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Chapter 9 Depreciation: Having Your Cake and Eating It Too!

Chapter 9 Depreciation: Having Your Cake and Eating It Too!. Depreciation. Matching If a resource (like a piece of equipment) is used up over the long term (greater than 1 year), its cost should be spread out (matched) with the revenues it helped to generate.

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Chapter 9 Depreciation: Having Your Cake and Eating It Too!

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  1. Chapter 9Depreciation:Having Your Cake and Eating It Too!

  2. Depreciation • Matching • If a resource (like a piece of equipment) is used up over the long term (greater than 1 year), its cost should be spread out (matched) with the revenues it helped to generate. • Example: 10 year asset acquired and expensed all in the first year. • Year 1 income is understated (due to full expense). • Income in years 2 – 10 are overstated due to lack of any expense. • Each year a portion of the original cost is taken as a depreciation expense.

  3. Amortization vs. Depreciation • Amortization • Spreading out of a cost over a period of time. • Depreciation • Specialized subset of amortization that applies to the wearing out of a tangible asset. • Resources that are finite in nature but do not wear out, such as oil or gas, are said to deplete. • For those resources that neither deplete nor depreciate we use the term amortize.

  4. The Depreciation Process

  5. Asset Valuation • Determine the full cost of the asset to be depreciated. • Historical cost. • Costs associated with putting asset into service. • Replacements or improvements that extend the life of the asset.

  6. Depreciable Base • How much of the asset’s cost gets depreciated? • Do not typically consume 100% of an asset. • If the asset will have value at the end of its useful life, this is referred to as salvage value. • Historical cost less the salvage value is the depreciable base – or the amount to be depreciated.

  7. Asset Life • How long does an asset last? • Attempt to depreciate an asset over its useful life. • If asset is depreciated over a period longer or shorter than its useful life we do not obtain an accurate match between revenues and expenses. • Ultimately, we can only guess. • The GAAP of conservatism tends to lead accountants to estimate a shorter useful life.

  8. Depreciation Method • Straight-line depreciation: (Cost – Salvage Value) / Useful Life • Accelerated methods. • Some assets are more likely to decline in value more rapidly in early years. • Most common accelerated methods are: • Double Declining Balance • Sum-of-the-years’ Digits

  9. Accelerated Methods • Double Declining Balance (DDB)Cost × (2 / Useful Life) • After each year the depreciable base (the cost) is reduced by the previous years depreciation. • Sum-of-the-years’ Digits (SYD)(Cost – Salvage Value) × (Useful life / Sum of the digits) • After each year the numerator in the fraction is reduced by 1.

  10. DDB Example • Cost of machine = $48,000 • Useful life = 6 years • Salvage value = $6,000 • Year 1 depreciation =$48,000 × (2/6) = $16,000 • Year 2 depreciation =$32,000 × (2/6) = $10,667 • Year 3 depreciation =$21,334 × (2/6) = $7,111 • so on through year 6

  11. SYD Example • Cost of machine = $48,000 • Useful life = 6 years • Sum-of-digits = (6+5+4+3+2+1) = 21 • Salvage value = $6,000 • Year 1 depreciation =$42,000 × (6/21) = $12,000 • Year 2 depreciation =$42,000 × (5/21) = $10,000 • Year 3 depreciation =$42,000 × (4/21) = $8,000 • so on through year 6

  12. Comparison of Depreciation Methods • Cost = $48,000 • Useful life = 6 years • Salvage value = $6,000

  13. Modified Accelerated Cost Recovery System (MACRS) • For-profit health care organizations do not have to use the same depreciation method for reporting to the IRS as they use for reporting to stockholders. • Straight line for financial statements showing stockholders lower depreciation and therefore higher income. • Accelerated (MACRS) for the IRS which lowers income and therefore lowers taxes.

  14. MACRS • IRS system assigns shorter lives to assets and therefore accelerates depreciation. • By accelerating depreciation, a profitable organization can push tax payments off to the future, effectively getting an interest-free loan from the government.

  15. MACRS Basics • Assets fall into one of the following classes: • 3-, 5-, 7- and 10-year class = DDB. • 15- and 20-year class = 150% Declining Balance. • 27.5- and 39- year class = Straight line.

  16. Deferred Taxes • If our income reported on the financial statements is more than that reported to the IRS (due to MACRS) then a tax deferral will be created. • This deferral is an interest free loan. • Balances in deferred taxes tend to grow because we replace equipment and continue to get new and larger deferrals.

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