Current & Long-Term Assets

4.1 Record inventory transactions (CS)

Discussion Guide

Performance Indicator: Record inventory transactions

THINK ABOUT IT

Imagine if your business had a bookkeeper who only recorded certain inventory transactions when they felt like it.

• How successful would your business be?

• Not very!

• Businesses must accurately track and record all their inventory transactions as they move items through every production phase.

KEY CONCEPTS

Slide #1 Importance of Recording Inventory Transactions

• Accurately recording inventory transactions is an important task for every business.

• Properly accounting for the movement of inventory, which consists of raw materials, supplies, and finished products, is vital to ensuring businesses operate as efficiently and profitably as possible.

• Businesses record inventory transactions for several reasons, including for income tax reporting and to evaluate the movement of specific products.

• Recording these transactions enables businesses to track the amount and cost of items as they’re purchased, and record details as the items move through departments in production and are sold to consumers.

• If a company mismanages its inventory transactions, it can cause debt and missed earnings.

• Responsible financial recordkeeping is a key component of effective inventory management and overall business success.

Slide #2 Performing Physical Inventory Counts

• Performing physical inventory counts is an essential component to keeping an accurate inventory management system.

• Even the most detail-oriented employee can forget to record a transaction.

• Regular physical inventory counts help a business ensure its units on paper or in the system match the units they have in physical inventory.

• Gathering up-to-date inventory information also allows businesses to forecast sales, plan for loss, reconcile errors, and efficiently control inventory.

Slide #3 Inventory Accounting Systems

• There are two main inventory accounting systems: perpetual and periodic.

  • Under a perpetual inventory system, a computerized point-of-sale (POS) system automatically records and updates all inventory transactions.

  • Under a periodic inventory system, the inventory account balance is updated at the end of an accounting period, which means purchases are recorded in a separate account, then closed and transferred into Cost of Goods Sold and Ending Inventory accounts at the end of the period.

    • A periodic system relies on physical inventory counts to update all accounts.

• This means inventory transactions are recorded differently under each system.

  • Under a perpetual system, inventory purchases are directly recorded in the Inventory account, while inventory purchases are recorded in the Purchases account under a periodic system.

    • This Purchases account is a temporary holding account that is reconciled at the end of the period.

  • Here are some examples:

    • Purchases under perpetual:

      • Debit Inventory, Credit Accounts Payable

    • Purchases under periodic:

      • Debit Purchases, Credit Accounts Payable

    • Sales under perpetual:

      • Debit Accounts Receivable, Credit Sales

      • Debit Cost of Goods Sold (COGS), Credit Inventory

    • Sales under periodic:

      • Debit Accounts Receivable, Credit Sales

• Closing entries are automatically tracked under a perpetual system, so businesses verify the numbers with a physical inventory count, then record Ending Inventory on the balance sheet and COGS on the income statement.

  • Under a periodic system, at the end of the accounting period, balances in all the temporary holding accounts are transferred to Inventory and adjusted to reflect the appropriate ending balance, then the COGS account is created.

• Businesses will end up with the same Ending Inventory and COGS with either inventory accounting system.

Slide #4 Procedures for Recording Journal Entries

• When recording inventory transaction entries in the accounting journal or ledger, businesses use double-entry accounting, where transactions are recorded twice.

  • Under double-entry accounting, a debit entry is recorded in one account and a credit entry is recorded in another account.

  • A chart of accounts lists each type of account and whether the entries will increase or decrease each account.

• Record separate inventory transactions as the product moves through all production phases.

  • Buying inventory requires one transaction, during which you debit Inventory and credit Accounts Payable or Cash.

  • As a product is manufactured, there are three separate entries:

    • Raw Materials:

      • Debit Raw Materials Inventory, Credit Accounts Payable or Cash

    • Work-in-Process:

      • Debit Work-in-Process Inventory, Credit Raw Materials Inventory

    • Finished Goods:

      • Debit Finished Goods Inventory, Credit Work-in-Process Inventory

  • When the item is ready for sale, transfer it from Finished Goods Inventory to COGS, then make an entry debiting COGS and crediting Finished Goods Inventory.

