1. Depreciation and Amortization

2.  IS NOT Accumulation of a cash fund for asset replacement A determination of an asset’s current value  IS The systematic allocation of an asset’s cost to the periods of benefit Financial Accounting, 7e Stice/Stice, 2006 © Thomson 2

3.  Causes of depreciation: ◦ Physical deterioration  Due to use, passage of time, and exposure to the elements ◦ Obsolescence  Outdated, outmoded, or inadequate Financial Accounting, 7e Stice/Stice, 2006 © Thomson 3

4.  Residual value (salvage value) ◦ An estimate of the asset’s worth at the time of its disposal  Depreciable cost ◦ The original cost minus the residual value  Estimated useful life ◦ A measure of the service potential in terms of years or units produced Financial Accounting, 7e Stice/Stice, 2006 © Thomson 4

5.  Straight-line ◦ Allocates an equal amount of asset cost per year  Units-of-production ◦ Allocates cost based on the productive output of the asset  Declining balance ◦ An accelerated method which allocates more cost to depreciation in the early years than the later years Financial Accounting, 7e Stice/Stice, 2006 © Thomson 5

6. 6 Assume the following information: Equipment purchase dateJanuary 1, 2006 Acquisition cost$40,000 Estimated residual value $4,000 Depreciable cost$36,000 Estimated useful life 5 years

7. Financial Accounting, 7e Stice/Stice, 2006 © Thomson 7

8. 8 An equal amount of depreciation expense is allocated to each period

9. Financial Accounting, 7e Stice/Stice, 2006 © Thomson 9 Annual depreciation is determined by applying a fixed percentage to the remaining book value at the beginning of each year ‘rate’ is the multiple of straight-line (double is 2 times the straight-line rate)

10. Financial Accounting, 7e Stice/Stice, 2006 © Thomson 10 2010’s expense is adjusted so that ending book value is not less than established residual value

11. Financial Accounting, 7e Stice/Stice, 2006 © Thomson 11 Accelerated methods allocate a greater portion of cost to the earlier years of the asset’s life

12.  Both methods allocate a depreciable cost of $36,000 over a five-year period Financial Accounting, 7e Stice/Stice, 2006 © Thomson 12

13.  Management may choose any GAAP-based method for financial reporting  Theoretically, best to use a method that reflects the pattern of the asset’s revenues or benefits ◦ The straight-line method is appropriate for assets whose benefits diminish on a fairly uniform basis ◦ The double-declining-balance method is appropriate for assets that give up a greater portion of their benefits in the early years  Most companies use the straight-line method due to its simplicity Financial Accounting, 7e Stice/Stice, 2006 © Thomson 13

14.  Salvage value is ignored for tax purposes  The half-year convention is used ◦ Property is depreciated for half the taxable year in which it is placed in service, regardless of when use actually begins  Deferred tax liability arises ◦ Accelerated depreciation for tax purpose vs straight-line depreciation for financial purpose ◦ Earlier years have higher tax deductions ◦ Later years have higher taxable income Financial Accounting, 7e Stice/Stice, 2006 © Thomson 14

15.  Depreciation is not a source of cash; it is a noncash expense  Depreciation indirectly affects cash flow ◦ depreciation reduces taxable income ◦ results in lower income taxes being paid Financial Accounting, 7e Stice/Stice, 2006 © Thomson 15

16.  Finite life intangibles: ◦ Amortize over the economic useful life or legal life, whichever is shorter ◦ Not to exceed 40 years ◦ Direct subtraction from the asset account  Indefinite life intangibles: ◦ No amortization Financial Accounting, 7e Stice/Stice, 2006 © Thomson 16