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Subject 2. Depreciation
- Straight Line Depreciation: The most popular one. Depreciation Expense = (Cost - Salvage Value) / Estimated Useful Life
- Accelerated Depreciation Methods: More depreciation should be allocated to earlier years than to later years.
- Sum of the Years Digits = (cost - salvage value)(years remaining)/(sum of years)
- Double Declining Balance (DDB) = 2 x (cost - accumulated depreciation)/(assets life)
- Units of Production: Depreciation [per period] = Output [per period] x Unit Cost. More depreciation expense is charged in years of higher production.
Estimates Required for Depreciation Calculations
Depreciable life, also called useful life, is the total number of service units expected from a depreciable asset. It can be measured in terms of units expected to be produced, or hours of service to be provided by the asset, or years the asset is expected to be used. The longer the depreciable life, the lower the annual depreciation expense.
Reducing the depreciable life of an asset has the following impact on financial statements over its depreciable life:
- Higher depreciation expense.
- Lower book value of the asset.
- Lower net income. The percentage effect on net income is usually greater than the effects on assets and shareholders' equity.
- Lower shareholders' equity (caused by lower retained earnings).
Consequently, a shorter depreciable life tends to reduce profit margin, returns on assets, and returns on equity, while raising asset turnovers and debt-to-equity ratio. However, changing the depreciable life has no effect on cash flows, since depreciation is a non-cash charge.
Salvage value, also called residual value, is the estimated amount that will be received when the asset is sold or removed from service.
- The higher the salvage value, the lower the annual depreciation expense, as salvage value is deducted from the original cost to compute annual depreciation expense for depreciation methods such as straight-line, units-of-production, service-hour and sum-of-the-years' digit.
- Salvage value serves as a floor for net book value for depreciation methods such as double-declining-balance, units-of-production and service hour depreciation.
- Note that MACRS assumes there is no salvage value.
The effects of choosing a lower salvage value are similar to those of a shorter depreciable life or an accelerated depreciation method. However, the effects do not reverse in the later years of the asset's useful life.
Shorter lives and lower salvage values are considered conservative in that they lead to higher depreciation expense. These factors interact with the depreciation method to determine the expense; for example, use of the straight-line method with short depreciation lives may result in depreciation expense similar to that obtained from the use of an accelerated method with longer lives.
Practice Question 1If a firm wishes to be conservative in its recognition of depreciation expense, which of the following is true?
I. higher salvage values should be used
II. shorter lives should be used
III. lower salvage values should be usedCorrect Answer: II and III
Using shorter lives and lower salvage values will yield larger depreciation expenses, which is more conservative.
Practice Question 2A significant change in the estimate of the salvage value of an asset to a much lower value will cause:
A. income to decrease in the period of the change.
B. depreciation expense to decrease.
C. return on assets to increase in the period of the change.Correct Answer: A
The lower salvage value will cause the depreciable base to be larger, which will cause more depreciation to be expensed each period.
Practice Question 3Taylor Corporation purchased a new asset for $80,000. The asset had an estimated life of 5 years and an estimated salvage value of $20,000. Now suppose that instead of using a life of five years, the company used an estimated life of ten years and a salvage value of $20,000. What is the effect on income in the second year, assuming straight-line method and a tax rate of 30%?
C. $4,200Correct Answer: C
If the life is extended to 10 years, the depreciation expense for each of the ten years would be $6,000 [($80,000-$20,000)/10]. The effect on the first five years' income before taxes would be $6,000 ($12,000 - $6,000). The after-tax effect on income would be $4,200 ($6,000 x .7). For the first five years, income would be greater by $4,200. For the next five years, income would be less by that amount (assuming no changes in the tax rate). The advantage to the company would be that more income could be recognized earlier by using a longer period, and the company could probably replace the asset during the last five years and not have to recognize the depreciation expense.
Practice Question 4A longer depreciable life will:
I. cause depreciation expense to be lower each period
II. cause depreciation expense to be higher each period
III. cause more costs to be allocated each period
IV. cause asset turnover ratios to be lower.Correct Answer: I and IV
A longer life will cause depreciation expense to be lower each period, as it is spread over a longer period of time. This will cause the asset turnover ratios to be lower.
Practice Question 5Filer Brother Imports, Inc. purchased a new conveyor belt system for $ 40,000 to use in its warehouse. The company uses double-declining balance (DDB) depreciation. The conveyor system has an estimated life of five years and a salvage value of five percent or $1,500. What is the depreciation expense on the conveyor belt system in the second year of its estimated life?
C. $9,600Correct Answer: C
The computation is $24,000 book value at the beginning of year 2 x 40% = $9,600. The $24,000 book value equals $40,000 - (40% x $40,000). Salvage is not used.
Practice Question 6Ashley Company has decided to change its method of depreciation from the straight-line method to the double-declining method. The change will be only for financial reporting purposes, and applicable to newly acquired assets only. Which of the following is true when comparing the double-declining method to the straight-line?
