Historical Cost Principle, Asset Impairment and Depreciation - Essay Example

? Historical cost principle, asset impairment and depreciation How historical cost principle is used to account for long-lived assets Historical cost principle values assets at the original cost of acquisition. The concept takes into consideration the purchasing cost of an asset. This principle works well where long-lived assets are involved. In order to understand the concept, it is worth discussing the Generally Accepted Accounting Principle that is in agreement with the historical cost principle. The Generally Accepted Accounting Principle requires reporting of assets based on the balance sheet at historical cost. The GAAP mainly relies on consistency of data conveyed by business financial records. Since historical methods does not depend on the speculated market prices, rather a real transaction that occurred, the cost is regarded as most reliable. For this reason, the historical cost principle is best used for reporting long-lived assets. It is the best method for reporting assets whose disposal may not be done in the near future. Examples of these assets include land, buildings, fixture, equipment and natural resources such as mineral deposits, oil wells and timber tracks. Under the historical cost principle, assets are recorded at acquisition cost as indicated on the balance sheet. In accounting for purchases of long-term assets, interest expense is subtracted from the original cost or cost of acquisition. The book value of long-term assets can be calculated by getting the accumulated depreciation subtracted from acquisition cost. To estimate an asset’s useful life, important variables such as acquisition cost, depreciation expense per year and salvage value should be determined. The following methods are used to estimate asset’s useful life; straight-line depreciation method, production method and double (declining) methods. Useful life can then be calculated as follows: Asset impairment Asset impairment refers to an abrupt deterioration in the usefulness of a long-term asset often caused by damage effects on the asset, obsolescence due to the ever-changing technology or a change in the county’s laws prohibiting the use of an asset. It occurs when the future benefit of an asset known as market value is below the recorded book value (cost-accumulated depreciation). When impairment occurs, the current market value of the asset should be written down and a loss recognized. First, long-lived assets are selected for purposes of performing impairment testing as well as establishing the net book value. Secondly, determine the level of impairment by finding the total undiscounted cash flows expected from the selected assets. The net book and the undiscounted cash flow figures are then compared with intent of establishing which of the values have higher figures. If the net book value is higher than the undiscounted cash flow value, then the amount of variance is determined and recorded. Common Asset Depreciation Methods Depreciation refers to two main concepts; i. Diminished value of assets also called fair value This principle or concept has an impact on the balance sheet of a firm or a business entity. ii. Depreciation with corresponding principle, which is the allocation of the asset cost to periods upon which that particular asset is in use. This affects the net gain of reported assets. It is worth noting that when computing depreciation using a particular method, the cost of an asset is allocated to that period the use of an asset covers or is used. The expense is vital for purposes of financial reporting and taxation. In choosing a suitable method of computing depreciation, value of assets, the type and periods upon which the asset is used is important. These computing methods are specified in laws and statutes or accounting standards that vary from one country to another. It is important to note that some depreciation computing methods exists, but the common methods include; fixed percentage depreciation method, straight-line computing method and declining balance. It is also important to note that depreciation balance of an asset is put forth at the instant an asset is put to use. There are three common asset depreciation methods, which include; Straight-Line depreciation method It is the simplest and commonly used depreciation computing method. This is a case where the depreciation expense is of the same amount each year. In straight-line depreciation method, depreciation value is calculated from the initial cost of the asset. This same amount is then claimed each year. The formula used in the calculation of depreciation expense per year is; For example, a machine that depreciates over a period of 10 years having been bought at a total cost of $ 34 000, and given salvage value of $ 4000 depreciates at $ 3000 annually. If straight-line computation method the book value at the end of the 10 years will be $ 4 000. Book value at the beginning of the year ($) Depreciation expense in year ($) Accumulated depreciation at the end of the year ($) Book value at the end of the year ($) 34 000 (original cost) 3 000 3 000 31 000 31 000 3 000 6 000 28 000 28 000 3 000 9 000 25 000 25 000 3 000 12 000 22 000 22 000 3 000 15 000 19 000 19 000 3 000 18 000 16 000 16 000 3 000 21 000 13 000 13 000 3 000 24 000 10 000 10 000 3 000 27 000 7 000 7 000 3 000 30 000 4 000 (scrap value) At the end of the 10 years, the machine will have depreciated from the original value of $ 34 000 to a scrap value of $ 4 000 Production depreciation method It is sometimes referred to as the Units-of-Production Method. In this method depreciation rate is calculated as follows; The units in this case may be number of products or even number of hours. (Double) Declining balance It is also called the accelerated declining method. “The method yields a higher amount of depreciation expense in the early years of an asset’s useful life, and a lower amount depreciation expense in the later years” (Gross, 2005). Depreciation rate is calculated as follows; Each year’s depreciation expense is the product of the book value of the asset and depreciation rate. The depreciation rate always remains the same but the book value changes every year. References Gross, M. J., McCarthy, J. H., & Shelmon, N. E. (2005). Financial and accounting guide for not- For-profit organizationsHoboken, N.J: Wiley. Pizzey, A. (2001). Accounting and finance: A firm foundation. London: Continuum. Ryan, B. (2004). Finance and accounting for business. London: Thomson Learning. Read More