    • This moves the item from Inventory to Expenses.

  • When a customer purchases the item using cash, debit Cash and credit Revenue, then debit COGS and credit Inventory.

    • This transaction moves the money from Expenses to Revenue.

4.2 Explain methods used to value inventory (e.g., FIFO, LIFO, average cost, etc.) (CS)

Discussion Guide

Performance Indicator: Explain methods used to value inventory (e.g., FIFO, LIFO, average cost, etc.)

THINK ABOUT IT

Businesses must implement effective accounting systems that accurately track inventory costs.

• Inventory accounting systems affect every business component, from selection and processing to warehousing and order fulfillment to product pricing and business profitability.

KEY CONCEPTS

Slide #1 Importance of Tracking Inventory Costs

• Generally Accepted Accounting Principles (GAAP) requires inventory to be accurately accounted for to prevent overstating or understating inventory value, which can inflate a company’s valuation.

• Tracking inventory through an accurate accounting process helps to make sense of the business’s financial standing.

• Effectively tracking inventory costs within an accounting system minimizes storage costs, minimizes losses, increases profitability, increases customer satisfaction, improves accuracy and efficiency, and enables a business to better serve its customers.

• Inefficiently tracking inventory costs can lead to delays, overstocking, dissatisfied customers and employees, and increased costs.

Slide #2 Periodic vs. Perpetual Inventory Accounting

• Periodic inventory accounting systems use intermittent physical counts to measure inventory levels.

  • Businesses track merchandise purchases, then the inventory and cost of goods sold accounts are updated at the end of a predetermined time, which could be once a month or once a quarter.

  • Periodic inventory systems rely on performing a physical count, which can be complicated and time-intensive if a business has thousands of products, meaning the inventory and cost of goods sold figures are not necessarily accurate at all times.

• Perpetual inventory accounting systems track inventory balances on a continual basis with automatic updates as products arrive or are sold.

  • Digital technology allows management to precisely track inventory in real time and helps prevent human errors.

• Most businesses use perpetual inventory accounting systems, as the automatic updates help provide accurate counts with high sales volumes in retail outlets.

  • Some small businesses choose periodic inventory accounting systems, as the expense of perpetual inventory accounting systems can be a deterrent.

Slide #3 Inventory Costing Methods

• Setting the value of inventory impacts a business’s financial statements by determining ending inventory, cost of goods sold, and ultimately profit.

  • The formula to determine cost of goods sold is:

    • Beginning Inventory + Inventory Purchases – Ending Inventory = Cost of Goods Sold

• Higher inventory valuation means lower costs of sales, resulting in greater profits, and vice versa.

• There are four main inventory costing methods:

  • First In, First Out (FIFO):

    • The items purchased first are sold first, which aligns with the way inventory moves in most businesses.

    • The cost is based on the earliest purchased items.

    • These products typically include fresh produce and large quantities of similar items.

  • Last In, First Out (LIFO):

    • The items purchased last are sold first, which means the items in stock are oldest.

    • This method is banned by the International Financial Reporting Standards, but the United States can use it because it is approved by GAAP.

    • Auto dealerships and convenience stores use LIFO to adjust for rising costs and take advantage of tax benefits.

  • Weighted Average Cost (WAC):

    • This method uses a single inventory layer, which means the cost of new purchases roll into the cost of existing inventory and is adjusted again as the business purchases more inventory.

    • Businesses use the weighted-average unit cost.

    • These items are often identical products, like books, games, or electrical tools.

  • Specific Identification:

    • The cost of each item is tracked separately, and the business charges the specific cost of the item to the cost of goods sold.

    • This method requires extensive data-tracking, so it is typically used with unique items like art, jewelry, and antiques.

• When companies assign costs to their products, they also include additional fees to account for administration and changes in the market.

• Accurate inventory costing helps companies determine the right amount of product to carry and the margins required for profitability.

• Businesses can use whichever valuating method they like, as long as they are consistent and identify the method.

Slide #4 Classifications of Inventory

• There are three main classifications of inventory: raw materials, work-in-progress, and finished goods.

