Fixed Assets and Depreciation Richard O’Callaghan

Current v. Long-term Assets Current Assets – Cash and other assets reasonably expected to be converted to cash or used up (consumed) within one year. (Accounts Receivable, Supplies, Inventory, Prepaid Expenses) Long-term Assets (also called Plant Assets or Fixed Assets) – Assets used in the business, not reasonably expected to be converted to cash or used up in one year. (Equipment, property, machinery, vehicles.)

Nothing lasts forever The cost (amount paid for it) of a long-term asset must be expensed (proportionally) over the time period the asset is used. There are 3 methods used to pro-rate the cost of an asset over the asset’s “life.” The 3 methods are: depreciation, amortization, and depletion

Charging Depreciation Richard O’Callaghan

Depreciation Used for tangible assets (equipment, machinery, vehicles) The cost of the asset is prorated over its useful life.

Using Long-term Assets A business buys long-term assets to earn revenue As the assets are used, and as time passes, they decrease in value (e.g., newer models become available.) For example – cars decrease in value as soon as they are driven off the lot.

Long-term assets All long-term assets have a limited useful life (except land) To match revenue with expenses used to earn the revenue, a part of an asset’s cost must be “expensed” in each fiscal period that the asset is used to earn revenue.

Expensing Long-term assets Businesses use an account called “Depreciation Expense” Depreciation Expense – the part of a long-term asset’s cost that is transferred to an expense account each fiscal period over the asset’s useful life.

Depreciation Depreciation expense does not represent the actual decline in value of an asset. It tries to allocate the asset’s cost over several fiscal periods Never depreciate below salvage value

Calculating Depreciation Expense You need to know 3 things to calculate depreciation expense: Original cost of the asset: all costs paid to make the asset useable to the business, including delivery and installation costs Estimated useful life of the asset – how long do you expect it to last Estimated scrap value – what you can sell it for (if anything) when you’re done using it

Calculating Useful Life: Two factors affect a long-term asset’s useful life: Physical depreciation -- wear and tear on the asset; an asset may deteriorate due to aging and weathering Functional depreciation – an asset becomes inadequate or obsolete – can no longer perform as needed. Obsolete means a newer machine can operate more efficiently or produce better service

Calculating Depreciation Expense Formula: Original Cost – Scrap Value = Depreciation Expense This is the total depreciation on the asset for its useful life

Calculating Depreciation Expense (Continued) To calculate the Depreciation Expense for a financial year: Depreciation Expense (Total) = Annual Depreciation Charge Years of Useful Life This type of depreciation is called straight line method of depreciation charges an equal amount of depreciation expense for a long-term asset, in each year of its useful life

Example: A business buys a piece of machinery that costs €8,000 plus €200 for installation costs, it is estimated to have a useful life of 5 years and that it will have a scrap value of €1,000 Original Cost = €8,200 (price €8,000 + installation €200) Yearly depreciation €8,200 - €1,000 5 = €1,440 per year

Class Question A business buys a truck for €30,000. Its useful life is 5 years and it is expected to have a scrap value of €15,000 What is the annual depreciation expense, using straight line depreciation?

Recording Depreciation Expense When you record depreciation, you do not reduce the “book value” of the asset There is a separate Depreciation Expense account to charge the expense, and another account that keeps a record of the amount of depreciation charged This account is known as Accumulated Depreciation It is deducted from the Book Value of the assets when the Balance Sheet is being prepared each year

Depreciation Note to the Accounts Motor Vehicles Fixtures and Fittings Office Equipment Total € Cost 1st Jan 2016 200,000 80,000 100,000 380,000 Accumulated Depreciation 40,000 50,000 190,000 Net Book Value 1st Jan 2016 Depreciation 2016 20,000 8,000 10,000 38,000 Net Book Value 31st Dec 2016 32,000 152,000

Asset Records Most businesses keep a separate record for each long-term asset Individual records are contained in a Fixed Asset Register (or sometimes just “Asset Register”) Includes information such as the date of purchase, the purchase price of the asset, information about the asset (e.g., model / serial no.) asset’s basis for depreciation*, estimated useful life, estimated scrap value, book value, and accumulated depreciation * Sometimes an approach called ”Reducing Balance” is used (more soon)

“Book Value” Book value is what an asset is worth according to the books of the business. It is the difference between its basis (original cost) and accumulated depreciation.

Calculating Book Value Suppose a machine has a purchase price of €5,000, and accumulated depreciation of €500. What is the machine’s Book Value? Basis - Accumulated Depreciation €5,000 - €500 = €4,500

Reducing Balance Depreciation Most assets do not depreciate the same amount each year Most assets depreciate / lose value faster in the first few years they are owned, and less in later years For these assets, more depreciation should be charged in the early years than the later years

Reducing Balance Depreciation The depreciation charge for each year is charged on the book value of the previous year This means that the charge is different each year and the asset value never gets to zero For example consider an asset purchased for €30,000 charged at 20% reducing balance each year Year 1 Purchase €30,000 Year 1 Depreciation €6,000 Year 1 Net Book Value €24,000 Year 2 Depreciation €4,800 Year 2 Net Book Value €19,200 Year 3 Depreciation €3,840 Year 3 Net Book Value €15,360 Etc

Disposal of Fixed Assets Richard O’Callaghan

Disposing of Fixed Assets When a business can no longer use a long-term asset, it disposes of it by selling it, trading it, or discarding it The company will need to: Remove the asset and its accumulated depreciation from the books Recognise any cash or other (new) assets received for the old asset and Recognise the gain or loss (if there is any) on the disposal of the asset

Calculating the Gain or Loss on Disposal A gain or loss on a sale of a long-term asset is the difference between the value of the asset received and the book value of the asset sold Asset Purchase Price €35,000 Accumulated Depreciation (€30,000) Net Book Value €5,000 Amount received on disposal (€4,000) Loss on Disposal €1,000