HW, Ch. 10

For-profits can use different methods for reporting depreciation to owners and to the government (for tax purposes). What is the practical effect of this allowance?

For-profit organizations are allowed to use one depreciation method for the financial statements submitted to stockholders and another depreciation method for reporting to the IRS. The result is that often the financial statements are recorded using a modest depreciation approach that lowers expenses and shows the stockholders how well the organization is doing. Taxes, however, are paid based on an accelerated method that increases the current expenses thereby lowering the current taxes that are due to the IRS. The difference between the two tax amounts recorded on the financial statements as deferred taxes. If the organization continues to grow its business and acquire/repair assets, differed taxes will grow and the end result will be an interest free loan from the government.

Why is depreciation added back to operating activities in a cash flow statement?

It is an expense that reduces net income but is not a current year outflow of cash. (Cash flow from operations starts with net income)

Step 1, Depreciation Process

The first step in calculating depreciation is to identify the full value of the asset being depreciated. Full valuation in this case refers to acquisition cost plus costs to place the item in service (such as delivery, installation, and any plant modifications), plus any replacements or improvements made to the asset over time.

Step 4, Depreciation Process

The fourth and final step in the depreciation process is the determination of which depreciation method the organization is going to use. The common methods are straight-line, declining balance, and sum-of-the-years digits.

Explain why we depreciate assets over their useful lives instead of just expensing them in the year they are acquired?

The matching principle requires it because the asset allows the organization to generate revenues over many years. Depreciation spreads out the acquisition cost and allows revenues and expenses to be appropriately matched throughout the life of the asset.

Which generally accepted accounting principle requires the use of depreciation for assets that have useful lives beyond one year? Explain why this is the case.

The matching principle requires that organizations use depreciation. If an asset that an organization acquires provides services for multiple years, it will help the organization earn revenues for multiple years. If one takes the acquisition cost as an expense in the first year, one would be understating income in the first year due to the high acquisition expense. In the later years, an organization would be overstating income by recognizing revenue that is being earned by an asset the organization is using up without talking any corresponding expense. Depreciation spreads out the acquisition cost and allows revenues and expenses to be appropriately matched throughout the life of the asset.

Step 2, Depreciation Process

The second step is the determination of the depreciable base. The depreciable base is equal to the full value of the asset identified in the first step less any salvage value. The salvage (or terminal) value represents what value remains after the useful life of the asset. Often assets can be sold after their useful life even if only for scrap.

Step 3, Depreciation Process

The third step in the depreciation process is the determination of the useful life. An asset's true life can only be an estimate. In many cases, it is extremely difficult to assess the potential life of an asset. Often accountants' estimates of useful life are shorter than the asset's actual life. Accountants would typically prefer to be conservative and have the asset outlast the estimated useful life than have an asset become obsolete before it if fully depreciated.