Chapter 3
Depreciate and Revaluate
Ranging from large corporate to small companies, there’s always a need to test fixed assets and adjust their value in accordance with the business accounting strategy.
Fixed assets value changes in the market continuously. There are many reasons for these changes, however, there are two methods in accounting that help the business justify these changes: fixed assets depreciation and revaluation.
Depreciation of Fixed Assets Simplified
What is Depreciation?
Depreciation is an accounting procedure where the company can write off an asset over a period of time. It does not involve any type of cash transaction.
Depreciation of Fixed Assets
Most fixed assets cost a substantial amount of money. Businesses would like to be able to write this off as an expense which they can but only over a period of time. This is done through depreciation. It is accepted that each year a fixed asset loses some of its value. This can be claimed through a set percentage of allowable depreciation.
Purpose of Depreciation
The purpose of depreciation is to be fair to businesses to be able to claim the investment they have made into their assets. Depreciation is the accounting practice that allows for the cost of the fixed asset to be claimed as an expense over time but also allows for the recording of the loss of the market value of the item.
Methods of Depreciation
Straight Line Depreciation
This method of depreciation is recommended to be used when the fixed asset is straightforward and there are no special circumstances applied to it.
Depreciation is calculated evenly over the estimated life of the asset. Calculations are based on.
- Starting with the cost of the fixed asset
- Deduct the salvage value
- Estimate the useful life of the asset – divide this by years to determine the depreciation rate.
- Depreciation rate X asset cost (after the salvage value has been deducted.)
Double Declining Balance
This is also known as accelerated depreciation. It is a method used for depreciating a fixed asset faster. But, it does not change the overall amount that is allowed for depreciation of the asset. The amount will be the same as what it would be with straight line depreciation.
The advantage to double declining balance is that a greater amount of depreciation will be realized in the first few years of the fixed asset.
The double means twice or 200%.
Here is an example using the double declining depreciation method:
- A piece of machinery was purchased for $50,000. At the beginning of the fiscal year. It has a life expectancy of 10 years but will have no salvage value.
- If the straight line depreciation method were going to be used, then 10% would be applied for depreciation for a depreciation amount of $5,000.
- With the double declining balance, the percentage will double and will be 20% giving a depreciation amount of $10,000.
Now the book value at the beginning of the next fiscal year for this fixed asset will be $40,000.
As each year progresses the depreciation expense reduces. Some businesses decide at some point in time to then switch to the straight depreciation formula.
Units of Production
The two preceding methods of depreciation are based on the passage of time for expensing the fixed asset. The units-of-production depreciation is based on the use of the fixed asset. It may include the activity of the fixed asset or what the asset produces.
Example:
- A machine is purchased for $250,000. It is projected that this unit will be able to produce 125,000 products. The salvage value of the machine after this point is $10,000.
- From the $250,000. the $10,000 is deducted to give the depreciation cost of the machine which would be $240,000. Now, this gets divided by the number of products it produced which is 125,000. Which equals $1.92 per product.
- In the first year, the machine was able to produce 25,000 products. Multiply 25,000 by $1.92 = $48,000. which is the depreciation for the first year. The calculation for the depreciation will continue each year in this manner until the $240,000. has been depreciated.
Sum of Years Digits Depreciation
Another method of depreciation based on the passage of time using an accelerated formula. The concept behind this depreciation method is based on the premise that the fixed asset is at peak production during the first two or three years of its life. Therefore the company wants to recoup as much of its depreciation during this time period. The depreciation value is based on a per years formula.
For example, assume that a fixed asset purchased for $225,000 had a ten-year productive expectancy; the formula would be as follows;
1+2+3+4+5+6+7+8+9+10= 55
Year one depreciation: $225,000 cost of asset > 10 years remaining life>depreciation fraction 10/55 >depreciation expense =$40,909. The book value of the start in the second year would be $184,091.
MACRS Depreciation
This is the short form for Modified Accelerated Cost Recovery System
The basis of this deduction is to be able to claim larger amounts of depreciation if the first few years of the asset with a decline in the later years.
There are two methods that can be used under MARCS
- General Depreciation System (GDS)
- Alternative Depreciation System (ADS)
Procedure:
- Determine the classification
- When asset acquired: middle of month, last quarter of month, half year.
- Determine the depreciation method.; 150% declining balance, or 200% declining balance or straight-line method.
There are four components to the MACRS Depreciation
- The relevant system
- The classification
- The convention
- Method
There is IRS information to help with each of these as they pertain to the type of fixed asset.
Depreciation of Land and Land Improvements
Land in itself is not depreciated. This is because it is assumed that the land will always retain its usefulness. This does not deteriorate over time. But, there are many that do land improvements and this may or may not require depreciation.
Property owners will often make changes to the land to make it more useful. This is called land improvements.
If there is going to be a time span that the improvements will only remain useful then they will need to be depreciated.
