Company A and Company B each purchased a $50,000 asset with an expected life of 10 years on January 1, 2011. Company A uses the straight-line method, and Company B uses the double-declining balance method. Each company had the same sales and expenses other than the depreciation on this asset in 2011. Company A’s method is appropriate for an asset whose benefits are expected to decline over the periods of use. Company B’s 2011 net income is lower than Company A’s. The term depreciation describes the allocation of the cost of tangible assets, such as property, plant, and equipment.
Explain how a top-selling product may actually result in losses for the company. Describe the rationale for reducing pension expense by the expected return on investments instead of the actual return. Explain the difference between absorption costing and variable costing. Discuss how the internal rate of return method differs from the net present value method.
Depreciation, Depletion and Amortization:
Declining balance — This allows for deduction of a percentage of the specific method that changes each year. Fixed percentage — The company can deduct a fixed percentage of the value of the asset each year. The property must have a fixed useful life which must be over a period difference between depreciation and depletion of one year. Explain why the book value of a long-term asset depends on management’s choice of depreciation. Discuss the differences between the different methods of depreciation. Depletion occurs due to only one reason – exhaustion of supply of the natural resource.
Depreciation is the method used to allocate the cost of buildings and equipment; other types of assets use different methods of cost allocation. Depletion is used to allocate the cost of natural resources such as timber or coal. Amortization is used to allocate the cost of something intangible, such as a patent. Each of these methods matches the expense of an asset to the period it is being used in. Both depreciation and depletion are cost allocations and thus non-cash expenses as they do not impact the cash flow of the entity.
For tangible assets such as property or plant and equipment, it is referred to as depreciation. Accelerated (declining-charge) methods are appropriate when the benefits from the asset are expected to decline over each period of use. The selection of a particular declining depreciation method is basically arbitrary, because generally a specific declining depreciation method cannot be matched against the expected pattern of declining revenue. Accelerated methods include the sum of-the-years’-digits method and declining-balance method. The first step is to determine an average price for the natural resource unit. Then you have to calculate the depletion expense per unit.
- Depreciation, depletion, and amortization (DD&A) refer to an accounting technique that a company uses to match the cost of an asset to the revenue generated by the asset over its economic useful life.
- If a company uses all three of the above expensing methods, they will be recorded in its financial statement as depreciation, depletion, and amortization (DD&A).
- Discuss how the internal rate of return method differs from the net present value method.
- Company A uses the straight-line method, and Company B uses the double-declining balance method.
However, there are situations when the accumulated depreciation account is debited or eliminated. For example, let’s say an asset has been used for 5 years and has an accumulated depreciation of $100,000 in total. In a double-entry accounting system, accounts are entered in either a debit or credit column.
How to Calculate Units of Activity or Units of Production Depreciation
Depreciation can be calculated on straight line, units of production or reducing balance methods. Depletion is applicable only to wasting assets, namely natural resources such as oil reserves, coal mines, mineral reserves, timber forests etc. For example, if a large piece of machinery or property requires a large cash outlay, it can be expensed over its usable life, rather than in the individual period during which the cash outlay occurred. This accounting technique is designed to provide a more accurate depiction of the profitability of the business. Value is reduced or exhausted with removal or extraction.
That being the case, support equipment and facilities will very likely be depreciated using the unit of production method. Estimated future decommissioning costs of well sites, net of estimated salvage values, are to be included in the cost base used to calculate DD&A. These costs would include such activities as the dismantlement of drilling equipment and land reclamation activities. All three terms are used in the oil and gas industry, where the term DD&A has arisen to refer to all three types of expense recognition.
The depreciation is calculated from the time an asset is used / placed for service and the depreciation is recorded periodically. Depreciation is calculated taking the cost of the asset, the expected useful life of the asset, residual value of the asset and percentage where necessary. Depreciation is not taken into account once the full cost of the asset is recovered / the asset is no longer in the company’s possession (i.e. sold, stolen and fully depreciated).
Unlike the first two indicators, depreciation and amortisation, which are applicable for all industries and businesses, depletion works only for the energy and natural-resources field . There are several methods to calculate amortisation at a company’s disposition. To calculate this, divide 100% to the life span value. Then the number obtained shall be multiplied by 2, and you’ll get the depreciation rate.
Then the annual or monthly depreciation amount is determined using depreciation methods. The cumulative depreciation value must be in tandem with the original price of the asset. The account created for accumulated depreciation is a compensatory one which decreases the fixed assets account.
- The base for calculation of depreciation is its estimated useful life or its estimated production capacity.
- Accelerated–more amortization taken in the early years of the asset.
- However, the methods may mask faulty estimates and defer gains and losses beyond the period of occurrence.
- It works by assigning a fixed percentage to gross income to allocate expenses.
- It is therefore not closed at the end of the accounting period.
- A company using the retirement method expenses the cost of the old asset when the asset is retired.
Harold Averkamp has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. The term amortization is also used to indicate the systematic reduction in a loan balance resulting from a predetermined schedule of interest and principal payments. Proved reserves are used to amortize the acquisition costs of proved property. These reserves include oil and gas that will be produced from existing wells, and from wells that will be drilled at a later date. With liabilities, amortization often gets applied to deferred revenue, such as cash payments usually received before delivery of services or goods. The value of an asset decreases due to a number of reasons including wear and tear or obsolescence.
A company reviews a productive asset for impairment when events or circumstances indicate that the asset’s book value is overstated. After an impairment loss is recognized, the productive asset is reported at its fair value. The choice of depreciation method will have no effect on total income over the life of an asset.
- Use the accumulated depreciation account to record the amount an asset has depreciated.
- Amortize literally means “to kill.” So, as you pay down a loan, you will eventually “kill” it.
- Explain the differences between absorption and variable costing.
- Accelerated (declining-charge) methods are appropriate when the benefits from the asset are expected to decline over each period of use.
- To be rational, a method must relate each period’s depreciation expense to the benefits generated in that period.
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- In accounting, the matching principle states that revenue should be recorded when it is earned, and expenses should be recorded when they are incurred.