DEPRECIATION Chapter Fourteen Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

1. Explain the concept and causes of depreciation. 2. Prepare a depreciation schedule and calculate partial-year depreciation. LU 14-1: Concepts of Depreciation and the Straight-Line Method LEARNING UNIT OBJECTIVES LU 14-2: Units-of-Production Method 1. Explain how use affects the units-of-production method. 2. Prepare a depreciation schedule LU 14-3: Declining-Balance Method 1. Explain the importance of residual value in the depreciation schedule. 2. Prepare a depreciation schedule. LU 14-4: Modified Accelerated Cost Recovery System (MACRS) with Introduction to ACRS (1986, 1989, 2010) 1. Explain the goals of ACRS and MACRS and their limitations. 2. Calculate depreciation using the MACRS guidelines.

Estimated Useful Life – Number of years or time periods for which the company can use the asset Depreciation – An estimate of the use or deterioration of an asset Asset Cost – Amount paid for an asset including freight charges CONCEPT OF DEPRECIATION Residual Value (Salvage Value) - Expected cash value at the end of an asset’s useful life. 14-3

Accumulated Depreciation – The total amount of the asset’s depreciation taken to date. CONCEPT OF DEPRECIATION Book Value - The unused amount of the asset cost that may be depreciated in future accounting periods. Book value cannot be less than residual value. Book value = Asset cost -- Accumulated book value 14-4

CAUSES OF DEPRECIATION Product ObsolescencePhysical Deterioration 14-5

STRAIGHT-LINE METHOD Distributes the same amount of expense to each period of time. Depreciation expense = Cost -- Residual value each year Estimated useful life in years Ajax Company bought equipment for $2,500. The company estimates that the equipment’s period of useful life will be 5 years. After 5 years the residual value is $500. Calculate depreciation expense and complete a depreciation schedule. ($2, $500) 5 100% = 100% # of yrs. 5 = $400= 20% 14-6 Example:

DEPRECIATION SCHEDULE 14-7

DEPRECIATION FOR PARTIAL YEARS Assume Ajax Company bought equipment on May 6. The cost is $2,500 with an estimated useful life of 5 years. The residual value is $500. What would be depreciation for the first year? 15th Rule $2, $500 = 5 May, June, July, Aug, Sept., Oct., Nov., & Dec. $400 x 8 = $ th Rule: If a company buys an asset before the 15 th of the month, the company calculates the asset’s depreciation for a full month.

UNITS-OF-PRODUCTION METHOD Depreciation determined by how much the company uses the asset. Depreciation expense = Cost -- Residual value per unit Total estimated units produced Ajax Company (in Learning Unit 14–1) buys equipment ($2,500), and the company estimates how many units the equipment can produce. Let’s assume the equipment has a useful life of 4,000 units. After 5 years the residual value is $500. Calculate depreciation expense and complete a depreciation schedule. Depreciation = Unit x Units amountdepreciation produced 14-9 Example: ($2, $500) 4000 = $.50=

DEPRECIATION SCHEDULE 14-10

Rate = 100% 5 years Depreciation expense = Book value of equipment x Depreciation each year at beginning of year rate Accelerated method which computes more depreciation expense in the early years of the asset’s life. Uses up to twice the straight-line rate. DECLINING-BALANCE METHOD x 2 = 40% Ajax Company (in Learning Unit 14–1) buys equipment ($2,500), and the company estimates how many units the equipment can produce. Let’s assume the equipment has a useful life of 4,000 units. After 5 years the residual value is $500. Calculate depreciation expense and complete a depreciation schedule. Example:

DEPRECIATION SCHEDULE 14-12

MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) Federal tax laws state how depreciation must be taken for income tax purposes. Provides users with tables giving the useful lives of various assets and the depreciation rates

KEY POINTS OF MACRS 1. It calculates depreciation for tax purposes. 2. It ignores residual value. 3. Depreciation in the first year (for personal property) is based on the assumption that the asset was purchased halfway through the year. (A new law adds a midquarter convention for all personal property if more than 40% is placed in service during the last 3 months of the taxable year.) 4. Classes 3, 5, 7, and 10 use a 200% declining-balance method for a period of years before switching to straight-line depreciation. You do not have to determine the year in which to switch since Table 14.5 builds this into the calculation. 5. Classes 15 and 20 use a 150% declining-balance method before switching to straight- line depreciation. 6. Classes 27.5 and 31.5 use straight-line depreciation

MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) (TABLE 14.4) 14-15

ANNUAL RECOVERY FOR MACRS (TABLE 14.5) 14-16

DEPRECIATION SCHEDULE 14-17