Transcript LECTURE 2

DEALING WITH ASSETS




Fixed assets appear in the Balance Sheet
Cost to the organization is the total cost of acquisition
 Purchase price
 Cost of installation
 Cost of transportation to organization
Assets decrease in value as time progresses,
 i.e. Assets depreciate with time
 Possible exceptions - land, property, collectable items
Classifications of depreciation:
 Physical
 Functional
1
PHYSICAL DEPRECIATION
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Depreciation resulting from physical impairment of the asset
 Example: corrosion of tubes in a heat exchanger
This type of depreciation results in the lowering of the ability of a
physical asset to perform its intended purpose
Primary causes:
 Deterioration due to action of the elements including the
corrosion of pipes, rotting of timber, chemical decomposition,
bacterial action. Deterioration is substantially independent of
use.
 Wear and tear from use that subjects the asset to abrasion,
shock, vibration, impact, etc. These forces primarily result from
use and result in a loss of value over time.
2
FUNCTIONAL DEPRECIATION
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Depreciation resulting from changes in the demand for the services
it is designed to provide
Demand change can result from it being a more profitable tool for
the manufacture of a part, the more efficient achievement of a task
or provision of a specific service. Can also result when the asset is
used in excess of its designed capacity
Primary causes:
 Obsolescence of another asset
 Inadequacy or inability to meet demand placed upon the asset
due to revised product demand
Examples of functional obsolescence include steam trains, sailing
ship (other than for pleasure), horse drawn carriages
3
SUMMARY
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Depreciation:
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“... the measure of the wearing out, consumption or other reduction
in the useful economic life of a fixed asset whether arising from use,
passage of time or obsolescence through technology or market
changes”
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Fact based:
 Original total cost of acquisition of the asset
 Ownership strategy – expected life
4
ACCOUNTING FOR DEPRECIATION
Value of the
asset to the
organization
Asset Purchase
Cost
Initial value
Annual charge
1st Year of use
in production
End 1st year
Annual charge
1st Year of use
in production
End 2nd year
Annual charge
1st Year of use
in production
Some of the
life of the
asset is ‘used’
each year of
use. This
amount is a
charge to the
operation for
the year
Annual
charge
End 3rd year
5
DEPRECIATION
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
Depreciation is the annual amount by which an asset is reduced in
‘book value’ within the organisation
This annual depreciation is also the annual amount charged to the
profit and loss statement in recognition of the use of the asset for the
purposes of producing something
Note the notion of a balance here
we need this to ensure the balance sheet balances!
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‘Book Value’ is the acquisition cost of an asset less its accumulated
depreciation charges.
How do we decide the annual charge?
6
DEPRECIATION METHODS
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Traditional methods
 Linear depreciation - ‘Straight Line’ depreciation
 Accelerated depreciation - Reducing/Declining Balance
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Modern methods
 Accelerated Cost Recovery System (ACRS)
 Modified Accelerated Cost Recovery System (MACRS)
7
STRAIGHT LINE DEPRECIATION
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Characterized by a constant annual depreciation amount
C  R

A
n
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Where:

 A = annual charge
 C = total acquisition cost
 n = useful life of the asset in years
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Simple method, requires definition of ‘n’
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STRAIGHT LINE - EXAMPLE
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1.
2.
3.
A high specification compressor is purchased for 100,000 m.u.
It is expected to have a usable life of 5 years after which it will have
a residual value of 10,000 m.u.
The compressor is used to make balloons. Each balloon costs 1.00
m.u. and sells for 2 m.u.
25,000 balloons are sold each year
Calculate the annual depreciation charge
Show how the asset book value changes over time
Show how the depreciation charge affects reported profit
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STRAIGHT LINE - SOLUTION
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C  R

A
C = 100,000
R = 10,000
n=5
Year
A = 18,000 m.u.
n

1
2
3
4
5
Annual charge to
Profit and Loss
18,00
0
18,00
0
18,00
0
18,00
0
18,00
0
Net Book Value
82,00
0
64,00
0
46,00
0
28,00
0
10,00
0
Sales revenue
Cost of sales
Gross profit
Depreciation
Reported profit
50,00
0
25,00
0
25,00
0
50,00
0
25,00
0
25,00
0
50,00
0
25,00
0
25,00
0
50,00
0
25,00
0
25,00
0
50,00
0
25,00
0
25,00
0
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REDUCING BALANCE METHOD
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Characterized by a constant annual percentage reduction in asset
value
r  1 n

