Depreciation and depletion are two models of computing financial reports. These techniques are used as adjustments when preparing statements of cash flow within the direct or indirect method. This paper will identify and examine the methods of depreciation and depletion, describe the difference between the methods, and compare and contrast depreciation and depletion as well using scholarly references to support the points. Net income is reduced through depreciation and is an expense of the company. It does not reduce cash of the company. This adjustment does not involve the calculations of current cash flow.
Calculations should be put back on net income in order to produce the outcomes of cash that has been provided by the operations of the company. Depreciation occurs when economic and physical factors cause a decline with potential services. It provides replacement funds but does not provide funds. Depreciation is a non-cash expense given by the IRS that is very important to a company’s cash flow. Book depreciation is based upon the usage of assets. Tax depreciation is subtracted from the company’s income when completing yearly taxes using MACRS.
Kieso, Kimmel, and Weygandt (2011) explain that depreciation as “the process of allocating the cost of an asset to expense over its useful life” (p. 197). It is a way to basically created funding for the company and also means the value of an asset has been deducted. It causes a loss in value and can decrease the marketing price of valued good. It can also create a decrease in taxes and increase cash flow. One thing that cannot be depreciated is land. Wiley (2007) states that retaining funds, depreciation reduces “taxable income and retained earnings available for dividends” (p. 5). Capital assets have a chance to depreciate.
Fixed assets include shipping, installation, preparation costs, repairs, additions, and improvements. It occurs and is calculated in debit and credit. There are many different depreciation methods. Some of these methods include straight-line, declining balance, and sum-of-the-years’-digits. (Noland, 2011) These classical depreciation methods are used to find annual depreciation. The accelerated depreciation methods, such as the sum-of years’ digits method and the double declining method, allow companies to record little amounts of depreciation within a asset’s later years of life.
It also allows depreciation is larger amount to be recorded earlier in the life of an asset. Many assets show decline when it comes to the asset’s productivity and fair value over time. (Noland, 2011) Issues are bound to occur within depreciation methods. Depreciation is usually computed on the nearest full month. Companies need to know how to compute depreciation when it comes to partial periods. Revenues serve as funds used for the replacement of occurring assets. Another issue is handling revisions of the rates associated with depreciation. The double declining balance method is an accelerated depreciation model.
Due to this method doubling the rate of the straight line method, it was called the double declining balance method. This type of method is systematic and rational, as well as more flexible than the other methods. (Noland, 2011) It is also easier to apply the method to partial periods. Not to mention, it is acceptable to use this method for reporting taxes. (Noland, 2011) Currently, this method is likely to be the best candidate to produce to best cost allocation outcome. The declining balance method is not approved for tax depreciation and is mostly used for book depreciation.
This method uses a fixed percentage to reduce the book value. Using the double declining balance method, the annual depreciation is found by the formula: d = 1 – (s / b) to 1/10 squared. The implied salvage value is found by using the formula: BV = B (1 -d)? Another method of depreciation is called sum-of-the-years’-digits. This method divides the number of time periods remaining by the sum of the total number of time periods. (Noland, 2011) It divides the number of time periods remaining by the sum of the total number of time periods. The sum of year method is also known as amortization and accelerated depreciation techniques.
It is put to use when one applies intangible assets and is an acceptable way to calculate cost allocation. (Noland, 2011) Many used to see this method as producing the best possible cost allocation outcomes. The sum of the year model is mostly used by regulated industries and banks. (Noland, 2011) It is acceptable to use this method to report finances, but is not acceptable to use for reporting taxes. This method was used by many until it was no longer acceptable to use for reporting taxes. This occurred when the Accelerated Cost Recovery System was placed.
Noland (2011) stated that this act, that was placed in 1981 “specified both the life of the asset and the depreciation rate for tax purposes” (p. 2). This system has changed and has been renamed and is now known as MACRS. The Modified Accelerated Cost Recovery System is another model of depreiciation. The MACRS is the only approved method to use in the US. Using this method, the depreciation always equals 0. Properly is categorized and then placed in classes. These classes normally determine recovery periods, leaving a year longer to recover. With this method, the rates are tabulated.
By using the regular MACRS, the recovery periods will be longer. Straight line can be used in combination with MACRS. The MACRS does not consider useful life, but class life instead. It is used by a majority of companies when it comes to reporting their taxes. It categorizes company assets, and allows write-offs per each class. Over long periods of time, it allows larger accelerate depreciation. Acceleration occurs faster using this method. When it comes to calculators, typewriters, and copiers it is known as 5 year. Microsoft (2012) explains that the IRS allows “3, 5, 7, 10, 15, 20, 25, and 27. years for residential real property, and 39 years for nonresidential real property” (¶24). Factory machinery is known as 7 year. Common problems occur when choosing the correct class type to classify items. It is important to avoid improper averaging convention as well. One should ensure that this method is the correct method to use. It is essential to make sure it is in the best interest of the company to depreciate the asset. The company may make out better taking section 179 allowing full deduction of the cost of some assets. The straight line method is a classical, a non-accelerated depreciation model.
