The Financial Accounting Standards Board - Coursework Example

Depreciation Depreciation The Financial Accounting Standards Board (FASB) is charged with developing principles by which all accountants must abide with when preparing financial statements (CCH Incorporated 2005, 13). Depreciation implies apportioning the cost of an asset or economic resource, over a stated number of periods. The Financial Accounting Standards Board (FASB) depreciation rules allow organizations to make complete and accurate accounting reports at the end of every year or quarter. Key analysis of definition and guidelines of depreciation by FASB solely point to the view that it is a reduction in the value of a given asset or economic resource with the passage of time statements (CCH Incorporated 2005, 31). There are various reasons and theories behind the idea of depreciation. Depreciation is intended to reflect the real consumption of the underlying asset. This is undertaken where the carrying extends of the asset, or economic resource has been greatly reduced to save its value by the period its useful life is over (Stickney 2010, 16). Depreciation is helpful in various ways in accounting In calculating the profits from the transaction, the receipts from the activity must be lowered by appropriate costs. Depreciation is generally a technique of allocation, not valuation, even though it computes the value put on the asset in the balance sheet. Any firm or income creating activity using tangible assets may incur expenses related to those assets. If a resource is expected to produce a gain in the future, some of these expenses must be deferred as opposes treated as a present expense. The firm then notes depreciation in its financial reporting as the present periods allocation of such cost. This is normally done in a systematic manner. Normally this involves four criteria that are cost of the asset, a method of apportioning the cost over such period of life and useful life Depreciation causes are those events that cause a reduction in the worth of a given asset or economic resource with the passage of time. The following are common causes of depreciation: Physical Deterioration Physical deterioration is caused mainly from wear and tear and specifically when the asset is in use. Physical deterioration may occur due to rot, rust and erosion from being exposed to rain, wind, sun and other features of nature (Wolf and Chester Fitch 1994, 56). During wear and tear there is a decline in the efficiency of asset or an economic resource due to the assets continuous use. When an asset stops to be efficient, the worth or value reduces, and depreciation arises (Stickney 2010, 33). Physical deterioration is common tangible assets like machinery and plant, building, tools, furniture and equipment used in the factory. Economic Factors Economic factor is a problem on Inadequacy and Obsolescence. Obsolescence implies the process of becoming outdated or obsolete. Old machinery though in perfect physical condition may be considered obsolete by the introduction of new modern model that gives more than the old machinery (Stickney 2010, 39). Inadequacy, on the other hand, refers to the termination of the use of an asset due to development and alteration in the size of the firm or the firms production capability. However, inadequacy and obsolescence do not necessarily mean that the asset is scrapped. Inadequacy and Obsolescence may also be combined to mean changes in fashion, and are external factors that are answerable for throwing out of assets even if they are in good condition statements (CCH Incorporated 2005, 47). Time Factors There are given assets that in a way have a fixed point of legal life. These examples include as lease, software, copyrights and patents. Case in point, a lease can be entered into for any time frame while a patents legal life is always for some years but on certain basis this may be extended. Allocation for the consumption of these assets is referred to as amortization as opposed to depreciation (Stickney 2010, 26). Deletion Some sets of assets are of wasting in nature perhaps due to the extraction of raw materials from them. For instance, the case with wasting resources such as oil wells, quarries, forest stand and mines. On account of continuous extraction from them, a period will come where mines and oil wells get fully exhausted. These materials are then either are sold as raw materials to other firms or used by the organization to make something else. To postulate for the consumption of an assets or resource of wasting the nature is referred to as a provision for depletion (Wolf and Chester Fitch 1994, 71). Accident: An asset or economic resource may reduce in value over time because of meeting of an accident. Methods of depreciation There are various methods for calculating depreciation, usually based on either the level of use of the asset or the passage of time 1. Straight-line depreciation Straight-line depreciation is the easiest and most often used method or technique. In this technique, the organization estimates the scrap value of the asset at the end or culmination of the period through which it will be used to give revenues. This is what is called to as a useful life. The business will then charge the same value to depreciation annually over that period until the value