If no time length can be put on the improvement’s usefulness then they are not depreciated.
The cost of the improvements if they are not going to be depreciated then they get added to the property asset.
When it comes to maintenance of the land or landscaping that is ongoing this is an ongoing cost and should be accounted for as an expense, not a fixed asset.
Accumulated Depreciation
Accumulated depreciation has to be accounted for.
| Account | Debit | Credit |
|---|---|---|
| Depreciation Expense Account | 10,000 | |
| Accumulated Depreciation Account | 10,000 |
The depreciation account will be entered on the income statement. The Accumulated Depreciation appears on the balance sheet to reduce the fixed asset.
A look at the Basics of Fixed Asset Revaluation
Capitalization Of Additional Expenditures
Most of those familiar with accounting understand what capitalizing is. It is the expense that an asset generates but gets added to the cost of the asset as opposed to using these extra costs as an expense. These costs can eventually be realized as expense but over a period of time. The accounting procedure used for this based on the matching principal. In others words the costs are expended as an expense during the period of time that the expense is applicable to.Identifying Additional Expenditures
Additional expenditures often need to be classified as capital expenditures. These are applicable to assets that are going to provide usefulness for a company that extends beyond one accounting period. Some expenditures will not fit into this category. It may depend on what the capitalization limits are that have been set by the company in their capitalization policy. Most often companies create this type of policy to reduce the need of having to track small valued assets.Examples of Additional Expenditures
A Company may buy a building that they are going to make as their new head office. The purchase of the building is a capital expenditure. But, now the company needs to do some major improvements to the building in order to make it useable. This is going to generate some extra costs. But the usefulness that this creates is going to last for several years. Therefore this expense must be spread out over the period of time that is expected for the usefulness. The money spent on the improvements has to be accounted for. A building improvements account can be created. In this example, the building improvements cost $100,000.| Journal Entry | Debit | Credit |
|---|---|---|
| Building Improvement | 100,000 | |
| Cash | 100,000 |
Revaluation
If there is a company policy in place for revaluation procedures then these additional expenditures may also have to be taken into account. If so, then the revaluation procedures will need to be followed to provide accurate accounting.Additional Expenditures Not Capitalized
There are times when improvements will be made when they are not going to extend the usefulness of the asset for any lengthy period of time. For example, the new building following the improvements may need to be cleaned. This is something that will take place within an accounting period. Therefore it needs to be accounted for as an expense. It can be difficult for the small or new business to properly identify and categorize their assets. While all assets of a company are important a company must value them accurately.Tangible Assets
These are the assets of the company that have a visible form to them. Which makes sense as to why fixed assets would be included in the tangible asset category. But, a company can also have other types of assets that do not have a physical form such as brand recognition or a patent or trademark. These non visible types of assets are called intangible assets. Tangible assets can be categorized as current assets or fixed assets. Fixed assets are usually around for a longer term therefore they will appear on the financial statements over a period of several years. Each year accounting procedures are performed to account for the tangible assets. But, changes can take place concerning these assets and the accounting may not factor this in. For this reason periodically there needs to be a revaluation of the tangible assets.Revaluation of Tangible Assets
The purpose of the revaluation is so the financial records of the company will show what the fair market value of the assets is. Fair market value is what is deemed to be the value of the asset based on a set of metrics. Most commonly what is the average price one could sell the asset for.Why revaluation is Important
The revaluation provides the true figures for the financial records to show what value the asset has to the company. It indicates how much money the asset could be converted to if it were sold for cash.Accounting Procedures for Revaluation of Tangible Assets
Indexation
This method is dependent on using statistics pertaining to the assets provided by the country in which the business resides. The data provided is as a result of surveys.
CMP Revaluation
This is performing the revaluation based on the current market price. How complex it will depend on the asset itself. This method is most commonly used for land and building. Data can be collected by determining similar assets on the market that compared with this particular asset. Sometimes the expertise of professional is relied on for their expertise as to the value of this type of property. For equipment and machinery, it can be a bit more of a challenge. If the asset is still being produced then most often the manufacturers can place a current market value on the asset being used in the business.
Appraisal
Quite often a revaluation is performed by a business that is preparing to sell that particular asset. In these cases, it is not usual to use professionals that are qualified to conduct a formal appraisal and will prepare a formal report based on their findings.
Outcome of Revaluation
The findings of the revaluation have to be accounted for financially. It can create a need for an increase in the value of the asset. Or it may dictate a decrease.
The increase
The increase is entered as a credit to the revaluation reserve. This becomes a capital reserve.
The increase will create an increase in depreciation. This creates a debit to the revaluation reserve account, with the normal accounting for depreciation to the profit and loss statement.
Impairment
When a revaluation creates a decrease in the book value of the asset then it is classed as impairment. This is reflected in the profit and loss statement. More on this in Chapter 5.