  • Raw materials inventory is comprised of the unprocessed items that are used to create a product.

  • Work-in-progress inventory contains partially finished materials that are waiting for completed assembly.

  • Finished goods inventory is comprised of the completed products that are ready for sale, which are usually referred to as merchandise.

4.3 Determine the cost/value of inventory (SP)

Discussion Guide

Performance Indicator: Determine the cost/value of inventory

THINK ABOUT IT

From grocery stores and coffee shops to clothing companies and bookstores, each of these businesses is responsible for determining the cost and value of their inventory.

• Read on to learn about the reasons why businesses need to value inventory and how to determine this valuation.

KEY CONCEPTS

Slide #1 Cost vs. Value of Inventory

• Determining the value of inventory is more complicated than simply using the price it cost the business to purchase or sell the items.

  • Inventory valuation is based on all the costs associated with acquiring materials, manufacturing products, and transporting items for sale.

  • When determining the value of inventory, a business attempts to accurately represent the value of the items to that company.

  • This means the value of inventory includes all costs related to that inventory.

• The most accurate method to value inventory would involve identifying every single item in inventory, then adding the costs of each.

  • As you can imagine, this option is highly impractical for most businesses.

  • Therefore, businesses select a cost flow assumption concerning how inventory moves through the company.

  • These inventory valuation methods include First In, First Out (FIFO); Last In, First Out (LIFO); Weighted Average Cost (WAC); and specific identification.

Slide #2 Reasons To Determine Inventory Value

• Inventory is used to calculate Cost of Goods Sold (COGS), compute gross profit, and establish a company’s financial position.

• Businesses must accurately determine and carefully review their inventory valuation because it plays a major role in profitability and financial success.

• Companies determine inventory value for a variety of reasons, including:

  • Impact on financial statements:

    • Inventory valuation factors into a business’s Ending Inventory, which is used to calculate COGS.

    • Gross profit is then determined by subtracting COGS from Revenue.

    • If inventory is valued higher, cost of sales is lower, which results in higher reported profit levels (and vice versa).

  • Management decision-making:

    • Closely tracking and evaluating the cost and value of inventory enables management to make better financial decisions.

  • Taxes:

    • The method a business selects to determine its inventory cost directly impacts the amount of income taxes it pays.

  • Loans:

    • Inventory can be used as collateral, or security for payment, of a loan.

    • Accurate inventory valuation helps to determine the amount of money a business can borrow.

  • Business sales:

    • When a company is for sale, the purchase price includes inventory in its cost, which means the inventory valuation can work in favor of either the purchaser or seller.

Slide #3 Cost of Carrying Inventory

• It should come as no surprise that it costs money to hold, store, and manage inventory.

  • These costs are classified under inventory carrying cost, which is also referred to as carrying costs or holding costs.

  • Inventory carrying cost consists of all the expenses related to housing and storing unsold merchandise.

  • It includes tangible costs such as warehousing and storage, maintenance, shipping and handling, insurance, taxes, and salaries.

  • It also covers intangible costs like depreciation, opportunity cost, shrinkage, and obsolescence.

• Carrying costs usually make up 20% to 30% of total inventory costs.

  • Evaluating carrying cost percentages can clarify inventory numbers, determine the efficiency of inventory management, and highlight areas for improvement.

  • If a company doesn’t carefully monitor carrying costs, then profits and cash reserves will be impacted.

  • Companies generally set their prices based on total inventory costs, so tracking carrying costs helps present a better picture of their COGS.

  • By minimizing these carrying costs, businesses can optimize inventory value, set better prices, and enhance their profits.

Slide #4 Procedures for Calculating Inventory Value

• Businesses can use whichever inventory valuation method they choose, provided they identify it on their financial statements and use it consistently.

• However, special circumstances exist where businesses may need to use a different method to value their inventory.

  • The lower of cost or market (LCM) method is an inventory costing method that can be used when the value of inventory is less than the cost.

