreciation is: a systematic and rational allocation of the cost of a long-lived item from asset to expense. Depreciation is: a systematic and rational allocation of the cost of a long-lived item from asset to expense. © 2007 Pearson Custom Publishing

4. 4 Depreciation Over time, the cost of using the asset is transferred to the income statement as an expense. Over time, the cost of using the asset is transferred to the income statement as an expense. As the cost of the asset is transferred to the income statement, the historical cost on the balance sheet is reduced by the accumulated depreciation. As the cost of the asset is transferred to the income statement, the historical cost on the balance sheet is reduced by the accumulated depreciation. © 2007 Pearson Custom Publishing

5. 5 Determine depreciation expense amounts using both straight-line and double- declining-balance depreciation methods. Learning Objective 2: © 2007 Pearson Custom Publishing

6. 6 Effect of Estimates Estimated useful life of the asset and the estimated disposal value at the end of that useful life each play a large role in determining the amount of depreciation to be recognized in each year that we use the long-lived asset. Estimated useful life of the asset and the estimated disposal value at the end of that useful life each play a large role in determining the amount of depreciation to be recognized in each year that we use the long-lived asset. © 2007 Pearson Custom Publishing

7. 7 Discussion Questions Think about your most recent purchase of a long-lived asset. Maybe you bought a computer, a car, or a TV. How long do you expect to keep it and use it? How long do you expect to keep it and use it? What do you think it will be worth when you are through with it? What do you think it will be worth when you are through with it? How certain are you of these answers? How certain are you of these answers? © 2007 Pearson Custom Publishing

8. 8 Effect of Estimates Example: Assume that we buy a new $6,000 computer system. We are unsure whether to use a three-year life or a five-year life, and some of our “experts” think that it could be worth as little as $0 after three years or as much as $1,000 after five years. Example: Assume that we buy a new $6,000 computer system. We are unsure whether to use a three-year life or a five-year life, and some of our “experts” think that it could be worth as little as $0 after three years or as much as $1,000 after five years. © 2007 Pearson Custom Publishing

9. 9 Effect of Estimates Using 5 years and $1,000 disposal value, you depreciate $1,000 each year. Using 3 years and $0 disposal value, you would depreciate $2,000 each year. © 2007 Pearson Custom Publishing

10. 10 Effect of Different Methods When preparing the depreciation schedule for a newly purchased long-lived asset, an accountant has a choice of several different depreciation methods. When preparing the depreciation schedule for a newly purchased long-lived asset, an accountant has a choice of several different depreciation methods. By choosing one method over another, the accountant has an impact on the amount of expense that will be reported in any given year, and, therefore, also the net income. By choosing one method over another, the accountant has an impact on the amount of expense that will be reported in any given year, and, therefore, also the net income. © 2007 Pearson Custom Publishing

11. 11 Straight-line Depreciation In Chapter 6, the straight-line method of depreciation was illustrated. It is probably the easiest method, and it is definitely the most heavily used method in the U.S.A. In Chapter 6, the straight-line method of depreciation was illustrated. It is probably the easiest method, and it is definitely the most heavily used method in the U.S.A. Approximately 95% of major corporations in America use straight-line for some or all of their long-lived assets. Approximately 95% of major corporations in America use straight-line for some or all of their long-lived assets.

12. 12 Straight-line Alternatives The straight-line method could be calculated on the basis of time, with an equal amount of depreciation being allocated to each time period. The straight-line method could be calculated on the basis of time, with an equal amount of depreciation being allocated to each time period. Alternatively, the straight-line measure could be units of production or some other measure of usage, such as miles driven for a vehicle or hours flown for an airplane. Alternatively, the straight-line measure could be units of production or some other measure of usage, such as miles driven for a vehicle or hours flown for an airplane. © 2007 Pearson Custom Publishing

13. 13 Straight-line Based on Time The basic premise is that the same amount of depreciation will be recognized in each year of the useful life of a long-lived asset. The basic premise is that the same amount of depreciation will be recognized in each year of the useful life of a long-lived asset. The computer system (5-year or 3-year) depreciation schedules given previously are examples of the straight- line method based on the passage of time. The computer system (5-year or 3-year) depreciation schedules given previously are examples of the straight- line method based on the passage of time. © 2007 Pearson Custom Publishing

