Accounting: The Language of Business (Part 59)

“Behind every good businessman there is a great accountant.” —Unknown

Fixed Assets and Intangible Assets (Part C)

by

Charles Lamson

Units-of-Production Method

How would you depreciate a fixed asset when its service is related to use rather than time? When the amount of use of a fixed asset varies from year to year, the units-of-production method is more appropriate than the straight-line method. In such cases, the units-of-production method better matches the depreciation expense with the related revenue.

The units-of-production method provides for the same amount of depreciation expense for each unit produced or each unit of capacity used by the asset. To apply this method, the useful life of the asset is expressed in terms of units of productive capacity such as hours or miles. The total depreciation expense for each accounting period is then determined by multiplying the unit depreciation by the number of units produced or used during the period. For example, assume that a machine with a cost of $24,000 and an estimated residual value of $2,000 is expected to have an estimated life of 10,000 operating hours. The depreciation for a unit of 1 hour is computed as follows:

$24,000 cost - $2,000 estimated residual value / 10,000 estimated hours = $2.20 hourly depreciation

Assuming that the machine was in operation for 2,100 hours during a year, the depreciation for that year would be $4,620 ($2.20 * 2,100 hours).

Declining-Balance Method

The declining-balance method provides for a declining periodic expense over the estimated useful life of the asset. To apply this method, the annual straight-line depreciation rate is doubled. For example, the declining balance rate for an asset with an estimated life of 5 years is 40%, which is double the straight-line rate of 20% (100% / 5).

For the first year of use, the cost of the asset is multiplied by the declining balance rate. After the first year, the declining book value (cost minus accumulated depreciation) of the asset is multiplied by this rate. To illustrate, the annual declining balance depreciation for an asset with an estimated 5-year life and a cost of $24,000 is shown below.

You should know that when the declining balance method is used, the estimated residual value is not considered in determining the depreciation rate. It is also ignored in computing the periodic depreciation. However, the asset should not be depreciated below its estimated residual value. In the above example, the estimated residual value was $2,000. Therefore, the depreciation for the fifth year is $1,110.40 ($3,110.40 - $2,000) instead of $1,244.16 (40% * $3,110.40).

In the example above, we assumed that the first use of the asset occurred at the beginning of the fiscal year. This is normally not the case in practice, however, and depreciation for the first partial year of use must be computed. For example, assume that the asset above was in service at the end of the third month of the fiscal year. In this case, only a portion (9 / 12) of the first bold years depreciation of $9,600 is allocated to the first fiscal year. Thus, depreciation of $7,200 (9 / 12 * $9,600) is allocated to the first partial year of use. The depreciation for the second fiscal year would then be $6,720 [40% x ($24,000 - $7,200)].

Comparing Depreciation Methods

The straight-line method provides for the same periodic amount of depreciation expense over the life of the asset. The units-of-production method provides for periodic amount of depreciation expense that vary, depending upon the amount the asset is used.

The declining-balance method provides for a higher depreciation amount in the first year of the asset's use, followed by a gradually declining amount. For this reason, the declining balance method is called an accelerated depreciation method. It is most appropriate when the decline in an asset's productivity or earning power is greater in the early years of its use than in later years. Further, using this method is often justified because repairs tend to increase with the age of an asset. The reduced amount of depreciation in later years are thus offset to some extent by increased repair expenses.

The periodic depreciation amounts for the straight-line method and the declining-balance method are compared in Exhibit 6. This comparison is based on an asset cost of $24,000, an estimated life of 5 years, and an estimated residual value of $2,000. 

EXHIBIT 6 Comparing Depreciation Methods

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST, PP. 399-400*

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Accounting: The Language of Business (Part 58)

“10 out of 9 accountants can’t count!” —Unknown

Fixed Assets and Intangible Assets (Part B)

by

Charles Lamson 

Accounting for Depreciation

Three factors are considered in determining the amount of depreciation expense to be recognized each period. These three factors are (a) the fixed asset's initial cost, (b) its expected useful life, and (c) its estimated value at the end of its useful life. This third factor is called the residual value, scrap value, salvage value, or trade-in value. Exhibit 4 shows the relationship among the three factors and the periodic depreciation expense.

A fixed asset's residual value at the end of its expected useful life must be estimated at the time the asset is placed in service. If a fixed asset is expected to have little or no residual value when it is taken out of service, then its initial cost should be spread over its expected useful life as depreciation expense. If, however, a fixed asset is expected to have a significant residual value, the difference between its initial cost and its residual value, called the asset's depreciable cost, what is the amount that is spread over the asset's useful life as depreciation expense. 

A fixed asset's expected useful life must be estimated at the time the asset is placed in service. Estimates of expected useful lives are available from various trade associations and other publications. For federal income tax purposes, the Internal Revenue Service has established guidelines for useful lives. These guidelines may also be helpful in determining depreciation for financial reporting purposes. 

