Depreciation methods

Depreciation Methods in Garments Industry of Bangladesh

Depreciation In accountancy, depreciation refers to two aspects of the same concept: 1. The decrease in value of assets (fair value depreciation), and 2. The allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle).

The former affects the balance sheet of a business or entity, and the latter affects the net income that they report. Generally the cost is allocated, as depreciation expense, among the periods in which the asset is expected to be used. This expense is recognized by businesses for financial reporting and tax purposes. Methods of computing depreciation, and the periods over which assets are depreciated, may vary between asset types within the same business. These may be specified by law or accounting standards, which may vary by country. There are several standard methods of computing depreciation expense, including fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service. For example, a depreciation expense of 100 per year for 5 years may be recognized for an asset costing 500.

1. Accounting concept In determining the profits (net income) from an activity, the receipts from the activity must be reduced by appropriate costs. One such cost is the cost of assets used but not immediately consumed in the activity. Such cost so allocated in a given period is equal to the reduction in the value placed on the asset, which is initially equal to the amount paid for the asset and subsequently may or may not be related to the amount expected to be received upon its disposal. Depreciation is any method of allocating such net cost to those periods in which the organization is expected to benefit from use of the asset. The asset is referred to as a depreciable asset. Depreciation is technically a method of allocation, not valuation, even though it determines the value placed on the asset in the balance sheet.

Any business or income producing activity using tangible assets may incur costs related to those assets. If an asset is expected to produce a benefit in future periods, some of these costs must be deferred rather than treated as a current expense. The business then records depreciation expense in its financial reporting as the current period's allocation of such costs. This is usually done in a rational and systematic manner. Generally this involves four criteria: • • • •

cost of the asset, expected salvage value, also known as residual value of the asset, estimated useful life of the asset, and a method of apportioning the cost over such life.

1.1 Depreciable basis Cost generally is the amount paid for the asset, including all costs related to acquisition.

In some countries or for some purposes, salvage value may be ignored. The rules of some countries specify lives and methods to be used for particular types of assets. However, in most countries the life is based on business experience, and the method may be chosen from one of several acceptable methods.

1.2 Net basis When a depreciable asset is sold, the business recognizes gain or loss based on net basis of the asset. This net basis is cost less depreciation.

1.3 Impairment Accounting rules also require that an impairment charge or expense be recognized if the value of assets declines unexpectedly. Such charges are usually nonrecurring, and may relate to any type of asset.

1.4 Depletion and amortization Depletion and amortization are similar concepts for minerals (including oil) and intangible assets, respectively.

1.5 Effect on cash Depreciation expense does not require current outlay of cash. However since depreciation is an expense to the P&L account, provided the enterprise is operating in a manner that covers its expenses (e.g. operating at a profit) depreciation is a source of cash in a statement of cash flows, which generally offsets the cash cost of acquiring new assets required to continue operations when existing assets reach the end of their useful lives.

1.6 Historical cost

Depreciation is generally recognized under historical cost systems of accounting. Some proposals for fair value accounting have no provision for depreciation expense.

1.7 Accumulated depreciation While depreciation expense is recorded on the income statement of a business, its impact is generally recorded in a separate account and disclosed on the balance sheet as accumulated depreciation, under fixed assets, according to most accounting principles.

Accumulated depreciation is known as a contra account, because it separately shows a negative amount that is directly associated with another account.

Without an accumulated depreciation account on the balance sheet, depreciation expense is usually charged against the relevant asset directly. The values of the fixed assets stated on the balance sheet will decline, even if the business has not invested in or disposed of any assets. The amounts will roughly approximate fair value. Otherwise, depreciation expense is charged against accumulated depreciation. Showing accumulated depreciation separately on the balance sheet has the effect of preserving the historical cost of assets on the balance sheet. If there have been no investments or dispositions in fixed assets for the year, then the values of the assets will be the same on the balance sheet for the current and prior year. In other words it is a method of recovering capital expenditure in installments which is called as depreciation mike.