A. Income will be higher in the years following the change
B. Return on assets will be higher in the years following the change
C. In the year of the change, income will be lower
D. Stockholders' equity will be higherCorrect Answer: C
The accelerated method will have a higher depreciation and will thus lower assets, net income and stockholders' equity in the earlier years. The effect on assets is normally less than the effect on net income, so the return on assets will be lower.
Practice Question 7What is the cost of a fixed asset less its accumulated depreciation?
A. net realizable value
B. net book value
C. salvage valueCorrect Answer: B
The difference between the cost of a fixed asset and its accumulated depreciation is called its net book value or simply its book value.
Practice Question 8Accumulated depreciation is the result of:
A. an expense being prepaid.
B. capitalizing an asset.
C. writing off an asset.Correct Answer: B
Capitalizing an asset means writing off the benefit of the asset over its useful life. This in turn creates depreciation expense and accumulated depreciation.
Practice Question 9Carter Co. and Greer Corp. purchased identical plant assets, and both companies estimated the useful life at 10 years with no salvage value. Carter uses straight-line depreciation in its financial statements, whereas Greer uses an accelerated method.
A. Over the life of the asset, Greer will recognize more depreciation expense than Carter.
B. In the tenth year of ownership, Carter will recognize more depreciation expense on this asset than Greer.
C. If the asset is sold after 4 years, Carter is more likely to report a gain than is Greer.Correct Answer: B
Practice Question 10An asset having a four-year service life and a salvage value of $5,000 was acquired for $45,000 cash on January 2. What will be the depreciation expense for the second year ending December 31?
A. $11,250, using the straight-line method;
B. $11,250, using the double-declining-balance method;
C. $14,000, using the units-of-output method.Correct Answer: B
Under declining-balance, salvage value is ignored in the calculation. Depreciation for year one would be $22,500 (45,000 X 50%) and $11,250 (($45,000 - $22,500) X 50%) for year two.
Practice Question 11Bay Tree Company purchased a machine for $ 264,000 on 1/1/2007 and depreciated it using straight-line with an estimated useful life of eight years and no expected salvage value. Bay Tree determined in January 2015 that the machinery would likely have only three remaining years of life and an expected salvage value of $ 24,000. The balance in accumulated depreciation as of 12/31/2010 should be:
A. $ 146,000
B. $ 154,000
C. $ 160,000Correct Answer: A
Depreciation Expense per year (2012 - 2014)= $264,000/8= $33,000
Depreciation Expense (2015) ($165,000 carrying amount** -24,000)/3 yrs = $47,000
Accumulated Depreciation= $146,000 = ($33,000 x 3 years= 99,000) + $47,000
** carrying amount = original cost - accumulated depreciation = $264,000 - (33,000 x 3)
Practice Question 12Which depreciation method bases depreciation expense for a given period on actual use?
A. straight-line method
B. double-declining-balance method
C. units-of-production methodCorrect Answer: C
The units-of-production method bases depreciation expense based on actual use rather than on the amount of time the company used the asset.
Practice Question 13The entry to record depreciation on long-term assets:
A. decreases total assets and increases net income.
B. decreases current assets and increases expenses.
C. decreases total assets and decreases earnings before taxes.
D. increases earnings before taxes and increases tax expense.
E. decreases total assets and decreases expenses.Correct Answer: C
Practice Question 14Depreciation accounting is a system of accounting which aims
A. to record the carrying value of an asset.
B. to periodically allocate the cost of a tangible long-lived asset over its estimated life.
C. to distribute the cost or other basic value of tangible capital assets, less salvage, over the estimated useful life of the unit in a systematic and rational manner.Correct Answer: C
Practice Question 15Which of the following statements is the LEAST ACCURATE regarding accelerated depreciation methods?
A. Accelerated depreciation methods depreciate an asset in proportion to its actual use.
B. Accelerated depreciation compensates for the rising repair costs as an asset ages.
C. Accelerated depreciation methods are appropriate if the benefits from using an asset are highest when it is relatively new.
D. Accelerated depreciation methods are often used to reduce the tax burden immediately after an asset is purchased.Correct Answer: A
A is not correct since the units of production method depreciates assets in proportion to their use, and thus becomes a variable cost. Accelerated depreciation reduces the value of an asset by the largest amount in the early years regardless of when it is getting the most use.
Practice Question 16Which change needs to be applied retrospectively to the financial statements?
A. A company wants to change the useful life of an asset from 5 years to 7 years.
B. A company determines to change the residual value of an asset from $2,000 to $3,000.
C. None of them.Correct Answer: C
These changes need to be made prospectively (going forward).
Practice Question 17Assume the managers want to maximize bonuses, which are based on current net income. Managers should prefer:
A. Successful efforts rather than full costing of oil & gas drilling.
B. Expensing research & development costs.
C. Using straight-line rather than accelerated depreciation for financial statement purposes.Correct Answer: C
Practice Question 18Under the accelerated depreciation method,
A. Total asset turnover will be lower than that under the straight line method in the earlier years in the earlier years.
B. Total asset turnover will be greater than that under the straight line method in the later years.
C. Total asset turnover will be greater than that under the straight line method in the earlier years.Correct Answer: C
Under accelerated depreciation, asset book values are lower than those under the straight line method in the earlier years. Asset turnover is consequently higher under the former.