14. 14 The other variation of the straight-line method is often called the production depreciation method. The other variation of the straight-line method is often called the production depreciation method. Instead of estimating the number of years of useful life, we will instead estimate the amount of usage that we expect from the asset. Instead of estimating the number of years of useful life, we will instead estimate the amount of usage that we expect from the asset. Straight-line Based on Usage © 2007 Pearson Custom Publishing

15. 15 Production Depreciation Method Assume that a pizza parlor buys a delivery truck. Rather than drive the truck into the ground, they decide that they should sell it after it has 75,000 miles on it. The original cost is $20,000 and they estimate that the disposal value will be $5,000 at that time. Assume that a pizza parlor buys a delivery truck. Rather than drive the truck into the ground, they decide that they should sell it after it has 75,000 miles on it. The original cost is $20,000 and they estimate that the disposal value will be $5,000 at that time. © 2007 Pearson Custom Publishing

16. 16 Production Depreciation Method Step One: Calculate the depreciation charge per mile driven: Step One: Calculate the depreciation charge per mile driven: Depreciable Base $15,000 Estimated Miles 75,000 = $.20/mile Depreciable Base $15,000 Estimated Miles 75,000 = $.20/mile Step Two: Calculate depreciation each year (or interim period) by multiplying actual miles driven by the per mile depreciation: Step Two: Calculate depreciation each year (or interim period) by multiplying actual miles driven by the per mile depreciation: Year 1: 30,000 miles X $.20 = $6,000 Year 1: 30,000 miles X $.20 = $6,000 © 2007 Pearson Custom Publishing

17. 17 Effect of Different Methods Several other depreciation methods are considered acceptable and are used by some companies. Several other depreciation methods are considered acceptable and are used by some companies. Most of these other methods are called accelerated depreciation methods. They are accelerated in that a larger amount of expense is taken in the early years, and less in later years. Most of these other methods are called accelerated depreciation methods. They are accelerated in that a larger amount of expense is taken in the early years, and less in later years. © 2007 Pearson Custom Publishing

18. 18 Double-Declining-Balance Method The most heavily used accelerated method is the double-declining-balance method. The most heavily used accelerated method is the double-declining-balance method. The main features of this method are: The main features of this method are: (1) it depreciates at a rate (%) equal to double the straight-line rate, and (1) it depreciates at a rate (%) equal to double the straight-line rate, and (2) you do not consider the estimated disposal value during the early years of depreciation. (2) you do not consider the estimated disposal value during the early years of depreciation. © 2007 Pearson Custom Publishing

19. 19 Double-Declining-Balance Method First step: determine the DDB rate. The DDB rate is equal to twice the annual straight-line rate. First step: determine the DDB rate. The DDB rate is equal to twice the annual straight-line rate. For a five-year asset, the annual straight-line rate is 1/5 or 20%. The DDB rate is 40%. For a five-year asset, the annual straight-line rate is 1/5 or 20%. The DDB rate is 40%. For an three-year asset, the annual straight- line rate is 1/3 or 33.3%. The DDB rate is 66.7%. For an three-year asset, the annual straight- line rate is 1/3 or 33.3%. The DDB rate is 66.7%. © 2007 Pearson Custom Publishing

20. 20 Double-Declining-Balance Method Second step: Multiply the DDB rate by the book value at the beginning of the year. Second step: Multiply the DDB rate by the book value at the beginning of the year. You will use the same rate (%) each year, however, the amount of depreciation will decrease each year because the beginning book value also decreases each year. You will use the same rate (%) each year, however, the amount of depreciation will decrease each year because the beginning book value also decreases each year. NOTE: Be careful in the later years, don’t depreciate the asset below salvage value. NOTE: Be careful in the later years, don’t depreciate the asset below salvage value. © 2007 Pearson Custom Publishing

21. 21 Double-Declining-Balance Method Let’s prepare double-declining-balance depreciation schedules for the computer system mentioned in an earlier slide. Let’s prepare double-declining-balance depreciation schedules for the computer system mentioned in an earlier slide. First, let’s assume a five-year life with $1,000 disposal value, and First, let’s assume a five-year life with $1,000 disposal value, and Second, let’s assume a three-year life with a $0 disposal value. Second, let’s assume a three-year life with a $0 disposal value. © 2007 Pearson Custom Publishing

22. 22 DDB Schedule, 5-Year Asset Due to the accelerated amount of depreciation, the asset is fully depreciated after four years. © 2007 Pearson Custom Publishing

23. 23 DDB Schedule, 3-Year Asset Using the 3-year life with zero disposal value, the amount of depreciation for year 3 is equal to whatever amount remains. © 2007 Pearson Custom Publishing