2. Methods of depreciation There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.

2.1 Straight-line depreciation Straight-line depreciation is the simplest and most often used method. In this method, the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life). (The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero or even negative. Salvage value is also known as scrap value or residual value.) The company will then charge the same amount to depreciation each year over that period, until the value shown for the asset has reduced from the original cost to the salvage value.

Straight-line method:

For example, a vehicle that depreciates over 5 years is purchased at a cost of $17,000, and will have a salvage value of $2000. Then this vehicle will depreciate at $3,000 per year, i.e. (17-2)/5 = 3. This table illustrates the straight-line method of depreciation. Book

value at the beginning of the first year of depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated depreciation. book value = original cost − accumulated depreciation Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals scrap value.

Book value at Depreciation Accumulated beginning of year expense in year depreciation at end of year $17,000 $3,000 $3,000 (original cost) $14,000 $3,000 $6,000 $11,000 $3,000 $9,000 $8,000 $3,000 $12,000 $5,000 $3,000 $15,000

Book value at end of year $14,000 $11,000 $8,000 $5,000 $2,000 (scrap value)

If the vehicle was to be sold and the sales price exceeded the depreciated value (net book value) then the excess would be considered a gain and subject to depreciation recapture.

In addition, this gain above the depreciated value would be recognized as ordinary income by the tax office. If the sales price is ever less than the book value, the resulting capital loss is tax deductible. If the sale price were ever more than the original book value, then the gain above the original book value is recognized as a capital gain.

If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.

2.2 Declining Balance Method Suppose a business has an asset with $1,000 original cost, $100 salvage value, and 5 years of useful life. First, the straight-line depreciation rate would be 1/5, i.e. 20% per year. Under the double-declining-balance method, double that rate, i.e. 40% depreciation rate would be used. The table below illustrates this: Book value at beginning of year $1,000 (original cost) $600 $360 $216 $129.60

Depreciation rate 40% 40% 40% 40% $129.60 $100

Depreciation Accumulated Book value at expense depreciation end of year $400 $400 $600 $240 $144 $86.40 $29.60

$640 $784 $870.40 $900

$360 $216 $129.60 $100 (scrap value)

When using the double-declining-balance method, the salvage value is not considered in determining the annual depreciation, but the book value of the asset being depreciated is never brought below its salvage value, regardless of the method used. Depreciation ceases when either the salvage value or the end of the asset's useful life is reached.

Since double-declining-balance depreciation does not always depreciate an asset fully by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This has the effect of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the asset's life.

With the declining balance method, one can find the depreciation rate that would allow exactly for full depreciation by the end of the period, using the formula:

, Where N is the estimated life of the asset (for example, in years).

2.3 Activity depreciation Activity depreciation methods are not based on time, but on a level of activity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life is estimated in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. The per-mile depreciation rate is calculated as: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the depreciation expense is then calculated by multiplying the number of miles driven by the per-mile depreciation rate.

2.4 Sum-of-years-digits method Sum-of-years-digits is a depreciation method that results in a more accelerated write-off than the straight line method, and typically also more accelerated than the declining balance method. Under this method the annual depreciation is determined by multiplying the depreciable cost by a schedule of fractions.

Depreciable cost = original cost − salvage value Book value = original cost − accumulated depreciation Example: If an asset has original cost of $1000, a useful life of 5 years and a salvage value of $100, compute its depreciation schedule.

First, determine years' digits. Since the asset has useful life of 5 years, the years' digits are: 5, 4, 3, 2, and 1.

Next, calculate the sum of the digits: 5+4+3+2+1=15 The sum of the digits can also be determined by using the formula (n2+n)/2 where n is equal to the useful life of the asset in years. The example would be shown as (52+5)/2=15 Depreciation rates are as follows: 5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th year, and 1/15 for the 5th year.