    • This means valuing inventory at the lower value of either its historical cost (i.e., inventory cost set under FIFO, LIFO, WAC, or specific identification) or its market cost (i.e., the item’s replacement cost).

    • The assumption of the LCM method is that if an item’s purchase price has fallen, then its selling price has fallen or will fall.

    • To put it simply, businesses use whichever valuation is lower, either the cost or market value of the inventory.

• Companies calculate inventory value at the end of each financial year.

  • They evaluate their specific business needs, then select one of the four inventory valuation methods (or LCM in special cases).

  • After calculating their valuation, it is recorded as a current asset on the balance sheet.

4.4 Discuss the impact of obsolescence on business expense (SP)

Discussion Guide

Performance Indicator: Discuss the impact of obsolescence on business expense

THINK ABOUT IT

To be profitable and keep expenses low, businesses must pay close attention to obsolescence and depreciation when designing products, choosing inventory, and making strategic business decisions.

KEY CONCEPTS

Slide #1 What Is Obsolescence?

• Obsolescence is a significant reduction in the utility and value of an asset or product.

  • Obsolescence occurs when there are less expensive alternatives available, new technological developments, or when customer preferences change over time.

• Functional obsolescence is the decrease in a product’s value due to an outdated element that cannot be easily modified.

  • Often applied in real estate, functional obsolescence exists when certain features or amenities (or lack thereof) cause a property to lose its usefulness.

  • Electronics, like smartphones, are also prone to become functionally obsolete when new models offer more features and the old models are incompatible with new technology.

• External (economic) obsolescence is the loss of value caused by external factors, including new legislation, increased competition, reduced demand, the economics of an industry, loss of resources, and/or operating restrictions.

  • External (economic) obsolescence can arise at any time and is often outside the owner or business’s control.

Slide #2 Obsolescence vs. Depreciation

• Depreciation is the gradual decrease in value of a product or asset over time caused by natural wear and tear.

  • A product undergoes physical deterioration over its life cycle through use.

  • Depreciation refers to a product or asset’s diminishing usefulness over time.

  • To calculate depreciation, businesses consider the product or asset’s cost, its useful life, and its salvage value.

  • Companies typically write off the value of an asset (e.g., a piece of equipment) over the length of its useful life (e.g., 10 years) instead of paying the entire cost in one year.

• Obsolescence, on the other hand, is deterioration that results from new technological developments, shifts in product design, and/or changes in consumer demand.

• Depreciation is directly related to the use of the product or asset over time.

Slide #3 Planned Obsolescence

• Planned obsolescence is a strategy of purposefully ensuring the version of a product will be useless or dated within a certain period of time.

  • This proactive strategy guarantees customers will pursue the new and improved replacement products moving forward, which increases demand.

  • Technology companies often rely on planned obsolescence with two- and three-year replacement cycles in smartphones and computer hardware.

  • Consumers often do not react well to planned obsolescence, especially if the next product does not offer notable improvements.

  • However, many businesses implement this strategy to control costs.

Slide #4 Unanticipated Obsolescence

• Businesses need to account for both physical obsolescence, due to wear and tear, and technological obsolescence, due to newer available models.

• When companies do not plan for obsolescence, it can negatively impact their profitability and business costs.

• Businesses can lose time, money, and customers if the company cannot effectively make and sell current products.

Slide #5 Reducing Obsolescence Expense

• There are numerous strategies that can aid in reducing obsolescence expense.

  • Businesses should actively scan for future technological and sociopolitical trends that could lead to obsolete products or processes.

  • Businesses can build in future functional change options into their products, test prototypes extensively for quality construction, and encourage flexibility and adaptability within product design.

  • Companies should forecast customer demand as accurately as possible and avoid purchasing excess inventory.

  • Within operations and maintenance, businesses can adapt products or facilities for reuse and retrofit.

• Overall, it is important for business owners, product users, and supply chain members to work together when researching, designing, constructing, and managing the creation of products.

4.5 Discuss the nature of long-term assets (e.g., tangible assets, intangible assets, natural resources, etc.) (SP)

Discussion Guide

Performance Indicator: Discuss the nature of long-term assets (e.g., tangible assets, intangible assets, natural resources, etc.)