Practice Question 19Best Cycles has invested in a new project and is considering depreciating it under the sinking fund method. Which of the statements presented below would be CONSISTENT with this depreciation method? Annual cash flows are projected to be level.
A. Net profit would show a varying rate of return on book value.
B. Asset book value will decline by an unequal but a rising amount every year.
C. Pre-tax profit can be calculated by the product of internal rate of return of the project and the initial cost of the asset.Correct Answer: B
Under the sinking fund method, depreciation is based on the amortization formula based on the pre-tax IRR of the project. The annual amount is allocated to depreciation and net profit. As the book value declines, annual depreciation increases at an increasing rate, lowering asset book value also at an increasing rate, or by rising amounts.
Practice Question 20Accelerated depreciation method is appealing for all of the following reasons EXCEPT
A. It reflects the physical deterioration of a physical asset more realistically.
B. It enables a company to better cope with the effects of inflation on assets' replacement values.
C. It smoothens out the total of depreciation and repair and maintenance costs over time.Correct Answer: A
None of the accounting depreciation methods represent the actual physical depreciation of the underlying asset. They are all assumptions made for convenient allocation of an asset's purchase price over the economic life of the asset. Besides, the accelerated depreciation method generates greater present value of tax savings over the straight line method.
Practice Question 21Taylor Corporation purchased a new asset for $80,000. The asset had an estimated life of 5 years and an estimated salvage value of $20,000. What is the depreciation expense in the second year if the company uses the double-declining balance method?
C. $14,400Correct Answer: B
The double-declining rate is 40% [(100%/5) x 2]. The beginning book value of $80,000 is multiplied by the 40% rate to get $32,000 depreciation expense for the first year. The second year will be .4 x ($80,000 - $32,000) = $19,200. The accelerated method will cause more depreciation in the early years and a lower value for the assets.
Practice Question 22Taylor Corporation purchased a new asset for $80,000. The asset had an estimated life of 5 years and an estimated salvage value of $20,000. What is the depreciation expense for the second year if the company uses the straight-line method?
C. $14,440Correct Answer: B
Depreciation expense each year for five years would be $12,000 [($80,000 - $20,000)/5].
Practice Question 23At the end of 2010, a firm changes its depreciation method from the double-declining balance method to straight line. The firm only has one asset, a building that cost $4,000,000 and has a salvage value of $200,000 after a life of 20 years. The tax rate is 20%. The asset was purchased in January of 2008. What will be the cumulative effect of the change on the 2010 depreciation resulting from the years 2008 and 2009?
A. $210,000 lower
B. $380,000 lower
C. $190,000 lowerCorrect Answer: B
Depreciation under the straight-line method would be $190,000 each year [($4,000,000 - $200,000)/20]. Depreciation under the double-declining balance method would be $400,000 in the first year. The double-declining rate is 10% [(100%/20) x 2]. Applying the rate of 10% to the beginning book value of $4,000,000 = $400,000 for the first year. The second year will be the beginning book value of $3,600,000 ($4,000,000 - $400,000) x .1 = $360,000. The difference between $400,000 and $190,000, of $210,000, will be the change in the depreciation expense for the year 2008. The second year for the straight line is $190,000. The difference between $360,000 and $190,000, of $170,000, will be the change in the depreciation expense for the year 2009. The cumulative effect of the change for the year 2010 will be $210,000 + $170,000 = $380,000 lower.
Practice Question 24Which statement is not true concerning changes in depreciation method?
A. A company can change its depreciation method only for newly acquired assets and continue to depreciate previously acquired similar assets using the same method as in the past.
B. When a new method of depreciation is applied retroactively, companies must disclose the pro forma impact of the new method on prior periods. The cumulative effect of the change must be reported separately and net of taxes.
C. Changes in salvage values are considered changes in accounting principle.Correct Answer: C
Changes in salvage values and asset lives are changes in accounting estimates and are not considered changes in accounting principle.
Practice Question 25At the end of 2010, a firm changes its depreciation method from the double-declining balance method to straight line. The firm only has one asset, a building that cost $4,000,000 and has a salvage value of $200,000 after a life of 20 years. The tax rate is 20%. The asset was purchased in January of 2008. What will be the effect of the change on 2010 net income resulting from the years 2008 and 2009?
A. $440,000 increase.
B. $380,000 increase.
C. $304,000 increase.Correct Answer: C
The effect on income will be the changes in depreciation expense this year and the cumulative effect of the change on prior years. The straight-line depreciation for two years is $380,000 (2 x $190,000), and the double-declining depreciation for two years is $760,000 ($400,000 + $360,000). The cumulative effect before taxes would be $380,000 ($760,000 - $380,000). After the tax effect, the effect on the income of 2010 resulting from the change in 2008 and 2009 depreciation is a $304,000 increase, resulting from the change from a method with larger depreciation expense to a method with smaller depreciation expense.
Study notes from a previous year's CFA exam:
b. explain and evaluate how the different depreciation methods for property, plant, and equipment affect financial statements and ratios;