Book value Total Depreciation Depreciation at depreciable rate expense beginning of cost year $1,000 $900 5/15 $300 ($900 * (original 5/15) cost) $700 $900 4/15 $240 ($900 * 4/15) $460 $900 3/15 $180 ($900 * 3/15) $280 $900 2/15 $120 ($900 * 2/15) $160 $900 1/15 $60 ($900 * 1/15)

Accumulated depreciation $300

Book value at end of year $700

$540

$460

$720

$280

$840

$160

$900

$100 (scrap value)

2.5 Units-of-production depreciation method Under the units-of-production method, useful life of the asset is expressed in terms of the total number of units expected to be produced:

Suppose, an asset has original cost $70,000, salvage value $10,000, and is expected to produce 6,000 units.

Depreciation per unit = ($70,000−10,000) / 6,000 = $10 10 Ă— actual productions will give the depreciation cost of the current year.

The table below illustrates the units-of-production depreciation schedule of the asset.

Book value

Units of

Depreciation Depreciation Accumulated

Book

at beginning of year $70,000 (original cost) $60,000 $49,000 $37,000 $24,000

production cost per unit

expense

depreciation

1,000

$10

$10,000

$10,000

1,100 1,200 1,300 1,400

$10 $10 $10 $10

$11,000 $12,000 $13,000 $14,000

$21,000 $33,000 $46,000 $60,000

value at end of year $60,000 $49,000 $37,000 $24,000 $10,000 (scrap value)

Depreciation stops when book value is equal to the scrap value of the asset. In the end, the sum of accumulated depreciation and scrap value equals the original cost.

2.6 Units of time depreciation Units of time depreciation are similar to units of production, and are used for depreciation equipment used in mine or natural resource exploration, or a case where the amount the asset is used is not linear year to year.

A simple example can be given for construction companies, where some equipment is used only for some specific purpose. Depending on the number of projects, the equipment will be used and depreciation charged accordingly.

2.7 Group depreciation method Group depreciation method is used for depreciating multiple-asset accounts using straight-line-depreciation method. Assets must be similar in nature and have approximately the same useful lives.

2.8 Composite depreciation method The composite method is applied to a collection of assets that are not similar, and have different service lives. For example, computers and printers are not similar, but both are part of the office equipment. Depreciation on all assets is determined by using the straight-line-depreciation method.

Asset

Historical cost Computers $5,500 Printers $1,000 Total $ 6,500

Salvage value $500 $100 $600

Depreciable cost $5,000 $ 900 $5,900

Life Depreciation per year 5 $1,000 3 $ 300 4.5 $1,300

Composite life equals the total depreciable cost divided by the total depreciation per year. $5,900 / $1,300 = 4.5 years.

Composite depreciation rate equals depreciation per year divided by total historical cost. $1,300 / $6,500 = 0.20 = 20% Depreciation expense equals the composite depreciation rate times the balance in the asset account (historical cost). (0.20 * $6,500) $1,300. Debit depreciation expense and credit accumulated depreciation.

When an asset is sold, debit cash for the amount received and credit the asset account for its original cost. Debit the difference between the two to accumulated depreciation. Under the composite method no gain or loss is recognized on the sale of an asset. Theoretically, this makes sense because the gains and losses from assets sold before and after the composite life will average themselves out.

To calculate composite depreciation rate, divide depreciation per year by total historical cost. To calculate depreciation expense, multiply the result by the same total historical cost. The result, not surprisingly, will equal to the total depreciation Per Year again.

Common sense requires depreciation expense to be equal to total depreciation per year, without first dividing and then multiplying total depreciation per year by the same number.

3. Tax depreciation Most income tax systems allow a tax deduction for recovery of the cost of assets used in a business or for the production of income. Such deductions are allowed for individuals and companies. Where the assets are consumed currently, the cost may be deducted currently as an expense or treated as part of cost of goods sold. The cost of assets not currently consumed generally must be deferred and recovered over time, such as through depreciation. Some systems permit full deduction of the cost, at least in part, in the year the assets are acquired. Other systems allow depreciation expense over some life using some depreciation method or percentage. Rules vary highly by country, and may vary within a country based on type of asset or type of taxpayer. Many systems that specify depreciation lives and methods for financial reporting require the same lives and methods be used for tax purposes. Most tax systems provide different rules for real property (buildings, etc.) and personal property (equipment, etc.).