24. 24 Describe in your own words the effects on the income statement and balance sheet of using different methods of depreciation. Learning Objective 3: © 2007 Pearson Custom Publishing

25. 25 Understanding the Effects The choice of straight-line or an accelerated method affects all of the following: ¶ Depreciation expense in each year. · Net income in each year (because of #1). ¸ Accumulated depreciation in each year (except the last year when fully depreciated). ¹ Net book value in each year (because of #3, except the last year again). © 2007 Pearson Custom Publishing

26. 26 Understanding the Effects However, the choice of method does NOT affect the following: ¶ The amount of depreciation taken over the entire useful life. · The amount of net income reported over the entire useful life. ¸ The book value at the end of the useful life of the asset. © 2007 Pearson Custom Publishing

27. 27 Compare gains and losses to revenues and expenses. Learning Objective 4: © 2007 Pearson Custom Publishing

28. 28 Disposal of Assets At some point, a business will decide to dispose of a long-lived asset. This could happen at the end of the estimated useful life, or it could just as easily happen sooner or later than we originally estimated. At some point, a business will decide to dispose of a long-lived asset. This could happen at the end of the estimated useful life, or it could just as easily happen sooner or later than we originally estimated. Each time we dispose of an asset, we need to determine whether there is a gain or loss on disposal. Each time we dispose of an asset, we need to determine whether there is a gain or loss on disposal. © 2007 Pearson Custom Publishing

29. 29 Gains and Losses A gain is a net inflow resulting from a peripheral activity of the company, such as selling a long-lived asset for an amount greater than its net book value. A gain is a net inflow resulting from a peripheral activity of the company, such as selling a long-lived asset for an amount greater than its net book value. A loss is a net outflow resulting from a peripheral activity of the company, such as selling a long-lived asset for an amount less than its net book value. A loss is a net outflow resulting from a peripheral activity of the company, such as selling a long-lived asset for an amount less than its net book value. © 2007 Pearson Custom Publishing

30. 30 Gains and Losses Gains and losses are important accounting elements. They are reported on the income statement along with revenues and expenses. Gains and losses are important accounting elements. They are reported on the income statement along with revenues and expenses. Thus, the income statement equation is now expanded to: Net income = Revenue + Gains - Expenses - Losses Thus, the income statement equation is now expanded to: Net income = Revenue + Gains - Expenses - Losses © 2007 Pearson Custom Publishing

31. 31 Calculate a gain or loss on the disposal of a long- lived depreciable asset. Learning Objective 5: © 2007 Pearson Custom Publishing

32. 32 Determining Gains & Losses Consider these various examples of the disposal of a depreciable asset: Consider these various examples of the disposal of a depreciable asset: 1. A fully depreciated delivery truck (with 220,000 miles on it) is hauled off to the junk yard. 1. A fully depreciated delivery truck (with 220,000 miles on it) is hauled off to the junk yard. 2. A delivery van with a net book value of $8,000 is traded in on a company car for the sales staff. 2. A delivery van with a net book value of $8,000 is traded in on a company car for the sales staff. 3. A one-year-old rental car with a net book value of $15,000 is sold at auction to a car dealership. 3. A one-year-old rental car with a net book value of $15,000 is sold at auction to a car dealership. Let’s explore this third example further. © 2007 Pearson Custom Publishing

33. 33 Calculating Gain on Disposal A gain on disposal of a depreciable asset will occur when the asset is sold for an amount in excess of the ending book value. A gain on disposal of a depreciable asset will occur when the asset is sold for an amount in excess of the ending book value. Example: The Car Rental Company sells a one- year-old car to a car dealership. The company has depreciated the asset to a book value of $15,000. The dealership pays $16,500 to buy the car. The Car Rental Company records a gain on disposal of $1,500. Example: The Car Rental Company sells a one- year-old car to a car dealership. The company has depreciated the asset to a book value of $15,000. The dealership pays $16,500 to buy the car. The Car Rental Company records a gain on disposal of $1,500. © 2007 Pearson Custom Publishing

34. 34 Calculating Loss on Disposal A loss on disposal of a depreciable asset will occur when the asset is sold for an amount less than the ending book value. A loss on disposal of a depreciable asset will occur when the asset is sold for an amount less than the ending book value. Example: The same situation with the Car Rental Company selling a car (book value of $15,000) to a dealership. The car dealership pays $14,500 to buy the car. The Car Rental Company records a loss on disposal of $500. Example: The same situation with the Car Rental Company selling a car (book value of $15,000) to a dealership. The car dealership pays $14,500 to buy the car. The Car Rental Company records a loss on disposal of $500. © 2007 Pearson Custom Publishing

