Ch6_W10 - DepreciationandFinancialAccounting Reasons for...

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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 loss due to obsolescence Example 6-2. Give an example of an asset that might NOT lose value over time.   Depreciation and Financial Accounting
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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.
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B. Income Statement, with "Cash Flow" Approach 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 Equipment Cash Outflow 120 120 Total Expenses 180 60 60 60 60 180 60 60 60 60 Profit Before Taxes -80 40 40 40 40 -80 40 40 40 40 Profit is high in most years, but disastrous "losses" when equipment is replaced. This suggests that equipment should not be replaced, thus killing the company! What is never done, because it is misleading.
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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 0 (age of asset)
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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
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SLD
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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 0
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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 = ) 0 ( 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
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Ch6_W10 - DepreciationandFinancialAccounting Reasons for...

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