THINK ABOUT IT

Let’s say you just bought a car.

• You anticipate that you will own the car for about 10 years.

• You think that you want to set aside some money each month in case the car breaks down, especially as you drive the car around over time.

• The more time passes, the more likely the car may break down.

• The car is a long-term asset, and the expectation that a breakdown may occur is an example of depreciation.

• You’ll learn more about how businesses manage situations like this every day below.

KEY CONCEPTS

Slide #1 Long-term assets, also called fixed assets, are assets that are held for one year or more by a business.

• When a long-term asset, such as land or machinery, is purchased by a business, the transaction is logged as the purchase price for that year.

• Some long-term assets, like investments, will generate revenue for a business.

• Long-term assets can be categorized as either tangible or intangible.

• Tangible assets are items that can be physically possessed, including office space, work equipment, and even investments like stocks.

• Intangible assets are those that are not physical in nature, and can include things like patents, intellectual property, and even goodwill from stakeholders.

• Intellectual property is an asset that results from thinking processes.

• The designs for a new product or process, as well as copyrights to a book are examples of intellectual property.

Slide #2 Both tangible and intangible assets will lose value over time.

• Depending on the type of asset, businesses will account for the loss of value as either depreciation, amortization, or depletion.

• Depreciation, used for tangible assets, is the reduction in value of goods and assets over a period of time.

• A business will take away a percentage of the original price of the long-term asset each year to account for depreciation.

• Amortization accounts for the loss of value for intangible goods.

• Costs associated with an intangible asset are classified as operating costs, and revenue is deducted to reduce federal tax liability

• Finally, depletion is the loss of value specific to natural resources industries.

• It is used to account for the use of natural resources, because they cannot be replaced after being depleted.

• Examples of natural resources include natural gas or oil.

• Depreciation, amortization, and depletion allow businesses to deduct the cost of the asset from federal tax returns, meaning more cash on hand over time.

• Generally, the cost of long-term assets is spread out over time.

• Money that comes back from tax deduction comes back as cash, and then payments are documented as expenses.

• This allows businesses to eventually earn back money used to purchase the asset over a period of time.

Slide #3 There are times when an asset may depreciate faster than anticipated.

• This accelerated depreciation is an example of a long-term asset becoming impaired.

• Impairment is when the value of an asset goes below the value it was originally accounted for.

• This could happen because a business’s environment changed, if there were new government regulations, or even if a building suffered extensive damage due to a natural disaster.

Slide #4 Businesses need to have a strategy for how they will manage their long-term assets, because they will frequently possess many at the same time.

• For example, a business may have office space, vehicles for work, investments, and intellectual property.

• Businesses and organizations need to document their long-term assets, assess their value, and make decisions regarding whether the assets are still needed as time passes.

  • For example, imagine a city government bought a garbage truck to help with its weekly trash pick-up.

  • The city currently has five trucks, but one of them has been used for 15 years and repair bills are piling up.

  • The other four trucks are operating normally.

  • A step-by-step guide for how the city government implements its asset management strategy is below:

1. The city documents all of its current garbage truck fleet, including any issues.

2. If there are any major issues with an asset, the city will try to either fix the asset or get a new one to replace it.

3. The city purchased the new truck, recorded its current value, and the maintenance program starts again.

4.6 Describe the methods used to value long-term assets (e.g., tangible assets, intangible assets, natural resources, etc.) (SP)

Discussion Guide

Performance Indicator: Describe the methods used to value long-term assets (e.g., tangible assets, intangible assets, natural resources, etc.)

THINK ABOUT IT

Think about grocery stores.

• If you walked in and noticed that a dozen eggs are being sold for $100, you likely wouldn’t buy those eggs!

• And, if you noticed a gallon of milk being sold for 25 cents, you’d know the store wouldn’t be making enough money from that sale.

• Products are priced at their appropriate value.

• The same is true for all of the long-term assets of a business, including natural resources, tangible assets like equipment, and intangible assets like intellectual property.

• In this handout, you’ll learn how businesses value these long-term assets.