35. 35 Disposal with No Gain or Loss There will be no gain or loss on the disposal of a depreciable asset when the asset is sold (or traded) for an amount equal to the recorded book value. There will be no gain or loss on the disposal of a depreciable asset when the asset is sold (or traded) for an amount equal to the recorded book value. Example: The same situation with the Car Rental Company selling a car (book value of $15,000) to a dealership. The car dealership pays $15,000 to buy the car. No gain or loss. Example: The same situation with the Car Rental Company selling a car (book value of $15,000) to a dealership. The car dealership pays $15,000 to buy the car. No gain or loss. © 2007 Pearson Custom Publishing

36. 36 Explain the effects on a company’s financial statements when management disposes of a depreciable asset. Learning Objective 6: © 2007 Pearson Custom Publishing

37. 37 Effects of an Asset Disposal on the Balance Sheet The book value of the asset will be removed from the balance sheet and decrease both the asset account and accumulated depreciation account. The book value of the asset will be removed from the balance sheet and decrease both the asset account and accumulated depreciation account. Cash will increase by the amount received for the asset. Cash will increase by the amount received for the asset. If cash exceeds book value, equity will increase by the amount of the gain. If book value exceeds the cash, equity will decrease by the amount of the loss. If cash exceeds book value, equity will increase by the amount of the gain. If book value exceeds the cash, equity will decrease by the amount of the loss. © 2007 Pearson Custom Publishing

38. 38 Effects of an Asset Disposal on the Income Statement A gain on the disposal will increase net income. A gain on the disposal will increase net income. A loss on the disposal will decrease net income. A loss on the disposal will decrease net income. © 2007 Pearson Custom Publishing

39. 39 Draw appropriate conclusions when presented with gains or losses on an income statement. Learning Objective 7: © 2007 Pearson Custom Publishing

40. 40 True Meaning of Gains/Losses Net book value is the end result of the depreciation amounts charged against an asset. Net book value is the end result of the depreciation amounts charged against an asset. Therefore, if book value does not equal the disposal value of an asset, we simply took too much or too little depreciation for the asset. Therefore, if book value does not equal the disposal value of an asset, we simply took too much or too little depreciation for the asset. The gain or loss is just a depreciation adjustment at the end of the process. The gain or loss is just a depreciation adjustment at the end of the process. © 2007 Pearson Custom Publishing

41. 41 Case #1: You bought an asset at a cost of $9,000. You have been depreciating this asset at a straight-line rate of $1,000 per year for 4 years. Case #1: You bought an asset at a cost of $9,000. You have been depreciating this asset at a straight-line rate of $1,000 per year for 4 years. The net book value at this time is $5,000 and you sell it for $4,000. The net book value at this time is $5,000 and you sell it for $4,000. You will record a loss on sale of $1,000. You will record a loss on sale of $1,000. True Meaning of Gains/Losses © 2007 Pearson Custom Publishing

42. 42 Case #2: Same asset, $9,000 original cost and depreciated for the past four years. Case #2: Same asset, $9,000 original cost and depreciated for the past four years. If you had depreciated $1,250 each year (total of $5,000), the book value would have been equal to $4,000. If you had depreciated $1,250 each year (total of $5,000), the book value would have been equal to $4,000. When the asset was sold for $4,000, there would be no gain or loss. When the asset was sold for $4,000, there would be no gain or loss. True Meaning of Gains/Losses © 2007 Pearson Custom Publishing

43. 43 In case #1, you have $4,000 depreciation and a $1,000 loss on sale. This reduces net income by $5,000 over the life of the asset. In case #1, you have $4,000 depreciation and a $1,000 loss on sale. This reduces net income by $5,000 over the life of the asset. In case #2, you have $5,000 depreciation and no gain or loss on sale. Again, net income has been reduced by $5,000. In case #2, you have $5,000 depreciation and no gain or loss on sale. Again, net income has been reduced by $5,000. Either way, total net income is the same over the life of the asset. Either way, total net income is the same over the life of the asset. True Meaning of Gains/Losses © 2007 Pearson Custom Publishing

44. 44 End of Chapter 8 © 2007 Pearson Custom Publishing