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:
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 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.
I. higher salvage values should be used
Using shorter lives and lower salvage values will yield larger depreciation expenses, which is more conservative.
A. income to decrease in the period of the change.
The lower salvage value will cause the depreciable base to be larger, which will cause more depreciation to be expensed each period.
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.
I. cause depreciation expense to be lower each period
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.
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.
A. Income will be higher in the years following the change
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.
A. net realizable value
The difference between the cost of a fixed asset and its accumulated depreciation is called its net book value or simply its book value.
A. an expense being prepaid.
Capitalizing an asset means writing off the benefit of the asset over its useful life. This in turn creates depreciation expense and accumulated depreciation.
A. Over the life of the asset, Greer will recognize more depreciation expense than Carter.
A. $11,250, using the straight-line method;
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.
A. $ 146,000
Depreciation Expense per year (2012 - 2014)= $264,000/8= $33,000
** carrying amount = original cost - accumulated depreciation = $264,000 - (33,000 x 3)
A. straight-line method
The units-of-production method bases depreciation expense based on actual use rather than on the amount of time the company used the asset.
A. decreases total assets and increases net income.
A. to record the carrying value of an asset.
A. Accelerated depreciation methods depreciate an asset in proportion to its actual use.
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.
A. A company wants to change the useful life of an asset from 5 years to 7 years.
These changes need to be made prospectively (going forward).
A. Successful efforts rather than full costing of oil & gas drilling.
A. Total asset turnover will be lower than that under the straight line method in the earlier years in the earlier years.
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.
A. Net profit would show a varying rate of return on book value.
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.
A. It reflects the physical deterioration of a physical asset more realistically.
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.
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.
Depreciation expense each year for five years would be $12,000 [($80,000 - $20,000)/5].
A. $210,000 lower
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.
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.
Changes in salvage values and asset lives are changes in accounting estimates and are not considered changes in accounting principle.
A. $440,000 increase.
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.