KEY CONCEPTS

Slide #1 Long-term assets are assets businesses possess for more than one year.

• Because a tangible asset is a physical object, it’s a bit easier to value than intangible assets.

• Tangible assets include work equipment, buildings, office space, and vehicles.

• Tangible assets are usually valued at the price that a business originally acquired the asset.

• The assets depreciate over time, and businesses use a formula to account for general wear and tear the assets experience over time.

  • Depreciation is commonly calculated with the salvage value—the anticipated value of an asset—purchase price, and expected asset life.

  • The formula looks like this:

    • (Purchase Price – Salvage Value) / Anticipated Asset Life = Depreciation

• Another way to value tangible assets would be finding the fair market value of an asset.

  • That is done by evaluating how similar assets are priced.

  • In this situation, a business would typically use the help of an appraiser; that is, someone who professionally values assets.

Slide #2 Intangible assets are a bit more difficult to value.

• They are not physical objects, but instead are assets like intellectual property, patents, and goodwill from stakeholders.

• And, for an intangible asset to actually be listed on a businesses’ balance sheet, the asset has to have been purchased and controlled by that same business.

• In that scenario, the value of the intangible asset should be recorded at the price of the intangible asset’s cost.

• There are three general ways to assess the value of an intangible asset that a business developed.

  • They are the cost approach, income approach, and market approach. Let’s look at each one a bit further.

• Cost approach:

  • The cost approach is used to assess how much it has cost to develop the intangible asset at the point in time the valuation is occurring.

  • Another way businesses use the cost approach is to determine how much it would cost to replace the intangible asset.

• Income approach:

  • Businesses use the income approach in two ways.

  • The first is to evaluate how much revenue is currently made by the intangible asset, if any.

    • The asset is also compared to similar assets and a generally accepted royalty rate is added to that value.

    • A royalty is a fee that is paid to a company that is often based on a percentage of the company’s profits.

    • This type of income approach is called the relief from royalty method.

  • Another way is to evaluate how much money a business would make if the business estimated the revenue from after-tax cash flow.

    • This income approach is called the excess earnings method.

• Market approach:

  • In the market approach, businesses evaluate how much other comparable intangible assets are valued.

  • This can be difficult because of the unique qualities of each intangible asset.

Slide #3 If a business owns natural resources like oil, they are generally valued by the cost at which the resources were acquired.

• Often, fees that go into the development and acquisition of the natural resource are also included on the balance sheet.

• Over time, natural resources are depleted, meaning that the value goes down over time.

Slide #4 Businesses need to value their long-term assets for a variety of reasons.

• First, it helps to take stock of all of the capital and assets that help run the business.

  • Evaluating how much their assets—tangible and intangible—are worth helps companies make decisions in regard to running the business.

  • Assets are included on the balance sheet of businesses and gives a fuller picture of what a financial situation is at a specific point in time.

4.7 Discuss the nature of depreciation (SP)

Discussion Guide

Performance Indicator: Discuss the nature of depreciation

THINK ABOUT IT

All tangible assets lose value over time.

• Businesses need to keep track of that loss of value to accurately account for their own financial situations.

• They do that by using an accounting method called depreciation, which you’ll learn more about below.

KEY CONCEPTS

Slide #1 Depreciation is the reduction in value of tangible assets that a business owns for more than one year.

• Tangible assets are assets that are physical in nature, like office buildings, equipment, and vehicles.

• Businesses depreciate their tangible assets over time to account for their drop in value, and to spread the cost of expensive assets over time.

• When an asset is depreciated, it lowers the company’s income, meaning that a business has less taxes to pay while the asset is on record.

• That’s because depreciation is an expense.

• Depreciation is tracked in two ways in a business’ accounting records.

  • The first is the depreciation expense, which is logged on the income statement.

    • The income statement is the summary of a business’s income and expenses over time.

    • Depreciation expense is the amount that an asset is depreciated during the specific time covered in the income statement.

  • The second way is through the accumulated depreciation of an asset, which is the total depreciation of the asset year after year.

    • Accumulated depreciation is recorded on a business’s balance sheet.