R
C
Where:

 r = depreciation rate
 C = total acquisition cost
 R = residual value of the asset
 n = useful life of the asset in years
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REDUCING BALANCE - EXAMPLE
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1.
2.
3.
A high specification compressor is purchased for 100,000 m.u.
It is expected to have a usable life of 5 years after which it will have
a residual value of 10,000 m.u.
The compressor is used to make balloons. Each balloon costs 1.00
m.u. and sells for 2 m.u.
25,000 balloons are sold each year
Calculate the annual depreciation charge
Show how the asset book value changes over time
Show how the depreciation charge affects reported profit
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REDUCING BALANCE - SOLUTION
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C = 100,000
R = 10,000
n=5
Year
R
r  1
C
n

r = 36.9%
1
2
3
4
5
Annual charge to
Profit and Loss
36,90
0
23,30
0
14,69
0
9,270
5,800
Net Book Value
63,10
0
39,80
0
25,10
0
15,80
0
10,00
0
Sales revenue
Cost of sales
Gross profit
Depreciation
Reported profit
50,00
0
25,00
0
25,00
0
50,00
0
25,00
0
25,00
0
50,00
0
25,00
0
25,00
0
50,00
0
25,00
0
25,00
0
50,00
0
25,00
0
25,00
0
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WHAT IS THE LIFE OF AN ASSET?
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Experience
General policy
‘Standardized’ systems
IRS Class Life Asset Depreciation Range (CLADR)
Asset Description
Automobiles, taxis
Agricultural equipment
Hydraulic parts
Manufacturing
Rubber products
Electrical equipment
Ferrous metals
Furniture
Complete CLADR tables in Revenue Procedure 83-35 (IRS)
Lower Limit
ADR Life
Upper Limit
5
8
40
6
10
50
7
12
60
11
9.5
14.5
8
14
12
18
10
17
14.5
21.5
12
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ACCELERATED COST RECOVERY
SYSTEM (ACRS)
1.
2.
3.
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Ascribed assets to proper class
Assign prescribed depreciation rates
Apply declining-balance depreciation (which switches to straight line
depreciation (see table)
The method assumes no residual asset value at the end of its
service life.
The method assumes the asset is acquired during the first year,
hence 50% of the first years depreciation is charged.
Upon salvage and difference between salvage value and Book
Value determines the tax liability.
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ACCELERATED COST RECOVERY
SYSTEM (ACRS)
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All assets fall into one of four classes of property:
 3-year property includes cars and light vehicles, machinery and
equipment used in research and experimentation and all
equipment having an CLADR of 4 years or less.
 5-year property includes all personal property not included in any
other class, most production equipment and public utility
property with 5 < CLADR < 18 years.
 10-year property includes public utility property with
18 < CLADR < 25 years and depreciable buildings and
structural components with CLADR < 12.5 years.
 15-year property includes depreciable buildings with CLADR >
12.5 years and public utility property with CLADR > 25 years.
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ACCELERATED COST RECOVERY
SYSTEM (ACRS)
Recovery year
3-year property
5-year property
10-year property
15-year property
1
25
15
8
5
2
38
22
14
10
3
37
21
12
9
4
21
10
8
5
21
10
7
6
10
7
7
9
6
8
9
6
9
9
6
10
9
6
11
6
12
6
13
6
14
6
15
6
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ACRS - EXAMPLE
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An asset classified as a 5-year property is acquired for a total cost of
5,000 m.u.
The estimated salvage value is 1,000 m.u. at any time after
acquisition
What depreciation charge is made each year?
What is the impact of salvage?
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ACRS - EXAMPLE
Acquisition cost = 5,000, life = 5 years
End of year, t
Depreciation charges during
year t
0
Book value at end of year t
5,000
1
0.15 * 5,000 = 750
4,250
2
0.22 * 5000 = 1,100
3,150
3
0.21 * 5000 = 1,050
2,100
4
0.21 * 5000 = 1,050
1,050
5
0.21 * 5000 = 1,050
0
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ACRS - EXAMPLE
Acquisition cost = 5,000, life = 5 years, Salvage value = 1,000
End of year, t
Depreciation charges during
year t
Book value at end of year t