revealed for the asset has reduced from the original cost to the recoup value (Wolf and Chester Fitch 1994, 63). Formula given by Depreciation = (Cost - Residual value) / Useful life Example to illustrate Straight-line depreciation On May 1, 2011, a business purchased a machine at the cost of $140,000. This machine is estimated to possess 5-year useful life. After the end of the 5th year, the residual value will be $20,000. The organization considers depreciation to the nearest whole month. Calculate the depreciation expenses for years 2011, 2012 and 2013 applying straight-line depreciation method. Depreciation for year 2011 = ($140,000 - $20,000) multiplied by 1/5 x 9/12 = $18,000 Depreciation for year 2012 = ($140,000 - $20,000) by 1/5 x 12/12 = $24,000 Depreciation for year 2013 = ($140,000 - $20,000) by 1/5 x 12/12 = $24,000 Benefits of Straight-line depreciation method It is simple and predictable, and accountant knows exactly what to charge yearly. Inflated valuation of assets is possible and as such the business reported income may be higher than if the actual depreciation was used. You can compute your gains for future years easily; far as how much you will save due to depreciation. As profits grow, depreciation costs stay the same. This enables financial forecasts for many years. Depreciation is a business cost which may be deducted from taxes, and this method of depreciation gives a fixed deduction for each year of an assets useful life. Equally, accelerated depreciation uses a declining scale to account for the loss of value. It is worth noting that one period might be used to provide a huge tax deduction in the first years of an asset’s life span with lower deductions every year. 2. Double decline Balance method The double-declining balance method is a kind of accelerated depreciation technique that obtains a higher depreciation charge in the initial year of an assets life and gradually reduces depreciation cost in subsequent years (Stickney 2010, 65). Example to illustrate Double decline Balance method Suppose an organization has an asset with $1,000 initial cost, $100 residual value, and five years of useful life. First, the straight-line depreciation change would be 1/5, for instance, 20% annually. Under this method, double the rate, e.g. 40% depreciation rate would be used. The table illustrates this, for clarity: Depreciation change Depreciation cost Accumulated depreciation Book value at year -end original cost $1,000.00 40percent 400.00 400.00 600.00 40percent 240.00 640.00 360.00 40percent 144.00 784.00 216.00 40percent 86.40 870.40 129.60 129.60 - 100.00 29.60 900.00 scrap amount 100.00 When applying the double-declining-balance method, the residual value is never considered in obtaining the yearly depreciation. The book value of the resource that is depreciated is not brought beyond its salvage value, regardless of the technique used. With the declining balance technique, the result is the depreciation rate that would enable exactly for full depreciation of the asset by the end of the period. Applying the formula: Where N is the approximate life of the asset (for instance, in years) Benefits of Double Decline Balance Method The method is important where the usefulness of an asset falls over the assets useful life (i.e. IT equipment). 3. Sum-of-years-digits depreciation method Sum-of-years digits are a depreciation technique that outcome in a more accelerated write-off than in straight line method, but less accelerated than that of the double-declining balance technique statements (CCH Incorporated 2005, 67). Under Sum-of-years-digits, annual depreciation is obtained by multiplying the depreciable expense by various fractions depending on the total of the assets useful life digits. In the method, the sum of the digits can be obtained by using the formula. (m2+m)/2, Where m is the equivalence to the useful life of a given asset. To determine depreciation expense under the sum-of-years-digits method -- assume a piece of equipment is bought for $100,000 with the equipment’s residual value being 40,000 and a useful life of five years. To start with, obtain the depreciation rate by summing the years of useful life, or 1+2+3+4+5 gives to 15. Then, get the depreciation cost for year five, 100,000 - 40,000 * 5/15, or $ 20,000. For year 4, the computation uses book value of the asset (100,000 - 20,000) deducted from its residual value which is 40,000 and then multiplied by the rate for the year given 4 (4/15). Benefits Sum-of-years-digits depreciation method The method is another kind of accelerated method, computing higher depreciation in the initial few years. However, with this technique, the depreciation is much huge for the initial years of use more than it is with the double-declining-balance method or simple. This methods benefits are very similar to the previous method. It gives a more accurate fall in the worth of the asset if it is being utilized more often in the first years. In addition, it reduces tax burdens much more than the straight-line technique does (Stickney 2010, 54). If, for financial purpose, a business entity prefers an even huge estimate of depreciation during the initial years, this is the perfect method for the business. 