3.1 Capital allowances A common system is to allow a fixed percentage of the cost of depreciable assets to be deducted each year. This is often referred to as a capital allowance, as it is called in the United Kingdom. Deductions are permitted to individuals and businesses based on assets placed in service during or before the assessment year. Canada's Capital Cost Allowance is fixed percentages of assets within a class or type of asset. Fixed percentage rates are

specified by type of asset. The fixed percentage is multiplied by the tax basis of assets in service to determine the capital allowance deduction. The tax law or regulations of the country specifies these percentages. Capital allowance calculations may be based on the total set of assets, on sets or pools by year (vintage pools) or pools by classes of assets.

3.2 Tax lives and methods Some systems specify lives based on classes of property defined by the tax authority.

Canada Revenue Agency specifies numerous classes based on the type of property and how it is used. Under the United States depreciation system, the Internal Revenue Service publishes a detailed guide which includes a table of asset lives and the applicable conventions. The table also incorporates specified lives for certain commonly used assets (e.g., office furniture, computers, and automobiles) which override the business use lives.

U.S. tax depreciation is computed under the double declining balance method switching to straight line or the straight line method, at the option of the taxpayer. IRS tables specify percentages to apply to the basis of an asset for each year in which it is in service.

Depreciation first becomes deductible when an asset is placed in service.

3.3 Additional depreciation Many systems allow an additional deduction for a portion of the cost of depreciable assets acquired in the current tax year. The UK system provides a first year capital allowance of ÂŁ50,000. In the United States, two such deductions are available. A deduction for the full cost of depreciable tangible personal property is allowed up to $500,000 through 2013. This deduction is fully phased out for businesses acquiring over $2,000,000 of such property during the year. In addition, additional first year depreciation of 50% of the cost of most other depreciable tangible personal property is allowed as a deduction. Some other systems have similar first year or accelerated allowances.

3.4 Real property Many tax systems prescribe longer depreciable lives for buildings and land improvements. Such lives may vary by type of use. Many such systems, including the United States and Canada, permit depreciation for real property using only the straight line method, or a small fixed percentage of cost. Generally, no depreciation tax deduction is allowed for bare land. In the United States, residential rental buildings are depreciable over a 27.5 year or 40 year life, other buildings over a 39 or 40 year life, and land improvements over a 15 or 20 year life, all using the straight line method.

3.5 Averaging conventions Depreciation calculations require a lot of record-keeping if done for each asset a business owns, especially if assets are added to after they are acquired, or partially disposed of.

However, many tax systems permit all assets of a similar type acquired in the same year to be combined in a "pool". Depreciation is then computed for all assets in the pool as a single calculation. These calculations must make assumptions about the date of

acquisition. The United States system allows a taxpayer to use a half year convention for personal property or mid-month convention for real property. Under such a convention, all property of a particular type is considered to have been acquired at the midpoint of the acquisition period. One half of a full period's depreciation is allowed in the acquisition period (and also in the final depreciation period if the life of the assets is a whole number of years). United States rules require a mid-quarter convention for personal property if more than 40% of the acquisitions for the year are in the final quarter.

Comparing Depreciation Methods: To reinforce what we've learned thus far, here's a look at what the depreciation charges for the same $5,000 computer would look like depending upon the method used (the chart is at the bottom of this page).

Obviously, depending upon which method is used by management, the bottom-line reported profits of a company can vary greatly from year to year. The level of attention an investor must give depreciation depends upon the asset intensity of the business he or she is studying. The more asset-intensive an enterprise, the more attention depreciation should be given. In other words, you should understand the depreciation philosophy behind every management team when you are examining businesses that require huge plants, factories, equipment, and capital expenditure investment. This is much less important when analyzing businesses that are not asset intensive, such as software companies, advertising agencies, or insurance brokers.

If you have two asset intensive businesses, and they are using different depreciation methods, and / or useful lives, you must adjust them so they are on a comparable basis in order to get an accurate picture of how they stack up against each other in terms of profit.

