Accounting Basics: The Acquisition and Depreciation of Noncurrent Assets

Accounting Basics: The Acquisition and Depreciation of Noncurrent Assets

The matching principle in accrual accounting requires that expenses be subtracted from revenue in the period in which the revenue is recorded. Long-term capital expenditures for things such as buildings and equipment present a problem. A significant expense is incurred at one point, but the income derived from the expense is realized at many points in the future. Understanding how a company accounts for the acquisition and depreciation of long-term, or noncurrent, assets helps an investor to interpret and evaluate a company's financial statements.

Acquisition

To obtain an asset, a company spends cash, acquires debt, or both. The purchase price of the asset, not its assessed value, is recorded on the balance sheet; increases in value are not captured until the asset is sold. Additional costs required to get an asset "ready to go" should be capitalized along with the initial expenditure. If the purchase comprises more than one element, each asset is recorded separately. When the appraised value is greater than the amount paid, the cost of each asset is calculated based on its percentage of the total appraised value.

Fred's Gadget Company (FGC), a hypothetical business, acquires a small factory, land, and equipment for $750,000; appraisals are $400,000 for the land, $300,000 for the building, and $200,000 for the equipment. FGC spends $300,000 in cash and finances the remaining amount. This would be recorded as follows:

Debit land $337,500, debit building $247,500, debit equipment $165,000, credit cash $300,000, and credit note payable $450,000.

Depreciation

Depreciation solves the problem of how to allocate the initial costs of noncurrent assetsassets expected to help generate income over more than 1 year. The cost of the asset is distributed so that a depreciation expense is subtracted from revenue on income statements throughout the asset's useful life. Depreciation does not represent the market value of the asset. Depreciation is captured on the balance sheet as accumulated depreciation, a contra asset, which is subtracted from the original cost to yield the asset's net book value (NBV). This does not affect cash. Note that land is not depreciated, since its use continues indefinitely.

Calculating depreciation

There are 2 approaches to determining depreciation. Straight-line depreciation derives the annual depreciation expense by subtracting the anticipated salvage value of an asset from its original cost and dividing by its estimated useful life. The same result is reached by dividing 1 by the estimated useful life and multiplying that by the original cost minus estimated salvage. "Average useful life" can be replaced with "estimated units made" to calculate the depreciation expense per unit produced. In this case, the annual depreciation expense may vary from year to year depending on production.

Accelerated depreciation is calculated via declining-balance depreciation. The double-declining balance calculation doubles the straight-line depreciation rate. The NBV at the beginning of the year is multiplied by this rate to obtain the depreciation expense for the year. This amount is then subtracted from the beginning NBV to determine the new NBV. The process is repeated until the estimated salvage value is reached. For the final calculation, the estimated salvage value is subtracted from the beginning NBV to determine the depreciation expense.

Using straight-line depreciation, FGC's $200,000 equipment expenditure, which has an estimated useful life of 4 years and an estimated salvage value of $18,000, would show an annual depreciation expense of $45,500.

The declining-balance depreciation calculations for FGC would be as follows: The straight-line rate of 25% is doubled to 50%. In year 1, the beginning NBV of $200,000 is multiplied by 0.5 to get a depreciation expense of $100,000, which is subtracted from $200,000 to get the ending NBV of $100,000. In year 2, the beginning NBV of $100,000 is multiplied by 0.5 to get a depreciation expense of $50,000 and an ending NBV of $50,000. In year 3, the beginning NBV of $50,000 times 0.5 shows a depreciation expense of $25,000 and an ending NBV of $25,000. In year 4, the salvage value of $18,000 is subtracted from the beginning NBV of $25,000 to get a depreciation expense of $7,000, with the ending NBV at $18,000.

Compared with the straight-line method, the declining-balance method has higher depreciation expenses at the beginning and lower expenses at the end. Higher expenses lead to lower net income. For taxes, the Internal Revenue Service requires use of the Modified Accelerated Cost Recovery System, but a company may use another method to determine book value. Wise readers of financial statements examine the fine print to understand both methods and motivation. If capital expenses are not appropriately matched to revenue, net income can a be overstated, presenting an inaccurate view of the company.

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