Monday, October 10, 2011

Accelerated Depreciation

CFA Level 1 - Assets

Accelerated depreciation allows companies to write off their assets faster in earlier years than the straight-line depreciation method and to write off a smaller amount in the later years. The major benefit of using this method is the tax shield it provides. Companies with a large tax burden might like to use the accelerated-depreciation method, even if it reduces the income shown on the financial statement

This depreciation method is popular for writing off equipment that might be replaced before the end of its useful life since the equipment might be obsolete (e.g. computers).

Companies that have used accelerated depreciation will declare fewer earnings in the beginning years and will seem more profitable in the later years. Companies that will be raising financing (via an IPO or venture capital) are more likely to use accelerated depreciation in the first years of operation and raise financing in the later years to create the illusion of increased profitability (higher valuation).

The two most common accelerated-depreciation methods are the sum-of-year (SYD) method and double-declining-balance method (DDB):

Sum-of-year Method:

Depreciation in year i = (n-i+1) * (total acquisition cost - salvage value)
n!

Example: For \$2m, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for \$200,000 for scrap parts.

n! = 1+2+3+4+5 = 15
n = 5

Know that this depreciation method produces a variable depreciation expense. At the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straight-line depreciation.
 Look Out!

Double-declining-balance method
The DDB method simply doubles the straight-line depreciation amount that is taken in the first year, and then that same percentage is applied to the un-depreciated amount in subsequent years.

 DDB in year i =  2 * (total acquisition cost - accumulated depreciation)                          n n = number of years

Example
For \$2m, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years the company will be able to sell it for \$200,000 for scrap parts.

Know that this depreciation method produces a very aggressive depreciation schedule. The asset cannot be depreciated beyond its salvage value.
 Look Out!

Change in Useful life or Salvage Value

All depreciation methods estimate both the useful life of an asset and its salvage value. As time passes the useful life of a company's equipment may be cut short (new technology), and its salvage value may also be affected. Once this happens there is asset impairment.

Companies can do two things:

1) They can accelerate the asset's depreciation and fix the reduction in useful life or salvage value over time or

2) They can do the recommended thing, which is to recognize the impairment and report it on the income statement right away.

Note that changes in useful life and salvage value are considered changes in accounting estimates, not changes in accounting principle. The result is this: no need to restate past financial statements.
 Look Out!

Sale, Exchange, or Disposal of Depreciable Assets

Companies that are in the business of exploring and/or extracting and/or transforming natural resources such as timber, gold, silver, oil and gas, among other resources are known as "natural resource companies". The main assets these companies have are their inventory of natural resources. These assets must be reported at their cost of carry (or carrying cost). The carrying costs for natural resources include the cost of acquiring the lands or mines, cost of timber-cutting rights and the cost of exploration and development of the natural resources. These costs can be capitalized or expensed. The costs that are capitalized are included in the cost of carry. The cost of carry does not include the cost of machinery and equipment used in the extraction process.

When a resource company purchases a plot of land, it not only pays for the physical asset but also pays a large premium because of what is contained in the plot of land. That said, once a company starts extracting the oil or natural resource from the land, the land loses value, because the natural resources extracted from a plot of land will never regenerate. That loss in value is called "depletion". That is why cost of carry is depleted over time. The depletion of these assets must be included in the income statement's accounting period. This is the only time land can be depleted.

The carrying costs of natural resources are allocated to an accounting period by means of the units-of-production method.

Example: A company acquired cutting rights for \$1m. With these cutting rights, the company will be able to cut 5,000 trees. In its first year of operation, the company cut 200 trees.
Journal entries:

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