This model is widely accepted and used to find depreciation values. It is the only method used in real estate. Rather than the straight line method considering as a function as usage, it considers depreciation as function of time. Over x amount of years, the straight line method writes off capital investment and always considers the estimated salvage value. (Noland, 2011) Using the straight line method to calculate annual depreciation, the estimated salvage value is subtracted from the first cost or unadjusted basis and then divided by the recovery period.
The formula is as follows: D = (B-S) / n Special methods of depreciation include group method, composite approach, and hybrid of combination methods. The first method is group method. When assets basically have the same useful lives and have a similar nature, the group method is used. It uses the average depreciation rate for the group. This method is used with multiple accounts. The second method is the composite approach, which also uses the average depreciation rate for the group. When assets have different useful lives and do not have a similar nature, the composite approach is used.
It is also used on multiple accounts calculating assets individually, it calculates the assets collectively. Depletion, which is a systematic allocation, is another deduction granted from the IRS. It is available when natural resources become used up. The IRS (2012) explains that this type of deduction “allows an owner or operator to account for the reduction of a product’s reserves” (¶2). Some examples include quarrying, drilling, chopping timber, and mining. Each period natural resources are consumed, it is considered depletion. These resources are also wasted.
Ramos (2010) explains that “wasting assets are characterized as physically consumable and irreplaceable” (¶8). This means that the economic value of a resource will be important when calculating depletion. Assets in the form of depletions come in and go out. Kieso, D. E. , Kimmel, P. D. , ;amp; Weygandt, J. J. (2012) during accounting period when there are decrease from in economic benefits “in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity other than those relating to distributions to shareholders” is produces an expense for the company.
Finding depletion is accomplished by using either a cost depletion method of percentage depletion method. Depletion consists of acquisition cost and exploration costs. There are two main features associated with depletion. These features are complete removal of asset and replacement of the asset. When establishing a base for depletion, there are 4 main factors to take into consideration. These factors include acquisition cost of the deposit, exploration costs, development cost, as well as costs for restoration. Depletion uses the units of production method, which is an activity approach, to write-off the cost of resources.
During each period, the amount of units that are extracted is a function of depletion. Depletion cost per each unit is formulated as: depletion cost per unit = (total cost – salvage value) divided by the total estimated units available. Depletion is found by using the formula: depletion = Units extracted multiplied by the cost per unit. There are problems that occur within the depletion process of accounting. The first problem is that recoverable reserves may be difficult to estimate. There may also be a problem when it comes to the discovery value. Problem occur within natural resources and the tax aspects that are attached to it.
Accounting for liquidating dividends may also cause a problem in depletion. Depreciation and depletion both imply cost allocation. They shows when assets have declined. Depletion establishes a base and uses write -off of the resource cost. Both methods are introduced within Generally Accepted Accounting Principles (GAAP). They should also both take estimated useful life, historical cost, and salvage or residual value. Depreciation and depletion have their differences. Depreciation deals with fixed assets where as depletion deals with natural resources.
Both show different asset types when it comes to cost allocation. Depreciation is shown when assets decrease in value and depletion is shown when wasting assets. Depreciation has special issues where as depletion has special problems. When it comes to computing financial reports, depreciation and depletion are two models used to make adjustments. This paper has identified and examined the methods of depreciation and depletion, described the difference between the methods, and compare and contrast depreciation and depletion as well using scholarly references to support the points.
The methods that are used when preparing statement can show where there is loss and gain enabling the company to make better decisions for the future of the company. References IRS. (2012). Depletion . Retrieved November 19, 2012, from IRS: http://www. irs. gov/publications/p535/ch09. html Kieso, D. E. , Kimmel, P. D. , ;amp; Weygandt, J. J. (2000, 2012). Financial Accounting: Tools for Business Decision Making (6th ed. ). John Wiley ;amp; Sons, Inc. Retrieved October 2012, from http://bcs. wiley. com/he-bcs/Books? ction=resource;amp;bcsId=6075;amp;itemId=047053477X;amp;resourceId=24503 Microsoft. (2012). Understand Depreciation. Retrieved November 20, 2012, from Microsoft: http://office. microsoft. com/en-us/excel-help/understand-depreciation-HA001226442. aspx Noland, T. R. (2011). The sum-of-years’ digits depreciation method: use by SEC filers. Journal of Finance and Accountancy, 1-12. Retrieved November 20, 2012, from http://www. aabri. com/manuscripts/10577. pdf Ramos, J. L. (2010, June 11). Accounting terms: Depreciation, depletion, amortization.