Depreciation, accounting methods

USE OF BOOK VALUE FOR OLD EQUIPMENT IN REPLACEMENT STUDIES. This error is caused by refusal to admit that the depreciation accounting methods used in the past were wrong. Persons who make this error attempt to justify their actions by claiming that continued operation of the present equipment would eventually permit complete depreciation. This viewpoint is completely unrealistic because it gives no consideration to the competitive situation existing in modem business. The concern which can operate with good profit and still offer a given product or service at the lowest price can remain in business and force competitors either to reduce their profits or to cease operation. 

The value of property items, such as land, buildings, and equipment, is usually reported as the value of the asset at the time of purchase. Depreciation reserves are also indicated, and the difference between the original property cost and the depreciation reserve represents the book value of the property. Thus, in depreciation accounting, separate records showing accumulation in the depreciation reserve must be maintained. In the customary account, reserve for depreciation is not actually a separate fund but is merely a bookkeeping method for recording the decline in property value. 

Although the sinking-fund viewpoint assumes the existence of a fund into which regular deposits are made, an actual fund is seldom maintained. Instead, the money accumulated from the depreciation charges is put to work in other interests, and the existence of the hypothetical fund merely serves as a basis for this method of depreciation accounting. 

A concern has a total income of 1 million/year, and all expenses except depreciation amount to 600,000/year. At the start jjf the first year of the concern s operation, a composite account of all depreciable items shows a value of 850,000, and Ihe overall service life is estimated to be 20 years. The total salvage value at the end of the service life is estimated to be 50,000. Thirty percent of all profits before taxes must be paid out as income taxes. What would be the reduction in income-tax charges for the first year of operation if the sum-of-the-years-digits method were used for depreciation accounting instead of the straight-line method ... 

INCLUDING UNAMORTIZED VALUE AS AN ADDITION TO THE REPLACEMENT INVESTMENT. This is one of the most common errors. It increases the apparent cost for the replacement and tends to prevent replacements which are really economical. Some persons incorporate this error into the determination of depreciation cost for the replacement equipment, while others include it only in finding the investment on which the rate of return is based. In any case, this method of attempting to account for unamortized values is incorrect. The unamortized value must be considered as a dead loss (or gain) due to incorrect depreciation accounting in the past. 

ItBased on the 1954 tax revision for depreciation accounting, any method could be used if the depreciation for the first two-thirds of the usefid life of the properly did not exceed the total of such allowances if they had been computed by the double declining-balance method. 

Depreciation is an accounting method used to distribute the initial investment costs of productive fixed assets, except land, over the lifetimes of the assets, which are usually considered as standard financial lifetimes. Depreciation costs are calculated on the basis of the original value of fixed investments, using rates for either straight line, declining balance or accelerated deprecia-... 

Two identical companies can have different financial performance ratios due to nothing more than the choice of depreciation and inventory accounting methods. 

The relationships among the various annual costs given by Eqs. (9-1) through (9-9) are illustrated diagrammaticaUy in Fig. 9-1. The top half of the diagram shows the tools of the accountant the bottom half, those of the engineer. The net annual cash flow Acp, which excludes any provision for balance-sheet depreciation Abd, is used in two of the more modern methods of profitability assessment the net-present-value (NPV) method and the discounted-cash-flow-rate-of-return (DCFRR) method. In both methods, depreciation is inherently taken care of by calculations which include capital recoveiy. 

An alternative to allocating overheads by using a single method is to classify the various overheads into groups and to use the most appropriate allocation for each group. For example, depreciation would be allocated on the basis of capital cost, while indirect labor might be allocated either on the basis of direct labor cost or on the number of employees. Clearly, this alternative method is more complex, increases the associated accountancy costs, and is prone to misinterpretation and possibly abuse. 

The annualized capital cost (ACC) is the product of the CRF and TCC and represents the total instaUed equipment cost distributed over the lifetime of the project. The ACC reflects the cost associated with the initial capital outlay over the depreciable life of the system. Although investment and operating costs can be accounted for in other ways such as present-worth analysis, the capital recovery method is preferred because of its simplicity and versatUity. This is especiaUy true when comparing somewhat similar systems having different depreciable lives. In such decisions, there are usuaUy other considerations besides economic, but if all other factors are equal, the alternative with the lowest total annualized cost should be the most viable. 

Fixed capital investments are characterized by the fact that they have to be replaced after a number of years commonly referred to as service life or useful life period. This replacement is not necessarily due to wear and tear of equipment. Other factors include technological advances that may render the equipment obsolete. Furthermore, over the usefiil life of the equipment, the plant should plan to recover the capital cost expenditure. In this regard, the notion of depreciation is useful. Depreciation or amortization is an annual allowance which is set aside to account for the wear, tear, and obsolescence of a process such that by the end of the useful life of the process, enough fund is accumulated to replace the process. The simplest method for determining depreciation is referred to as the straight line method in which... 

This model does not take into account the time value of money, and no consideration is given to cash flows that occur in a project s later years after the depreciable investment has been recovered. A variation on this method includes interest, called payout period plus interest (POP + I) and the net effect is to increase the payout period. This variation accounts for the time value of money. 

In Equation 8.3-1, D is depreciation, FCI is fixed-capital investment, t is the number of years over which the depreciation is accounted for, and S is the salvage value. Thus S is the value the plant could be sold for after the t years of operation. In this discussion we assume that the plant lasts for ten years, and that its salvage value is zero. With the straight-line method, annual depreciation costs are constant. Other methods, such as the sum-of-the-years-digits method, determine depreciation costs to be greater in the early years of the property than in the later years. Local regulatory laws generally define which method can be used to determine depreciation costs. 

The same approach used in the sinking-fund method may be applied by analyzing depreciation on the basis of reduction with time of future profits obtainable with a property. When this is done, it is necessary to use an interest rate equivalent to the annual rate of return expected from the use of the property. This method is known as the present-worth method and gives results similar to those obtained with the conventional sinking-fund approach. The sinking-fund and the present-worth methods are seldom used for depreciation cost accounting but are occasionally applied for purposes of comparing alternative investments. 

A composite account includes all depreciable assets in one single group, and an overall depreciation rate is applied to the entire account. With this method, the composite depreciation rate must be redetermined when important changes occur in the relative distribution of the service lives of the individual assets. 

When you first see the administration of an organization it will probably be some variant of this grouping method. You will see the costs of your team or department, all subdivided into project accounts. You will probably not see the depreciation this is handled by the bookkeepers. As we shall see, this grouping is not as sharp as one might wish the division is a bit arbitrary. 

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