4. Unit of Production method The units-of-production depreciation technique allocates an equal value of the expense to every unit produced or service made by the asset. This procedure is typically directed to assets used in the production channel. The formula to obtain depreciation cost involves two key steps: First compute depreciation per unit ((assets initial cost - approximated salvage value) / approximated total units of production during the assets life span); finally obtain the cost for the accounting time (it is depreciation per unit Y number of units produced in that time) statements (CCH Incorporated 2005, 74). An illustration of how to compute depreciation cost under the units of production: given a piece of equipment, purchased for $ 100,000 with a residual value of 40,000, is predicted to produce 10,000 units throughout its useful life. Start by, computing the depreciation for every unit given as 100,000 - 40,000 / 10,000, or $ 6 for every unit. The depreciation value for the period is the per unit value multiplied by the periods given production amount -- assume 1,000 units were produced; depreciation cost equals $ 6,000 (1,000 * 6). This value is disclosed on the income statement and is a portion of the assets accumulated depreciation on the balance sheet. Benefits of unit of production method The unit of production method goal is to overcome the drawbacks of the straight line method by relating the actual function of an asset to the estimated cost in value. Units of Production technique may be useful where there is a huge correlation between action of an asset and the assets given physical wear and tear. This is due to the view that no depreciation under this technique is charged when an asset stays idle (Stickney 2010, 59). 5. Annuity depreciation method Annuity depreciation procedures are not based on the period, but on a level of Annuity. For example, this may be miles driven for a car or a cycle totals for a given machine. When an asset is purchased, the assets life is approximated in terms of this rate of activity. If the car above is predicted to go up to 50,000 miles in its entire life then each mile depreciation rate is obtained by: ($17,000 cost - $2,000 recoup) / 50,000 miles = $0.30 each mile. Every year, the depreciation cost is then computed by multiplying the amount of miles driven by the each-mile depreciation rate. Benefits of Annuity depreciation method Interest on capital investment is taken into consideration. This technique is perceived to the most exact, detailed and scientific form from the point of view of computation. This technique is not appropriate for those assets that require, additions, frequent and Extension. Usually, the interest on capital investment is keenly taken into account. This technique is perceived to the most precise, exact and scientific method from the point of view of computation (Stickney 2010, 81). 5 .Other methods of calculating depreciation are unit of time depreciation method, group depreciation method and composite depreciation method. It is worth noting that depreciation does not always show a decline in asset market value. The market value is always considered only in case of liquidation. The double declining balance depreciation method and straight line depreciation technique always gives the same book value every year. So to summarize, the different method produce various book values on a year after year manner, however, by the finality of the useful life of the asset, and the book values are the similar. All factors are remaining constant if one gain interest on the cash balance, the double-declining technique produces a huge book value by the end of the useful life of a given asset. Depreciation under IFRS Estimates of residual value and useful life and the method of depreciation are revised at least at each annual reporting day. For a company presently using GAAP a change to IFRS would result in a greater regularity of review in depreciation IFRS allows a company to choose between two different systems so as to value PP&E acceptance on the books: Cost model: This system is like GAAP where PP&E is put at its cost less any given accumulated depreciation and any accumulated impairment expenses depreciation rates, which in turn may mean less approximated depreciation cost. Revaluation model: This model gives room for a business to revalue PP&E on its books to fair value should it be reliably measured. For an organization presently using GAAP or an alteration to IFRS, it is a fact that the use of the revaluation technique may lead to a substantial rise in asset worth on the balance sheet as well as a parallel substantial rise in depreciation cost. Tax issues with depreciation Most income tax models provide for a tax deduction for salvage of the cost of assets used in an organization or for the production of income. Such deductions are performed for individuals and businesses. Where the assets are consumed continuously, the expense may be deducted currently as a cost or treated as the portion of the cost of goods sold. The costs of assets not continuously consumed normally have to be deferred and recovered over a period, such as through assets depreciation. Some model permit complete deduction of the cost, at least in a portion, in the year the assets are obtained. Other models allow depreciation cost over some life using some depreciation technique or percentage. Guidelines may vary highly by region