0
5,000
1
0.15 * 5,000 = 750
4,250
2
0.22 * 5000 = 1,100
3,150
3
0.21 * 5000 = 1,050
2,100
4
0.21 * 5000 = 1,050
1,050
5
0.21 * 5000 = 1,050
0
If asset sold before fully depreciated no depreciation can be charged in
the year of salvage.
Consider salvage in year 3
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ACRS - EXAMPLE
Acquisition cost = 5,000, life = 5 years, Salvage value = 1,000
End of year, t
Depreciation charges during
year t
0
Book value at end of year t
5,000
1
0.15 * 5,000 = 750
4,250
2
0.22 * 5000 = 1,100
3,150
3
Asset sold during this year
4
5
Consider salvage in year 3
Book value at time of disposal = 3,150. Salvage value = 1,000.
Write-off to Profit and Loss Account = 3,150 - 1,000 = 2,150 m.u.
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MODIFIED ACCELERATED COST
RECOVERY SYSTEM (MACRS)
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Introduced into the U.S. in 1986 through the Tax Reform Act
Still used
Similar to ACRS but
 Increased number of property classes
 Revised depreciation rates
 Some realignment of class definitions
 No distinction between new and used property
 Salvage value is still ignored
 50% depreciation in first year + 50% in final year + 1
Quick look at the classes and depreciation rates
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MODIFIED ACCELERATED COST
RECOVERY SYSTEM (MACRS)
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Personal Property
 All business property, other than structural components,
contained in or attached to buildings or real property is tangible
personal property. Examples include machinery, vehicles used
for business & equipment.
 Copyrights and patents are considered to be intangible personal
property
Real Property
 Property that is permanently part of the land.
 Buildings and their structural components
 Air conditioning systems, plumbing & wiring
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MODIFIED ACCELERATED COST
RECOVERY SYSTEM (MACRS)
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Personal Property classes
 3-year property - special material handling devices and special
tools for manufacturing. ADR < 4 years
 5-year property - autombiles, light and heavy trucks, computers,
copiers, semiconductor manufacturing equipment, equipment
used in research. 4 < ADR < 10 years
 7-year property - property not assigned to another class, office
furniture, fixtures, single-purpose agricultural structures.
10
< ADR < 16 years
 10-year property - assets used in petroleum refining,
manufacture of castings, forging, manufacture of tobacco
products and some food products. 16 < ADR < 20 years
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MODIFIED ACCELERATED COST
RECOVERY SYSTEM (MACRS)
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Personal Property classes
 15-year property - telephone distribution equipment, municipal
water and sewerage treatment plants. 20 < ADR < 25 years
 20-year property - vessels, barges and tugs and municipal
sewers.
25 years < ADR
Real Property classes
 Residential property - includes apartment buildings and rental
houses. [Straight line depreciation 27.5 years with half-year
convention1]
 Nonresidential property - office buildings, warehouses,
manufacturing facilities, refineries, mills, parking facilities, fences
and roads. [Straight line depreciation 31.5 years with half-year
convention1]
1 Half-year’s
depreciation in year of purchase & year of disposal
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MODIFIED ACCELERATED COST
RECOVERY SYSTEM (MACRS)
Recovery
year
3-year
property
5-year
property
7-year
property
10-year
property
15-year
property
20-year
property
1
33.33
20.00
14.29
10.00
5.00
3.75
2
44.44
32.00
24.49
18.00
9.50
7.22
3
14.81
19.20
17.49
14.40
8.55
6.68
4
7.41
11.52
12.49
11.52
7.70
6.18
5
11.52
8.92
9.22
6.93
5.71
6
5.76
8.92
7.37
6.23
5.28
7
8.92
6.55
5.90
4.89
8
4.46
6.55
5.90
4.52
9
6.55
5.90
4.46
10
6.55
5.90
4.46
11
3.28
5.90
4.46
5.90
4.46
12
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MODIFIED ACCELERATED COST
RECOVERY SYSTEM (MACRS)
Recovery
year
3-year
property
5-year
property
7-year
property
10-year
property
15-year
property
20-year
property
13
5.90
4.46
14
5.90
4.46
15
5.90
4.46
16
2.95
4.46
17
4.46
18
4.46
19
4.46
20
4.46
21
2.23
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