    • The number that is decreased over the accumulated time is called the carrying value.

      • For example, if an asset was valued at $50,000 at its purchase cost, and it accumulated $10,000 in depreciation for one year, the carrying value is $40,000.

    • Carrying value is also known as book value.

Slide #2 There are four methods that are typically used to account for depreciation: straight-line, double declining, units of production, and sum of years.

• Read about all four methods below.

• Straight-line depreciation

  • Straight-line depreciation is the most used depreciation method.

  • Businesses use it to take the carrying value of an asset in equal amounts over the asset’s lifespan.

  • It is also the simplest of the four methods to use.

  • With straight line depreciation, you’re solving for the annual depreciation expense.

  • To solve for depreciation using the straight-line method, subtract the salvage value—the amount an asset is expected to be worth at the end of its lifespan—from the original asset cost.

  • Then divide by the estimated life of the asset.

  • The formula is below:

    • Annual depreciation expense = (Asset cost – Salvage value) / Estimated life of the asset

  • When using straight-line depreciation, you can also easily calculate the depreciation rate, which is a percentage that represents depreciation over one year.

  • The depreciation rate can be solved for this way:

    • Depreciation rate = 1 / Useful asset life

  • For example, if an asset was valued at $10,000 initially, and it has a useful asset life of 5 years, the depreciation rate would be 0.2 or 20 percent.

• Double declining balance depreciation

  • Double declining depreciation is an accelerated depreciation method.

  • Businesses use this method when they anticipate the rapid decline of an asset early in an asset’s life cycle.

  • This is a method that is used to depreciate cars or trucks businesses own.

  • There will be higher depreciation in the beginning of the asset’s life, and lower depreciation toward the end.

  • To solve for depreciation expenses for a specific year using the double-declining method, start with the carrying value of the asset, the estimated life of the asset, and the asset’s salvage value.

  • The depreciation rate will also be needed.

  • The formula is below:

    • Depreciation = Carrying value * Depreciation rate * 2

• Sum of Years’ Digits (SYD) depreciation

  • The sum of years’ digits depreciation method is another type of accelerated depreciation method.

  • It is used for more savings on tax payments early on and is typically used for technology that ages or becomes outdated quickly.

  • To solve for sum of years digits depreciation, you need the estimated useful asset life, the original value, and salvage value.

  • There are multiple steps to find the depreciation expense with SYD.

  • First, the years of the asset’s life need to be added up.

    • For example, if the asset’s life is five years, you would need to add 1 + 2 + 3 + 4 + 5 = 15.

  • Another way to find the sum of years’ is the formula below.

    • Sum of years’ digits = (n (n + 1)) / 2

  • After finding the sum of years’, you will need to find the depreciation expense.

  • That is done by taking the sum of years’ and placing it as the denominator of a fraction.

  • To find the depreciation expense, multiply the original value by the year divided by the sum of years’.

  • The formula to solve for depreciation expense will look like this:

    • Carrying value * (Remaining life / Sum of years)

    • For example, if there are four years remaining in a five-year lifespan, and the original value is 100,000, the equation would look like this:

      • 100,000 * 4 / 15 = 26,666

    • Another example for how to solve for sum of years digits depreciation can be found here: https://www.accountingtools.com/articles/2017/5/17/sum-of-the-years-digits-depreciation.

• Units of production depreciation

  • The units of production depreciation method is used for assets that are used at varying levels.

    • For example, if a manufacturing machine is used frequently during the summer and infrequently during the winter, it could change how much general wear and tear the machine has over time.

  • Units of production should not be used for an asset that is used consistently over its life cycle

  • To solve for depreciation using the units of production, you will need the original value, salvage value, the estimated production of the asset, and the units produced per year.

  • The salvage value is subtracted from the original value.

  • That number is then divided by estimated production in order to establish the production rate for the asset.

  • To solve for the depreciation expense, the production rate is multiplied by the units produced.

  • The formula is below.