and may vary within a country based on the asset or nature of the taxpayer statements (CCH Incorporated 2005, 81). Various systems that stipulate depreciation lives and technique for financial reporting expects the same lives and procedure be used for tax role. Many tax systems give various guidelines for real property like buildings and personal property like equipment. Calculation of tax depreciation highly depend on the organization and business policies although there are a lot more systems applied that have stood the test of time. Since businesses should match the expenses with the revenues, they do not want to write off the full cost of a fixed asset in one year. After all, they certainly are making use of the asset bought for more than one year. The IRS has done the bulk work for businesses by creating a chart that outlines the recovery periods allowed for company equipment (see the table below) Depreciation Recovery time for Business Equipment Property Class Recovery Period Business Equipment 3-year assets Tractor units and horses that are two years old and over 5-year property Taxis, cars, buses, trucks, office machines, computers ,research equipment, and cattle 7-year assets Fixtures and office furniture 10-year property Water transportation machines, single-purpose horticultural or agricultural structures, and fruit- or even nut-bearing vines and trees 15-year assets Land improvements, such as roads, fences and bridges 20-year property Farm property that are never agricultural or horticultural structures 27.5-year assets Residential rental property 39-year property Nonresidential real estate, such as home office but excluding the value of the land 1. Recovery time is the expected useful lifespan of a given fixed asset. For instance, cars have a five-year recovery period since the IRS approximate that they’ll have a useful lifespan of five years. While the car will run longer than five years, it is not likely to persist using that car for business function after the initial five years. It is more probable to trade it in and obtain a new car (Stickney 2010, 77). Salvage value is approximated amount that a company will obtain when it disposes of an asset at the end of its useful life. Always the salvage value is approximated to be zero. Though, we assumed $500 in order to show how the amount would tackled. Salvage value or it is disposal value, scrap value. Useful life and salvage value estimation. The useful life of an asset is an estimate of the period the asset will be used (contrary to how long the asset will last). For instance, a graphic artist might buy equipment in 2012 an assumed to replace it in 2014 with more advanced equipment. Therefore, a graphic artists equipment will have an estimated useful life of 2 years. An auditor buying similar equipment in 2012 expects to use it until 2016. The auditor will use an estimated useful life of 4 years when equipment depreciates. Both the graphic artist and the auditor are true—the graphic artists in using two years and the auditor in using 4 years even if the equipment will be in working order for several years after their life span end. Salvage value is used in accounting to find depreciation value and in the tax system to compute deductions. This is because, salvage value can be summarized as being the approximated value that an asset will attain upon its sale at the end of its useful life. Conclusion Market value and perishability of an asset are other causes of depreciation that lowers the value of assets. Today with few exceptions, most organizations have to handle the issue of depreciation at one point or another. Whether it links with computers, office equipment and furniture, vehicles or buildings the issue of depreciation is real. The theory and idea behind depreciation are that it represents how much of the assets must be replaced or say be saved up each year to replace it finally or restore it to appropriate working order (Stickney 2010, 38). For an organization, it is a type of a "reserve account." This is the acknowledgment that the asset or economic resource will survive longer than one year. As a result, the assets cost should be allocated over a time frame of its beneficial life but just in the same year in which it was put into its use. Finally, depreciation is a reality that many businesses have to encounter. Methods of calculating depreciation and the time over which assets are depreciated may be different between asset kinds within the same organization and may vary for the tax function. It is an important management to know that the method of calculation is specified by accounting standards or law, which may vary by country (Stickney 2010, 91). There are various standard methods of computing depreciation cost, such straight line, fixed percentage and declining balance techniques. Depreciation cost starts when the asset is placed in use. It is of importance that top management handles such issues in most appropriate way and accordance with the accepted principles. References CCH Incorporated. 2005. Depreciation CPE course. Chicago: CCH Inc. Stickney, Clyde P. 2010. Financial accounting: an introduction to concepts, methods, and uses. Mason, OH: South-Western/Cengage Learning. Wolf, Frank K., and W. Chester Fitch. 1994. Depreciation systems. Ames: Iowa State University Press. Read More