124 125
how finance works
Financial accounting
Year 2 After the second year, the
value has depreciated by another
$4,000. The van will lose an equal
amount of value each year for the next
three years of its useful economic life.
Year 3 At the end of the third
year, the van has depreciated
by another $4,000, and its book
value is $13,000, although its
actual value may be more or less.
Year 4 The van
has depreciated by
$4,000, to $9,000,
at the end of four
years of life.
Year 5 By the
end of year five,
the van is valued
at only $5,000—
its scrap value.
RACEHORSES
2 years
COMPUTERS
3 years
OFFICE
FURNITURE
6 years
ROADS
15 years
BOATS
20 years
FRUIT-
BEARING TREES
10 years
Time
(years)
5 15
10 20
$17,000
$13,000
$9,000
$5,000
TIME (YEARS)
2 3 4
5
Typical life of fixed asseTs
Tax authorities often specify the typical useful (economic) life of a particular asset.
This helps to standardize depreciation, and to eliminate uncertainty about value
and the number of years over which an asset can be depreciated.
60%
the value the
average car
loses after
three years
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DEPRECIATION
Sum of the years’ digits
method (SYD)
Depreciation is calculated by dividing each
year of the asset’s life by the sum of the total years to
give a percentage of the depreciable value. If the asset’s
useful life is 5 years, then the sum of the years as digits
is 15 (5 + 4 + 3 + 2 + 1). In year 1, it loses 33 percent
(5 ÷ 15), in year 2, 27 percent (4 ÷ 15), and so on.
Applying depreciation
When calculating depreciation,
there are a number of different
factors to consider. For instance,
a business needs to be able to
predict the number of years an
asset will last. Helpfully, tax
authorities in most countries issue
guidelines to accountants and
businesses with estimates of
the useful economic life of many
common business assets.
Companies may also wonder
which of the many methods of
calculating depreciation to use
for a given asset. Each method
reflects a different pattern of
depreciation, with some being
more suitable for particular
categories of assets. For example,
the “accelerated” methods that
chart rapid depreciation at the
beginning of an asset’s life are
more suitable for technology,
while the “activity” methods that
link depreciation to actual hours
of use or number of units produced
are best suited to transport and
production lines.
Again, tax authorities in most
countries offer guidelines on which
method to use. Although it is
technically possible for a company
to use two different methods for
their own accounting and for tax
purposes, this is best avoided.
(PURCHASE VALUE – SCRAP VALUE)
X
REMAINING USEFUL LIFE
SUM OF THE YEARS’ DIGITS
There are many different methods of calculating depreciation. Some are favored
by particular tax codes, while others are specifically applicable to certain industries
and types of assets, and their patterns of value loss.
Double declining balance method
A method used to claim more depreciation in
the first years after purchase, which is useful for
assets that lose most of their value early on. It reduces a
company’s net income in the early years of an asset’s life,
but generates initial tax savings.
PURCHASE VALUE – SCRAP VALUE
USEFUL ECONOMIC
LIFE (YEARS)
When to use it This accelerated method can be used for assets
that lose most value early on, such as computers or a delivery truck.
When to use it This is another accelerated method that can also
be used for vehicles that lose most of their value early on.
(
X 2 =
ANNUAL
DEPRECIATION
(%)
( )
=
ANNUAL
DEPRECIATION
(%)
)
Other depreciation methods
Misusing depreciation
The wrong method A company
must choose a method that is
permissible for an asset type
Frontloading Opting for an
accelerated method can result in a
taxable gain if an asset is sold early,
for more than its book value
Claiming beyond useful life
Depreciation cannot be claimed
after an asset’s useful life
Ignoring depreciation If a
company fails to claim depreciation,
it has to report a gain from the sale,
despite the loss on deduction
WARNING
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how finance works
Financial accounting
Hours of service method
The asset’s decline in value is measured
according to the number of actual hours it is
in use. To calculate depreciation using this method,
the company measures the hours of use per year as a
percentage of the estimated total lifetime hours. It is
particularly useful for transportation industries.
Units of production method
When a company uses an asset to produce
quantifiable units, such as pages printed
by a photocopier, it can claim depreciation with this
method, which calculates depreciation according to the
number of units an asset produces in a year.
(PURCHASE VALUE – SCRAP VALUE)
X
UNITS PRODUCED PER YEAR
LIFETIME PRODUCTION
(PURCHASE VALUE – SCRAP VALUE)
X
HOURS USED PER YEAR
LIFETIME HOURS
Previous year’s total
assets can be compared
Total assets are calculated
after depreciation has been
deducted
When to use it This method is typically used by factories to
calculate depreciation on machines that produce units of goods.
When to use it This method may be used to match an airplane’s
flying hours with the revenue generated from those hours.