    • Units of production = [(Original value – Salvage value) / Estimated production] * Units used per year

4.8 Account for long-term assets (e.g., record acquisition, record depreciation/amortization, record disposal) (SP)

Discussion Guide

Performance Indicator: Account for long-term assets (e.g., record acquisition, record depreciation/amortization, record disposal)

THINK ABOUT IT

Running a business means recording every transaction made over a company’s lifespan.

• That includes short-term office supplies like paper, but also larger purchases like company vehicles and office space that are long-term assets.

• There’s good reason for recording each transaction: it allows owners and business leadership to make informed decisions about their business’s future.

• Here you’ll learn more about how to account for long-term assets.

KEY CONCEPTS

Slide #1 You’ll remember that long-term assets, sometimes called fixed assets, are items a business owns for more than one year.

• Long-term assets are either tangible or intangible.

  • Tangible assets are physical objects and can include items like buildings, machinery, and equipment.

  • Intangible assets can include intellectual property like patents and copyrights, as well as goodwill.

• All of these assets show up cumulatively on a business’s balance sheet.

• The balance sheet is a financial statement that captures the financial condition of the business at that particular moment, including line items for total assets and total liabilities.

• An account is credited to record decreases in an account, and an account is debited to record increases in an account.

• Each account needs to be balanced, so if an asset’s value changes, a number will change in both the credit and debit section for the account of the asset.

  • For more information on crediting and debiting accounts, follow this link: https://www.accountingcoach.com/bookkeeping/explanation/5.

• As required under Generally Accepted Accounting Principles (GAAP), a long-term asset’s value needs to be depreciated or amortized over time.

• The disposal of a long-term asset will show up in the balance sheet and needs to be recorded.

• You’ll learn more about these processes and where each entry is recorded below.

Slide #2 When a business acquires or purchases a long-term asset, the asset is recorded on the balance sheet at the complete purchase cost.

• That includes any type of additional cost for the asset to ship to the business and could include sales tax cost.

• The purchase can be outright or through a loan.

  • If the purchase is outright, the assets account would be debited the purchase cost and the cash account would be credited the purchase cost.

  • If the purchase was made through a loan or an installment, recording the installment is not much different.

  • In that scenario, the down payment (the initial payment) is credited to the cash account.

  • Any additional payment would be credited to the loan account.

  • The asset account would be debited for the entire value of the asset in order to keep all accounts equal.

Slide #3 Depreciation and amortization are used to track the decline of a long-term asset’s value over time.

• Depreciation is used for tangible long-term assets and amortization is used for intangible long-term assets.

• Both depreciation and amortization are practices that are followed under GAAP and are usually done annually.

• Depreciation of an asset is recorded on a business’s balance sheet.

  • To depreciate assets, debit the depreciation expense account, and credit the accumulated depreciation account.

  • The book value is the number that will decrease over time.

  • An example can be found here: https://www.accountingtools.com/articles/what-is-the-accounting-entry-for-depreciation.html.

• Amortization of intangible assets works in a similar way.

  • To journalize the amortization of an intangible asset, debit the amortization expense account and credit the accumulated amortization account.

  • An example can be found here: https://www.accountingtools.com/articles/what-is-amortization.html.

Slide #4 Inevitably, a long-term asset will no longer be of use to a business.

• A business could dispose of an asset if it has depreciated or amortized fully, or if the asset is simply no longer needed.

  • Whatever the case may be, a long-term asset needs to be removed from a business’s books properly to indicate the disposal of the asset.

• Look at these scenarios below to see how a business would journalize the disposal of a long-term asset.

• Fully depreciated or amortized:

  • If the fixed long-term asset has depreciated or amortized fully, a journal entry has to be made that will debit the accumulated depreciation or amortization account and credit the asset account.

• Sale:

  • If a long-term asset is sold, the first thing that needs to be journalized will be an updated depreciation or amortization of the asset.

  • Because of the updated depreciation or amortization, the asset’s value will also be updated.

  • The cash given to the business in the sale of the asset will also be recorded.

  • For an example of both a sale for a gain and a sale for a loss, follow this link: https://www.accountingtools.com/articles/how-do-i-record-the-disposal-of-assets.html.