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16/01/2021 08:02:10 AM

Depreciation of fixed aset in international accounting

DEPRECIATION OF FIXED ASET IN INTERNATIONAL ACCOUNTING

Nguyễn Thị Kim Hương

1. Depreciation- A Method Of Cost Allocation

Most individuals at one time or another purchase and trade in an automobile. The automobile dealer and the buyer typically discuss what the trade-in value of the old car is. Also, they may talk about what the trade-in value of the new car will be in several years. In both cases a decline in value is considered to be an example of depreciation.

To accountants, however, depreciation is not a matter of valuation. Rather, depreciation is a means of cost allocation. Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. For example, a company like Goodyear (one of the world’s largest tire manufacturers) does not depreciate assets on the basis of a decline in their fair market value. Instead, it depreciates through systematic charges to expense.

This approach is employed because the value of the asset may fluctuate between the time the asset is purchased and the time it is sold or junked. Attempts to measure these interim value changes have not been well received because values are difficult to measure objectively. Therefore, Goodyear charges the asset’s cost to depreciation expense over its estimated life. It makes no attempt to value the asset at fair market value between acquisition and disposition. Companies use the cost allocation approach because it matches costs with revenues and because fluctuations in market value are uncertain and difficult to measure.

When companies write off the cost of long-lived assets over a number of periods, they typically use the term depreciation. They use the term depletion to describe the reduction in the cost of natural resources (such as timber, gravel, oil, and coal) over a period of time. The expiration of intangible assets, such as patents or copyrights, is called amortization.

2. Factors Involved in the Depreciation Process

Before establishing a pattern of charges to revenue, a company must answer three basic questions:

1. What depreciable base is to be used for the asset?

2. What is the asset’s useful life?

3. What method of cost apportionment is best for this asset?

Depreciable Base for the Asset

The base established for depreciation is a function of two factors: the original cost, and salvage or disposal value. We discussed historical cost in Chapter 10. Salvage value is the estimated amount that a company will receive when it sells the asset or removes it from service. It is the amount to which a company writes down or depreciates the asset during its useful life. If an asset has a cost of $10,000 and a salvage value of $1,000, its depreciation base is $9,000.

Estimation of Service Lives

The service life of an asset often differs from its physical life. A piece of machinery may be physically capable of producing a given product for many years beyond its service life. But a company may not use the equipment for all that time because the cost of producing the product in later years may be too high. For example, the old Slater cotton mill in Pawtucket, Rhode Island, is preserved in remarkable physical condition as an historic landmark in U.S. industrial development, although its service life was terminated many years ago.

Companies retire assets for two reasons: physical factors (such as casualty or expiration of physical life) and economic factors (obsolescence). Physical factors are the wear and tear, decay, and casualties that make it difficult for the asset to perform indefinitely. These physical factors set the outside limit for the service life of an asset.

We can classify the economic or functional factors into three categories:

(1) Inadequacy results when an asset ceases to be useful to a company because the demands of the firm have changed. An example would be the need for a larger building to handle increased production. Although the old building may still be sound, it may have become inadequate for the company’s purpose.

(2) Supersession is the replacement of one asset with another more efficient and economical asset. Examples would be the replacement of the mainframe computer with a PC network, or the replacement of the Boeing 767 with the Boeing 787.

(3) Obsolescence is the catchall for situations not involving inadequacy and supersession.

3.  Methods of Depreciation

The third factor involved in the depreciation process is the method of cost apportionment. The profession requires that the depreciation method employed be “systematic and rational.” Companies may use a number of depreciation methods, as follows.

1. Activity method (units of use or production).

2. Straight-line method.

3. Decreasing charge methods (accelerated):

(a) Sum-of-the-years’-digits.

(b) Declining-balance method.

4. Special depreciation methods:

(a) Group and composite methods.

(b) Hybrid or combination methods

Activity Method

The activity method (also called the variable-charge or units-of-production approach) assumes that depreciation is a function of use or productivity, instead of the passage of time. A company considers the life of the asset in terms of either the output it provides (units it produces), or an input measure such as the number of hours it works. Conceptually, the proper cost association relies on output instead of hours used, but often the output is not easily measurable. In such cases, an input measure such as machine hours is a more appropriate method of measuring the dollar amount of depreciation charges for a given accounting period.

Straight-Line Method

The straight-line method considers depreciation a function of time rather than a function of usage. Companies widely use this method because of its simplicity.

The straight-line procedure is often the most conceptually appropriate, too. When creeping obsolescence is the primary reason for a limited service life, the decline in usefulness may be constant from period to period

The major objection to the straight-line method is that it rests on two tenuous assumptions: (1) The asset’s economic usefulness is the same each year, and (2) the repair and maintenance expense is essentially the same each period.

