Describe the Depreciation and Amortization Methods Used in Accounting

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The Answer is MEASUREMENT OF DEPRECIATION AND AMORTIZATION

Calculating depreciation or amortization of long-lived assets requires management to

1. Measure the depreciable or amortizable basis of the asset.

2. Estimate its service (useful) life.

3. Decide the pattern of expiration of asset cost over its service life.

Depreciable or Amortizable Basis of Long-Lived Assets: Acquisition Cost Less Salvage Value

Firms base depreciation and amortization charges on the acquisition cost less the estimated salvage value of long-lived assets. The terms salvage value and residual value refer to the estimated proceeds on the disposition of an asset less all removal and selling costs. Firms recover salvage value through the proceeds of sale, so it is not part of the depreciable or amortizable basis of an asset.

For buildings, common practice assumes a zero salvage value on the assumption that the costs a firm will incur in tearing down the building will approximate the sales value of the scrap materials recovered. Other tangible assets may have substantial salvage value. For example, a car-rental firm will replace its automobiles at a time when other owners can use the cars for several years more. The car rental firm expects to recover a substantial part of acquisition cost from selling used cars. Intangible assets related to a contractual right, such as landing rights at an airport or franchise rights to sell a franchiser’s products, generally expire at a specific time and therefore have zero residual value. Identifiable intangibles acquired in a business combination that are separable, such as customer lists or brand names, may have significant salvage values.

Some assets are not readily salable at the end of their useful lives, and retiring them may impose substantial costs. Consider, for example, the cost of dismantling a nuclear power plant at the end of its service life. Firms must estimate the fair value of the dismantling costs and include that amount in the initial measurement of the asset. The firm must also recognize a liability, referred to as an asset retirement obligation, of equal amount. The firm computes depreciation based on the combined cost of the plant assets, including the fair value of the dismantling obligation, because the firm must recover this cost through depreciation during the asset’s useful life.

The second factor in calculating depreciation and amortization is the expected service life. Both physical and functional factors limit service lives. Physical factors for tangible assets include ordinary wear and tear from use, chemical action such as rust, and the effects of wind and rain. The most important functional factor for both tangible and intangible assets is obsolescence. Changes in production processes, for example, might reduce the unit cost of production to the point where a firm finds continued operation of old equipment uneconomical, even though the equipment remains usable. Computers may work as well as ever, but firms replace them because new, smaller computers occupy less space and compute faster. Although display cases and storefronts may not have worn out, retail stores replace them to make the store look better. Technology-based intangibles can become obsolete overnight. Although the legal life of a drug patent is 20 years, the expected economic life of the drug is often less than half of that period.

Estimating service lives presents the most difficult task in the depreciation and amortization calculation. Because obsolescence typically results from external forces, its effect on the service life is particularly uncertain. As a result, firms must review their estimates of service lives each year. A change in this estimate will change the depreciation and amortization amounts going forward.

IFRS, but not U.S. GAAP, requires firms to calculate depreciation separately for significant portions of plant and equipment if those portions have different service lives. Therefore, management must analyze the components of fixed assets to determine if those components have different service lives; if they do, firms must use a component’s service life to depreciate the cost of that component. For example, the airframe and the engines of an aircraft likely have different service lives, and the firm would therefore depreciate them separately.

Pattern of Depreciation and Amortization

An asset’s acquisition cost, salvage value, and service life determine both the total of depreciation or amortization charges and the time span over which to charge those costs. The firm must also select the pattern for allocating those charges to the specific years of the service life.

Depreciation of tangible assets follows one of three basic patterns.

1. Straight line over time.

2. Straight line with respect to usage.

3. Accelerated over time (with higher depreciation in the early years of the service life).

Amortization of intangible assets is usually straight line over time.

The next section describes and illustrates the depreciation and amortization patterns. When acquiring or retiring a long-lived asset during an accounting period, a firm calculates depreciation and amortization only for that portion of the period during which it uses the asset.

Straight-Line (Time) Method

The straight-line (time) method is the most common method for financial reporting. This method divides the acquisition cost of an asset (including the cost to dismantle and retire) less its estimated salvage value by the estimated service life to calculate depreciation or amortization.

Straight-Line (Use) Method.

For assets whose use is not uniform over time, the straight-line (time) method of depreciation may result in depreciation patterns unrelated to usage patterns. A straight-line (use) method is appropriate for such assets.

Accelerated Depreciation

The service capacity of some depreciable assets declines with age or use. Cutting tools lose some of their precision; printing presses require more frequent shutdowns for repairs; rent receipts from an old office building fall below those from a new one. Some assets provide more and better services in the early years of their lives and require increasing amounts of maintenance as they grow older. These cases justify accelerated depreciation methods, which recognize larger depreciation charges in early years and smaller depreciation charges in later years. However, authoritative guidance does not require the use of an accelerated method. Two common accelerated depreciation methods are the declining-balance method and the sum-of-the-years’-digits method.

U.S. GAAP and IFRS provide firms considerable flexibility in choosing their depreciation method(s).

Describe the Depreciation and Amortization Methods Used in Accounting

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