Some managements will report depreciation expense broken out as a separate line on the income statement, while others will be more clandestine about it, including it indirectly through SG&A expenses (for the deprecation costs of desks, for instance). Either way, you should be able to garner the information either through the income statement itself or going through the annual report or 10K.

Benjamin Graham's 3 Recommended Depreciation Questions: In the classic 1934 edition of Security Analysis, Benjamin Graham recommended the investor answer three questions when dealing with the effects of deprecation on a business (paraphrased):

1. Is depreciation reflected in the earnings statement? Today this is a moot point because GAAP accounting rules require that all companies report depreciation. This was not the case in the past.

2. Is management using conservative and (as much as possible) accurate depreciation rates? Accounting rules allow assets to be written off over a considerable time period.

Buildings, for example, can be depreciated anywhere from ten to thirty years, resulting in large differences in charges depending upon the time frame a particular business uses. A company's 10K filing should contain information on the depreciation rates employed by the company.

3. Are the cost or base to which the depreciation rates applied reasonably accurate? A company may set unrealistically high salvage values on its assets, thus reducing the amount of depreciation charges it must take every year.

Depreciation is a systematic and rational way to allocate the cost of long-lived tangible assets over their useful lives. This satisfies the goal of matching costs and revenues.

Done because fair values change and are difficult to measure.

• Depreciation — long-lived tangible assets.

• Depletion — natural resources.

• Amortization — intangible assets.

Information needed in order to calculate depreciation: (1) Depreciable base = original cost – salvage value.

(2) Estimated service (useful) life versus physical life.

(3) Depreciation method: • Activity based—units of use or production.

• Straight-line—based on calendar time.

• Accelerated—SoYD or declining-balance.

• Special—group & composite, retirement & replacement, hybrid, combination, other. ** All take the same total depreciation over an asset’s useful life.

Activity-based methods Big Steel uses an activity-based depreciation method. They have equipment with a cost of $250,000, salvage value of $10,000 and estimated useful life of 20,000 hours. In 2003, Big Steel used the equipment 3,000 hours. How much depreciation on this equipment should they recognize for 2003?

$240,000 * 3,000 hrs. = $36,000 20,000 hrs.

Why would some companies want to use this approach?

Straight-line method Simple & widely used.

Depreciation is function of time only.

Big Steel uses straight-line depreciation. They have equipment with a cost of $250,000, salvage value of $10,000 and estimated useful life of 10 years. Equipment was purchased 1/1/2002. In 2003, Big Steel used the equipment 3,000 hours. How much depreciation on this equipment should they recognize for 2003? $240,000 / 10 = $24,000 (each year for 10 years)

Accelerated Depreciation Methods (aka Decreasing-Charge methods) These methods take more depreciation in the early years of an asset’s life.

Two most used are: (1) Sum-of-years’-digits and (2) declining-balance [200% or 150%].

SoYD = n (n+1) / 2 Where n = useful life in years.

SoYD = 10(11) / 2 = 55 for a 10-year asset Or (10 + 9 + 8……+ 2 + 1) Big Steel uses Sum-of-years’-digits depreciation method. They have equipment with a cost of $250,000, salvage value of $10,000 and estimated useful life of 10 years. Equipment was purchased on 1/1/2002. How much depreciation on this equipment should they recognize for 2003?

Year 2002 2003 2004 2005 ….. …..

2011

Deprec. base $240,000 “ “ “ “ “ “

Remain life 10 9 8 7 . .

1

Depre. fraction 10/55 9/55 8/55 7/55 . .

1/55

Depreciation $43,636.34 39,272.12 34,904.08

4,363.63

Declining-Balance Method Apply some constant rate to the beginning of period book-value of the asset. Rate is defined usually as 1.5 or 2 times the straight-line rate (e.g., 20% is twice the straight-line rate for a 10-year asset).

Remember to not depreciate the asset to below its salvage value—therefore might have to take less than calculated depreciation in years close to end of life (maybe 0). If low SV, might have to take more depreciation in last year or switch to SL when greater depreciation.