In practice, many businesses use the guideline that all assets placed in or taken out of service during the first half of a month are treated as if the event occurred on the first day of that month. That is, these businesses compute depreciation on these assets for the entire month. Likewise, all fixed asset additions and deductions during the second half of a month are treated as if the event occurred on the first day of the next month. We will follow this practice in the next several posts.

It is not necessary that a business use a single method of computing depreciation for all its depreciable assets. The methods used in the accounts and financial statements may differ from the methods used in determining income taxes and property taxes. The three methods used most often are (1) straight line, (2) units of production, and (3) declining balance. Exhibit 5 shows the extent of the use of these methods in financial statements.

EXHIBIT 5 Use of Depreciation Methods

Straight-Line Method

The straight-line method provides for the same amount of depreciation expense for each year of the asset's useful life. For example, assume that the cost of a depreciable asset is $24,000, its estimated residual value is $2,000, and it's estimated life is 5 years. The annual depreciation is computed as follows:

$24,000 cost - $2,000 estimated residual value / 5 years estimated life = $4,400 annual depreciation

When an asset is used for only part of a year, the annual depreciation is prorated. For example, assume that the fiscal year ends on December 31 and that the asset in the above example is placed in service on October 1. The depreciation for the first fiscal year of use would be $1,100 ($4,400 * 3 / 12).

For ease in applying the straight-line method, the annual depreciation may be converted to a percentage of the depreciable cost. This percentage is determined by dividing 100% by the number of years of useful life. For example, a useful life of 20 years converts to a 5% rate (100% / 20), 8 years converts to a 12.5% rate (100% / 8), and so on. In the above example, the annual depreciation of $4,000 can be computed by multiplying the depreciable cost of $22,000 by 20% (100% / 5).

The straight-line method is simple and is widely used. It provides a reasonable transfer of costs to periodic expense when the asset's use and the related revenues from its use are about the same from period to period. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 397-399*

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Accounting: The Language of Business (Part 57)

“In the beginning God created man…and the costs followed afterwards.” —Unknown

 Fixed Assets and Intangible Assets (Part A)

by

Charles Lamson

Assume that you are a certified flight instructor and you would like to earn a little extra money by teaching people how to fly. Since you don't own an airplane, one of the pilots at the local airport is willing to let you use her car airplane for a fixed fee per year. You will also have to pay your share of the annual operating costs, based on hours flown. In addition, the owner will consider your request for upgrading the plane's equipment. At the end of the year, the owner has the right to cancel the agreement.

One of your friends is an airplane mechanic. He is familiar with the plane and has indicated that it needs its annual inspection. There is some structural damage on the right aileron. In addition to this repair, you would like to equip the plane with another radio and a better navigation system.

Since you will not have any ownership in the airplane, it is important for you to distinguish between normal operating costs and costs that add future value or worth to the airplane. These letter costs should be the responsibility of the owner. In this case, you should be willing to pay for a part of the cost of the annual inspection. The cost of repairing the structural damage and upgrading the navigation system should be the responsibility of the owner.

Businesses also distinguish between the cost of a fixed asset and the cost of operating the asset. In the next several posts, we discuss how to determine the portion of a fixed asset's cost that becomes an expense over a period of time. We also discuss accounting for the disposal of fixed assets and accounting for intangible assets, such as patents and copyrights.

Nature of Fixed Assets

Businesses use a variety of fixed assets, such as equipment, furniture, tools, machinery, buildings, and land. Fixed assets are long-term or relatively permanent assets. They are tangible assets because they exist physically. They are owned and used by the business and are not offered for sale as part of normal operations. Other descriptive titles for these assets are plant assets or property, plant, and equipment.

The fixed assets of a business can be a significant part of the total assets.

Classifying Costs

Exhibit 2 displays questions that help classify costs. If the purchased item is long-lived, then it should be capitalized, which means it should appear on the balance sheet as an asset. Otherwise, the cost should be reported as an expense on the income statement. If the asset is also used for a productive purpose, which involves a repeated use or benefit, then it should be classified as a fixed asset, such as land, buildings, or equipment. An asset need not actually be used on an ongoing basis or even often. For example, standby equipment for use in the event of a breakdown of regular equipment or for use only during peak periods Is included in fixed assets. Fixed assets that have been abandoned or are no longer used should not be classified as a fixed asset.

EXHIBIT 2 Classifying Costs

Fixed assets are owned and used by the business and are not offered for resale. Long-lived assets held for resale are not classified as fixed assets, what should be listed on the balance sheet in a section entitled investments. For example, undeveloped land acquired as an investment for resale would be classified as an investment, not land.

The Cost of Fixed Assets

The costs of acquiring fixed assets include all amounts spent to get the asset in place and ready for use. For example, freight costs and the costs of installing equipment are included as part of the asset's total cost. The direct costs associated with new construction, such as labor and materials, should be debited to a "construction in progress" asset account. When the construction is complete, the costs should be reclassified by crediting the construction in progress account and debiting the appropriate fixed asset account. For growing companies, construction in progress can be significant.

