Chapter 7 – Fixed Assets and Depreciation
What is a fixed asset?
A fixed asset is a relatively major purchase for a business – like equipment, furniture, tools,
machinery, buildings and land. These are assets which are owned and used by the firm for the
long-term (i.e., greater than 1 year), and would not be offered for sale as part of normal
operations.
How do we know whether a cost item should be capitalized (added to the
cost of the asset), or expensed when initially purchased?
Capitalize the initial cost of the asset plus any additional costs that will ready the asset for use.
For example, for machinery for which we are charged a purchase price plus charges for taxes,
freight, installation and testing, the capitalized price is the sum of all of these charges
Expense any expenditures that are considered wasteful or inefficient expenditures.
If we consider the same machinery described above, any charges that might have been
incurred due to damage or inappropriate use should be expensed.
Where does the concept of depreciation fit in?
It is generally assumed that as plant assets are used to generate revenue, the economic
potential of those assets is consumed.
The portion of economic potential that is used up in any given accounting period is called
depreciation (amortization, depletion) , and in keeping with GAAP, is recorded on the income
statement as an expense. Depreciation is a rather special kind of expense in the sense that
there is no outflow of cash associated with this expense. Acknowledging this expense should
decrease net income, and therefore decrease the amount of income tax paid.
With respect to the balance sheet, it is also important that there be a way to indicate to the
reader the current net book value of the asset. GAAP also says that assets must be recorded at
their historical cost. The net book value keeps the historical cost on the balance sheet but
matches it with accumulated depreciation so that the balance sheet reader can determine the
current value of the asset (net of accumulated depreciation).
What methods can be used to calculate depreciation?
There are 2 main methods used to calculate depreciation:
a) straight line method (easier to compute)
concepts to consider---salvage value and estimated life of the asset
Annual depreciation expense = Cost – Salvage value
Est. life of asset
b) accelerated method – this method is appropriate for an asset is more useful during its
early life, and less so as it gets older what will commonly be written is that the
accelerated is twice the rate of the straight line method. In addition, the salvage value is
often thought to be so small as to be ignored, in the calculations for this method.
How does the government deal with depreciation?
The government does not allow depreciation to be included in financial statements for tax
purposes. There is, however, a special type of depreciation which is permitted by the
government which is called Capital Cost Allowance (CCA). It is an accelerated depreciation
that allows a fixed percentage of depreciation on a declining balance, and ignores the salvage
value in the calculations.
How does the government expect companies to treat their expenditures on
fixed assets?
The government says that the following expenditures can be treated as revenue expenditures:
i.e. – expenditures that are expensed
a) expenditures for ordinary maintenance and repairs of existing plant assets
b) expenditures to acquire low cost items that can benefit the firm for several periods
c) expenditures that are considered unnecessaryor unreasonable under the circumstances
The government says that the following expenditures should be treated as capital expenditures
– expenditures that should be added to the cost of the asset
a) initial acquisition cost and additions
b) betterments – the cost of items that will improve the quality of the asset although not
necessarily extend the life of the asset
c) extraordinary repairs – extensive overhauls which can extend the life of the asset
beyond the original estimate.
Example 1:
Bridge Company uses straight-line depreciation in accounting for its machines. On January 3, 2001,
Bridge purchased a new machine for $50,000 cash. The machine’s estimated life was 10 years with
an estimated salvage value of $5000. In 2003, the company decided that its original useful life
estimate should be reduced by 2 years. Beginning in 2003, depreciation was based on an 8-year total
useful life, and no change was made to the salvage value estimate. On January 2, 2004, Bridge added
an automatic guide and a safety shield to the machine at a cost of $3000 cash. These improvements
did not change the machine’s useful life, but did increase the machine’s salvage value to $5500.
Required:
(a) What will be the depreciation expense for 2001, 2002, 2003 and 2004?
(b) Compute the book value of the machine at the end of 2004, that is, after recording the
value for the 2004 depreciation expense.
Solution:
Depreciation Expense for 2001and 2002: Cost – Salvage Value
Life of asset
50,000 – 5000
10
= $45,000/10 = $4500/yr
Depreciation Expense for 2003: The company has changed its estimate of useful life to 8
years from the original estimate of 10 years. With 2 years already gone, this means the
equipment has only 6 years of useful life left:
Depreciation Expense for 2003: Cost – salvage Value
Life of asset
41,000 – 5000 = $36,000/6 = $6,000/yr
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Depreciation Expense for 2004
At the end of 2003, we have a machine worth 35,000 on our books. Enhancements must be
capitalized so the machine is now worth 35,000 + 3,000 = $38,000 for 2004. At the end of
2003, there are 5 years left in the life of the asset, salvage value increases to $5500
Depn Expense for 2004: 38000 – 5500
5
=
Year
Depreciation Expense
2001
2002
2003
2004
$32,500/5 = $6500 yr for the next 5 years
Net Book Value
4500
4500
6000
Accumulated
Depreciation
4500
9000
15,000
6500
21,500
50,000-21,500
28,500
50,000-4500 = 45,500
50,000-9000 = 41,000
50,000-15,000
=
35,000
=
Example 2:
Rahim Corporation purchased a computer for $10,000. The company planned to keep it for four
years after which it expected to sell it for $3,000.
a)Calculate the depreciation expense for each of the first 3 years under a) the straight-line
method and b) the double declining balance method
Straight Line Method:
10,000 – 3000
=
7000/4 = 1750/yr.
4
Double Declining Method:
If depreciation is to be taken over 4 years, then the annual depreciation rate is 100%/4 = 25%.
That rate doubled is 2*25% = 50% . In this method, salvage value is ignored in the calculation,
although we would depreciate only to the salvage value.
Depn expense yr 1 = 50% of 10,000 = 5000
Net book value = $5000
Depn Expense yr 2 = 50% of 5000 = 2500
Net Book value = 10,000 – 7500 = 2500 This can’t be…salvage value is 3000.
Therefore, the depreciation expense for year 2 must be 2000.
Depn Expense yr 3 ---none
b)Assume Rahim sold the computer at the end of the third year for $2500. Calculate the gain or
loss under each amortization method.
Under the straight line method, accumulated depreciation at the end of year 3 is 1750*3 = 5250,
so the net book value is 10,000 – 5250 = 4750. If the computer is sold for $2500, there is a net
loss of $2250.
Under the deouble declining balance method, the computer is fully depreciated at the end of 2
years, but still has the same $3000 salvage value at the end of the 3rd year. In this case, the
sale would result in a loss of $500 ($3000 - $2500)
There are problems at the end of Chapter 7 that you can practise on.