( )
=
DEPRECIATION
(PER UNIT)
( )
=
DEPRECIATION
(PER HOUR)
Depreciation of fixed
assets is deducted
Fixed assets are shown
distinct from current assets
DEPRECIATION ON THE BALANCE SHEET
A company’s accounts have to list all assets held by the
company, including all fixed assets such as property and
equipment. The accumulated depreciation of these fixed
assets over the year is deducted from their value at the
start of the year to give the year-end total. Without a
depreciation figure, the accounts would give a false
reflection of the finances of the business. The assets
would appear as their original cost value and that might
well exceed their current value.
COMPANY NAME BALANCE SHEET
Assets
Current assets: 2013 2014
Cash 17,467.0 0 8,023.00
Investments 4,853.00 3,367.00
Inventories 1,056.00 2,138.00
Accounts receivable 2,165.00 3,600.00
Prepaid expenses 3,000.00 3,000.00
Other 860.00 976.00
Total current assets 29,401.00 21,104.00
Fixed assets: 2013 2014
Property and equipment 64,553.00 58,219.00
Building/site improvements 4,780.00 2,679.00
Equity and other investments 3,789.00 4,587.00
Less accumulated depreciation 5,625.00 4,171.00
Total fixed assets 67,497.00 61,314.00
Other assets: 2013 2014
Goodwill 1,577.00 1,650.00
Total other assets 1,577.00 1,650.00
Total assets 98,475.00 84,068.00
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how finance works
Financial accounting
Hours of service method
The asset’s decline in value is measured
according to the number of actual hours it is
in use. To calculate depreciation using this method,
the company measures the hours of use per year as a
percentage of the estimated total lifetime hours. It is
particularly useful for transportation industries.
Units of production method
When a company uses an asset to produce
quantifiable units, such as pages printed
by a photocopier, it can claim depreciation with this
method, which calculates depreciation according to the
number of units an asset produces in a year.
(PURCHASE VALUE – SCRAP VALUE)
X
UNITS PRODUCED PER YEAR
LIFETIME PRODUCTION
(PURCHASE VALUE – SCRAP VALUE)
X
HOURS USED PER YEAR
LIFETIME HOURS
Previous year’s total
assets can be compared
Total assets are calculated
after depreciation has been
deducted
When to use it This method is typically used by factories to
calculate depreciation on machines that produce units of goods.
When to use it This method may be used to match an airplane’s
flying hours with the revenue generated from those hours.
( )
=
DEPRECIATION
(PER UNIT)
( )
=
DEPRECIATION
(PER HOUR)
Depreciation of fixed
assets is deducted
Fixed assets are shown
distinct from current assets
DEPRECIATION ON THE BALANCE SHEET
A company’s accounts have to list all assets held by the
company, including all fixed assets such as property and
equipment. The accumulated depreciation of these fixed
assets over the year is deducted from their value at the
start of the year to give the year-end total. Without a
depreciation figure, the accounts would give a false
reflection of the finances of the business. The assets
would appear as their original cost value and that might
well exceed their current value.
COMPANY NAME BALANCE SHEET
Assets
Current assets: 2013 2014
Cash 17,467.0 0 8,023.00
Investments 4,853.00 3,367.00
Inventories 1,056.00 2,138.00
Accounts receivable 2,165.00 3,600.00
Prepaid expenses 3,000.00 3,000.00
Other 860.00 976.00
Total current assets 29,401.00 21,104.00
Fixed assets: 2013 2014
Property and equipment 64,553.00 58,219.00
Building/site improvements 4,780.00 2,679.00
Equity and other investments 3,789.00 4,587.00
Less accumulated depreciation 5,625.00 4,171.00
Total fixed assets 67,497.00 61,314.00
Other assets: 2013 2014
Goodwill 1,577.00 1,650.00
Total other assets 1,577.00 1,650.00
Total assets 98,475.00 84,068.00
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How it works
Amortization is how the cost of purchasing an
intangible asset, such as copyright of an artwork, is
spread over a period of time, usually its useful lifetime.
It is shown as a reduction in the value of the intangible
asset on the balance sheet and an expense on the
income statement. In lending, amortization can also
mean the paying off of debts over time. Depletion
shows the exhaustion of natural resources such as
coal mines, forests, or natural gas.
Amortization
and depletion
Amortization in practice
There are two types of amortization, one for spreading the cost of an
intangible asset, the other for loan repayment. Both are calculated in
similar ways, but loan repayments are worked out as a percentage.
Similar concepts to depreciation, amortization and depletion are used
by accountants to show how intangible assets and natural resources
respectively are used up.