One additional problem that occurs in using straight-line—as well as some others—is that distortions in the rate of return analysis (income/assets) develop

Decreasing-Charge Methods

The decreasing-charge methods provide for a higher depreciation cost in the earlier years and lower charges in later periods. Because these methods allow for higher early-year charges than in the straight-line method, they are often called accelerated depreciation methods.

What is the main justification for this approach? The rationale is that companies should charge more depreciation in earlier years because the asset is most productive in its earlier years. Furthermore, the accelerated methods provide a constant cost because the depreciation charge is lower in the later periods, at the time when the repair and maintenance costs are often higher. Generally, companies use one of two decreasing-charge methods: the sum-of-the-years’-digits method, or the declining-balance method.

Sum-of-the-Years’-Digits. The sum-of-the-years’-digits method results in a decreasing depreciation charge based on a decreasing fraction of depreciable cost (original cost less salvage value). Each fraction uses the sum of the years as a denominator (5 + 4 + 3 + 2 + 1 = 15). The numerator is the number of years of estimated life remaining as of the beginning of the year. In this method, the numerator decreases year by year, and the denominator remains constant (5/15, 4/15, 3/15, 2/15, and 1/15). At the end of the asset’s useful life, the balance remaining should equal the salvage value.

Declining-Balance Method. The declining-balance method utilizes a depreciation rate (expressed as a percentage) that is some multiple of the straight-line method. For example, the double-declining rate for a 10-year asset is 20 percent (double the straightline rate, which is 1/10 or 10 percent). Companies apply the constant rate to the declining book value each year.

Unlike other methods, the declining-balance method does not deduct the salvage value in computing the depreciation base. The declining-balance rate is multiplied by the book value of the asset at the beginning of each period. Since the depreciation charge reduces the book value of the asset each period, applying the constant-declining balance rate to a successively lower book value results in lower depreciation charges each year. This process continues until the book value of the asset equals its estimated salvage value. At that time the company discontinues depreciation.

 

4.  Special Depreciation Issues

We still need to discuss several special issues related to depreciation:

(1) How should companies compute depreciation for partial periods?

(2) Does depreciation provide for the replacement of assets?

(3) How should companies handle revisions in depreciation rates?

Depreciation and Partial Periods

Companies seldom purchase plant assets on the first day of a fiscal period or dispose of them on the last day of a fiscal period. A practical question is: How much depreciation should a company charge for the partial periods involved?

In computing depreciation expense for partial periods, companies must determine the depreciation expense for the full year and then prorate this depreciation expense between the two periods involved. This process should continue throughout the useful life of the asset.

Assume, for example, that Steeltex Company purchases an automated drill machine with a 5-year life for $45,000 (no salvage value) on June 10, 2009. The company’s fiscal year ends December 31. Steeltex therefore charges depreciation for only 62⁄3 months during that year. The total depreciation for a full year (assuming straight-line depreciation) is $9,000 ($45,000/5). The depreciation for the first, partial year is therefore:

The partial-period calculation is relatively simple when Steeltex uses straight-line depreciation. But how is partial-period depreciation handled when it uses an accelerated method such as sum-of-the-years’-digits or double-declining-balance? As an illustration, assume that Steeltex purchased another machine for $10,000 on July 1, 2009, with an estimated useful life of five years and no salvage value

(62⁄3/12) * $9,000 = $5,000

Depreciation and Replacement of Fixed Assets

A common misconception about depreciation is that it provides funds for the replacement of fixed assets. Depreciation is like other expenses in that it reduces net income. It differs, though, in that it does not involve a current cash outflow.

Note: Compare between IFRS and Vietnam Accounting

Revision of Depreciation Rates

When purchasing a plant asset, companies carefully determine depreciation rates based on past experience with similar assets and other pertinent information. The provisions for depreciation are only estimates, however. They may need to revise them during the life of the asset. Unexpected physical deterioration or unforeseen obsolescence may decrease the estimated useful life of the asset. Improved maintenance procedures, revision of operating procedures, or similar developments may prolong the life of the asset beyond the expected period.8

For example, assume that International Paper Co. purchased machinery with an original cost of $90,000. It estimates a 20-year life with no salvage value. However, during year 11, International Paper estimates that it will use the machine for an additional 20 years. Its total life, therefore, will be 30 years instead of 20. Depreciation has been recorded at the rate of 1/20 of $90,000, or $4,500 per year by the straight-line method. On the basis of a 30-year life, International Paper should have recorded depreciation as 1/30 of $90,000, or $3,000 per year. It has therefore overstated depreciation, and understated net income, by $1,500 for each of the past 10 years, or a total amount of $15,000.