Chapter – 8

Analysis of Long Lived

assets: PART II –
Analysis of Depreciation
and Impairment
The depreciation concept:
Depreciation:
Depreciation is the periodic charge off
of a part of the value of a fixed asset.

Depletion :
Applies to only natural resources.

Amortization:
Applied to intangible assets.
Loss of value on resources.
Expenditure should charge off.
Must cut down to reflect the
current value
Depreciation Methods:
Annuity or sinking fund depreciation

Straight-line method

Accelerated Depreciation methods:

Sum-of-years’ digit (SYD) method

A family of declining balance methods

(Exhibit 8.4)

Units of production and service hours

methods (Exhibit 8-5)
Annuity or sinking fund depreciation:

With the Amount of depreciation increasing

every year is known as annuity or sinking fund
depreciation. GAAP do not permit this form of
depreciation.
Straight line method:

Straight-line method is a method for finding

of depreciation per year of a Fixed Asset. It
is finding by dividing the difference of
actual cost of the asset and salvage value
in to the expected service life.

Cost – salvage value

Depreciation =
Expected service life
Accelerated methods:
In this method larger amount of cost is
deprecated in the initial year and smaller
amount is depreciated during the final year.

Methods for Accelerated depreciation:

Sum-of-years’ digit (SYD) method:

In order to use this method, we have to know

the service life.

Have to add digits year together. 5 year,

1+2+3+4+5 = 15
Allocate the total cost in such a way
Double Declining Balance:
Units of production and service
hours methods:

These methods depreciate assets in

proportion to their actual use rather
than as a function of the passage of
time.

Measurement requires an initial

estimate of the total number of units
of output or service hours expected
over the life of the machine.
Group and composite methods:

Group depreciation methods allocate the costs

of similar assets using depreciation rates
based on a weighted average of the service
lives of the assets.

Depletion:

The carrying cost of natural resources are

allocated to accounting periods using the units
of production method.
Amortization:
Amortization of intangible assets may be
based on useful lives as defined by law or
regulation, or such assets may be depreciated
over the period during which the firm expects
to receive benefits from them.companies use
either straight line or units or production
methods.
Depreciation method disclosures:
Disclosures of the depreciation method used is
required and can be usually be found in the
foot note listing accounting policies.

The Impact of Depreciation Methods On

Financial statement:
The choice of depreciation method impacts
both the income statement and balance
sheet
As depreciation is an allocation of past cash
flows, the method chosen for financial
reporting purpose has no impact on the
statement of cash flows
 Accelerated method:
Accelerated depreciation methods, with
higher depreciation expense in the early
years of asset life, tend to depress both
net income and stockholders equity when
compared with the straight-line method.
Initial years Later years
Expense High low
NI Low High

As the % effect on NI is usually greater than

the effect on net asset, return ratio tend to be
lower when accelerated depreciation methods
are used.
Accelerated depreciation and taxes:
At the onset of an asset’s life the total
amount of depreciable cost available is fixed.
Depreciation acts as a tax shield by reducing
the amount of taxes paid in any given year.
Firms are better off using accelerated
depreciation methods to obtain the benefit of
increased cash flow in the earlier years.
Impact of inflation on depreciation:

Historical cost based depreciation expense

may be used to define income as long as the
total expense over the asset’s life is enough to
replace the asset after it has been fully
utilized. If the replacement cost of the asset
increases, then depreciation expense based on
the original cost will be insufficient.

Accelerated depreciation method partially

compensate for this inflation effect be
shortening the recovery period.
 Changes in depreciation methods:
Companies may change the reported
depreciation of fixed assets in different ways:

•Changes in method applicable only to newly

acquired assets

•Changes in method applicable to all assets

Changes in asset lives or salvage value

•Changes in method applicable only to newly
acquired assets
•If the change in method is applicable only to
newly acquired assets, then the impact of the
change will be gradual, increasing as fixed
assets acquired after the change grow in
relative importance.
•This is a common method of changing
accounting principles, as it does not require
the restatement of past earnings.
•Impact will be gradual.
•Transfer over a number of years.
 Changes in method applicable to all
assets:
If the change in method applies to all
assets and retroactively, then the
impact will be greater and can be
significant in the year of the switch as
well as in future year.
The cumulative effect of the change
must be reported separately and net of
taxes.
Income can be positive or negative.
If negative, get tax benefit.
If positive, give tax.
Changes in asset lives (n) or salvage
value (SV):

Changes in asset lives and salvage values

are changes in accounting estimates and are
not considered changes in accounting
principles.
Estimates changes attract much less notice
than do changes in depreciation methods.
Thus it is important to read the footnotes
care fully to make sure that weather any
changes in estimates have been made or not.