$2,000
YEARLY
AMORTIZATION
%
2%
=
=
=
=
=
$20,000
10 YEARS
INITIAL COST
USEFUL LIFE
COST OF LOAN
YEARLY REPAYMENT
150,000
3,000
YEARS TO REPAY
100
50
100
Loan percentage
If a company has an outstanding loan worth
$150,000, and pays off $3,000 of this loan
each year, then $3,000 of the loan has been
amortized. It can also be said that 2 percent
of the loan has been amortized, as it will
take 50 years to repay the loan at this rate.
Time (years)
Intangible assets
In this example, a
company buys an
intangible asset—
a patent for a new,
revolutionary type
of tennis racket—for
$20,000. The patent
will be useful for 10
years, so its cost is
recorded as a $2,000
amortization (expense)
each year rather than as
a one-time cost. Unlike
tangible assets, a patent
does not have a salvage
value (see p.124).
Value ($)
1
2 3 4 5 6 7 8 9 10
$20,000
$16,000
$12,000
$8,000
$4,000
0
=
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HOW FINANCE WORKS
Financial accounting
GOODWILL
In business, goodwill describes an
intangible asset based on a company’s
reputation, including loyal customers
and suppliers, brand name, and public
profile. Goodwill arises when one
company buys another for more than
the fair market value of its net assets
(total assets minus total liabilities).
For example, if Company A buys
Company B for $10 million but the
total sum of its assets and liabilities is
$9 million, the goodwill is worth $1
million. According to International
Financial Reporting Standards since
2001, goodwill does not amortize,
so it does not appear as amortization
in financial statements. However, if
the value of goodwill falls (through
negative publicity, for example) it
can be recorded as an impairment.
How to calculate depletion
Like amortization, depletion is calculated using the straight-line
method (see pp.124–125) unless there is a particular reason to use
another method.
Intangible assets Non-
physical assets, such as patents,
trademarks, brand recognition,
and copyright; their valuation is
sometimes subjective
Patent A license granted by a
government or authority giving
the owner exclusive rights for
making or owning an invention
NEED TO KNOW
$900,000
DEPLETION
EXPENSE
UNITS
EXTRACTED
=
=
X
COST – SALVAGE VALUE
TOTAL UNITS
10,000,000 - 1,000,000
60,000
6,000
TIME (YEARS)
NUMBER
OF TREES
10987654321
In this example, a logging company buys
a forest with an estimated 60,000 trees for
$10million. The original salvage value is
$1.5million, but the company spends $500,000
on road building in the forest, bringing it down
to $1million. The company cuts down 6,000
trees during each accounting period.
X
60,000
50,000
40,000
30,000
20,000
10,000
0
$10
MILLION
$1
MILLION
$9.1
MILLION
$8.2
MILLION
$7.3
MILLION
$6.4
MILLION
$5.5
MILLION
$4.6
MILLION
$3.7
MILLION
$2.8
MILLION
$1.9
MILLION
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128 129
HOW FINANCE WORKS
Financial accounting
GOODWILL
In business, goodwill describes an
intangible asset based on a company’s
reputation, including loyal customers
and suppliers, brand name, and public
profile. Goodwill arises when one
company buys another for more than
the fair market value of its net assets
(total assets minus total liabilities).
For example, if Company A buys
Company B for $10 million but the
total sum of its assets and liabilities is
$9 million, the goodwill is worth $1
million. According to International
Financial Reporting Standards since
2001, goodwill does not amortize,
so it does not appear as amortization
in financial statements. However, if
the value of goodwill falls (through
negative publicity, for example) it
can be recorded as an impairment.
How to calculate depletion
Like amortization, depletion is calculated using the straight-line
method (see pp.124–125) unless there is a particular reason to use
another method.
Intangible assets Non-
physical assets, such as patents,
trademarks, brand recognition,
and copyright; their valuation is
sometimes subjective
Patent A license granted by a
government or authority giving
the owner exclusive rights for
making or owning an invention
NEED TO KNOW
$900,000
DEPLETION
EXPENSE
UNITS
EXTRACTED
=
=
X
COST – SALVAGE VALUE
TOTAL UNITS
10,000,000 - 1,000,000
60,000
6,000
TIME (YEARS)
NUMBER
OF TREES
10987654321
In this example, a logging company buys
a forest with an estimated 60,000 trees for
$10million. The original salvage value is
$1.5million, but the company spends $500,000
on road building in the forest, bringing it down
to $1million. The company cuts down 6,000
trees during each accounting period.
X
60,000
50,000
40,000
30,000
20,000
10,000
0
$10
MILLION
$1
MILLION
$9.1
MILLION
$8.2
MILLION
$7.3
MILLION
$6.4
MILLION
$5.5
MILLION
$4.6
MILLION
$3.7
MILLION
$2.8
MILLION
$1.9
MILLION
US_128-129_Amortization-depletion.indd 129 09/11/2016 11:01
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