The details of fixed assets are disclosed on the face of the balance sheet or the notes to the financial statements.

Exhibit 3 summarizes some of the common costs of acquiring fixed assets. These costs should be recorded by debiting the related fixed asset account, such as land, building, land improvements, or machinery and equipment.

EXHIBIT 3 Costs of Acquiring Fixed Assets

Only costs necessary for preparing a long-lived asset for use should be included as a cost of the asset. Unnecessary costs that do not increase the asset usefulness are recorded as an expense. For example, the following costs are included as an expense:

• Vandalism

• Mistakes in installation

• Uninsured theft

• Damage during unpacking and installing

• Fines for not obtaining proper permits from governmental agencies

Donated Assets

Civic groups sometimes give land or buildings to a corporation as an incentive to locate or remain in a community. In such cases, the corporation debits the assets for their fair market value and credits a revenue account. To illustrate, assume that on April 28 the Chamber of Commerce of the city of Moraine donates land to Merrick Corporation as an incentive to relocate its headquarters to Moraine. The land was valued at $500,000. Merrick Corporation would record the land as follows:

Nature of Depreciation

As we have discussed in earlier posts, land has an unlimited life and therefore can provide unlimited services. On the other hand, other fixed assets such as equipment, buildings, and land improvements lose their ability, over time, to provide services. As a result, the costs of equipment, buildings, and land improvement should be transferred to expense accounts in a systematic manner during their expected useful lives. Thus periodic transfer of a cost to expense is called depreciation.

The adjusting entry to record depreciation is usually made at the end of each month or at the end of the year. This entry debits Depreciation Expense and credits a contra asset account entitled Accumulated Depreciation or Allowance for Depreciation. The use of a contra asset account allows the original cost to remain unchanged in the fixed asset account.

Factors that cause a decline in the ability of a fixed asset to provide services may be identified as physical depreciation or functional depreciation. Physical depreciation occurs from wear and tear while in use and from the action of the weather. Functional depreciation occurs when a fixed asset is no longer able to provide services at the level for which it was intended. For example, all personal computers made in the 1980s would not be able to provide an internet connection. Such advances in technology have made functional depreciation an increasingly important cause of depreciation.

The term depreciation as used in accounting is often misunderstood because the same term is also used in business to mean a decline in the market value of an asset. However, the amount of a fixed asset's unexpired cost reported in the balance sheet usually does not agree with the amount that could be realized from its sale. Fixed assets are held for use in a business rather than for sale. It is assumed that the business will continue as a going concern. Thus, a decision to dispose of a fixed asset is based mainly on the usefulness of the asset to the business and not on its market value.

Another common misunderstanding is that accounting for depreciation provides cash needed to replace fixed assets as they wear out. This misunderstanding probably occurs because depreciation, unlike most expenses, does not require an outlay of cash in the period in which it is recorded. The cash account is neither increased nor decreased by the periodic entries that transfer the cost of fixed assets to depreciation expense accounts. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 393-397*

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Accounting: The Language of Accounting (Part 56)

“To multiply the years and divide by the desire to live is a kind of false accounting.” —Peter Heller

Inventories (Part H)

by

Charles Lamson

Financial Analysis and Interpretation

A merchandising business should keep enough inventory on hand to meet the needs of its customers. A failure to do so may result in lost sales. At the same time, too much inventory reduces solvency by tying up funds that could be better used to expand or improve operations. In addition, excess inventory increases expenses such as storage, insurance, and property taxes. Finally, excess inventory increases the risk of losses due to price declines, damage, or changes in customers' buying patterns.

As with many types of financial analyses, it is possible to use more than one measure to analyze the efficiency and effectiveness by which a business manages its inventory. Two such measures are the inventory turnover and the number of days' sales in inventory.

Inventory turnover measures the relationship between the volume of goods (merchandise) sold and the amount of inventory carried during the period. It is computed as follows:

Inventory turnover = Cost of merchandise sold / Average inventory

The average inventory can be computed using weekly, monthly, or yearly figures. To simplify, we determine the average inventory by dividing the sum of the inventories at the beginning and end of the year by 2. As long as the amount of inventory carried throughout the year remains stable, this average will be accurate enough for our analysis. 

Generally, the larger the inventory turnover, the more efficient and effective the management of the inventory. However, differences in companies and industries are too great to allow specific statements as to what is a good inventory turnover. As with other financial measures we have discussed, a comparison of a company's inventory turnover over time and with industry averages will provide useful insights into the management of its inventory.

The number of days sales in inventory is a rough measure of the length of time it takes to acquire, sell, and replace the inventory. It is computed as follows:

Number of days sales in inventory = Inventory, end of year / Average daily cost of merchandise sold

The average daily cost of merchandise sold is determined by dividing the cost of merchandise sold by 365. 

Generally, the lower the number of days sales in inventory, the better. As with inventory turnover, we should expect differences among industries. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 371-372*

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