Ch6 - Reasons for Depreciation Estimates: Financial...

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Unformatted text preview: Reasons for Depreciation Estimates: Financial statements Estimation of salvage values Example 6-1. Assets lose value for a variety of reasons. Give an example for each of the following types of reasons: use-related physical loss time-related physical loss functional loss Example 6-2. Give an example of an asset that might NOT lose value over time. Depreciation and Financial Accounting Normal use of depreciation as an "expense" instead of actual cash flow Consider 10 years of income statements (simplified) for a company that must replace its equipment every 5 years @ $120 thousand A. Income Statement, with Depreciation Approach (thousands of $) Year Revenues 1 2 3 4 5 6 7 8 9 10 Net Revenue from Sales 100 100 100 100 100 100 100 100 100 100 Expenses Operating Expenses 60 60 60 60 60 60 60 60 60 60 Depreciation Expenses 24 24 24 24 24 24 24 24 24 24 Total Expenses 84 84 84 84 84 84 84 84 84 84 Profit Before Taxes 16 16 16 16 16 16 16 16 16 16 Profit is steady in time: company performs just as well in every year. What is never done, because it is misleading. Estimation of Market Values by Book Value Formulas (A) Straight Line Depreciation (SLD) Dollar rate of loss is constant over its useful life, i.e., the value decreases linearly Easy to calculate but often inaccurate Time Book Value P S N (age of asset) P = purchase price S = salvage value at the end of N periods N = useful life of asset Depreciation in period n using SLD: Accumulated depreciation by period n: Book value at the end of period n : N S P ) n ( D SL = = N S P n P ) n ( BV SL = N S P n ) n ( BV P SL SLD Example 6-3 : An asset was purchased 7 years ago for $10 000. It was estimated to have a 10 year service life and a salvage value of $2000 at the end of its service life. If the value of the asset is believed to be depreciating at a constant rate each year (same number of dollars each year), what is its book value today? Time Book Value P S N (B) Declining Balance Depreciation for Market Value Estimation loss in value in a period is a constant proportion of current value d = depreciation rate (note: 0 < d < 1), P = purchase price Initial book value: In 1 year: depreciation = , book value = In 2 years: , In n years: 1 ) 1 ( ) ( = n db d Pd n D n db d P n BV ) 1 ( ) ( = P BV db = ) ( Time Value P S n (age of asset) Pd D db = ) 1 ( 1 ) 1 ( ) 1 ( d P Pd P BV db = = 1 ) 1 ( ) 1 ( ) 2 ( d Pd d BV D db db = = 2 ) 1 ( ) 2 ( ) 1 ( ) 2 ( d P DB BV BV db db db = = Book Value versus time DB Example 6-4 : A new press brake costs Medicine Hat Steel $780 000. It is expected to last 20 years, with a $60 000 salvage value. What rate of depreciation for the declining-balance method will produce a book value after 20 years that equals the salvage value of the press? Use this to estimate the book value after 5 years.estimate the book value after 5 years....
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This note was uploaded on 05/17/2011 for the course MSCI 261 taught by Professor Bonkoo during the Spring '09 term at Waterloo.

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Ch6 - Reasons for Depreciation Estimates: Financial...

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