Big Steel uses double-declining-balance depreciation method. They have equipment with a cost of $250,000, salvage value of $10,000 and estimated useful life of 10 years. Equipment was purchased on 1/1/2002. How much depreciation on this equipment should they recognize for 2003? * Switch to straight-line Year BV begin of Rate Depreciation A/D balance BV EOP period Expense (EOP) 2002 $250,000 20% $50,000 $50,000 $200,000 2003 $200,000 20% $40,000 $90,000 $160,000 2004 $160,000 20% $32,000 $122,000 $128,000 2005 $128,000 20% $25,600 $147,600 $102,400 2006 $102,400 20% $20,480 $168,080 $81,920 2007 $81,920 20% $16,384 $184,464 $65,536 2008 $65,536 .25* $13,884 $198,348 $51,652 2009 $51,652 .25 $13,884 $212,232 $37,768 2010 $37,768 .25 $13,884 $226,116 $23,884 2011 $23,884 .25 $13,884 $240,000 $10,000 Clarification on the “switch to straight-line” when using declining-balance method for depreciation: Companies do like the “distortion” in the later years when declining methods take little or no depreciation (high salvage value) or a large amount in the last year (low salvage value)—so they switch to straight-line when straight-line depreciation would be higher.

To test if the straight-line amount would be more, you divide the remaining amount to be depreciated (balance – salvage value) by the number of remaining years.

To avoid a test every year, they might have a policy to switch at the midpoint of the asset’s useful life.

For GAAP, companies do not have to switch if they do not want to.

For tax, the switch is required and already in the tax tables for all to use. So, the government allows you to pay less tax for year of switch!

4. DEPRECIATION UNDER GAAP (FOR BOOK PURPOSES): GAAP allows companies to develop their own custom methods. Only requirement is that the asset’s cost be allocated in a systematic and rational manner over its useful life.

Group & Composite Methods: Group—similar assets Composite—dissimilar assets Both use average depreciation and this simplifies bookkeeping costs.

Hybrid/combination Methods: use more than one method. E.g., depreciate part of cost using straight-line and the remainder with activity.

4.1 Partial Period Depreciation Firms seldom purchase depreciable assets on the first day of the period. There are several ways to handle the depreciation for the first and last period in this situation. Prorate using nearest full month or fraction of year. Half year in year of purchase, and half year in year of disposal (called “half-year” convention, used for tax purposes). Full years’ depreciation in year of purchase, none in year of disposal. No depreciation in year of purchase, full year’s in year of disposal.

4.2 Revisions (changes) in depreciation estimates.

Salvage value and/or useful life estimates can change anytime. This is not handled as an error. Change will be made in the current and future periods. Simply calculate a new rate based on the remaining life and total depreciable amount remaining after the change.

For straight-line: New rate = remaining amount to be depreciated Remaining useful life

4.3 Impairments—SFAS: Conservatism—PPE that is held for use is never written up, but will be written down in the case of impairment.

Events lead to possibility of impairment.

Recoverability test: If the sum of future net undiscounted cash flows is less than the carrying amount of the asset, than an impairment has occurred.

If an impairment, how much?

Impairment loss = CV – FairV of asset If no FairV, then use discounted future cash flows.

Use the risk-free rate of interest as the discount rate.

Loss on impairment A/D

xxx xxx

Other gains and losses section of IS. Assets held for disposal: valued at the lower of cost or net realizable value. Written up or down each period, but has to be no more than the CV prior to impairment.

4.4 Depletion of natural resources (wasting assets) Oil & gas, minerals, timber, coal…..

Accounting is similar to PPE. Depletion base: includes acquisition cost of resource (not land) + exploration cost + intangible development cost + restoration cost.

If exploration efforts are successful then capitalize, otherwise expense.

Depletion expense is calculated similar to how depreciation based on units-of-production is done.

Entry to record the depletion for the period is Inventory Accum. Depletion

XXX XXX

Depletion expense is included in CoGS for the period.

It is often very difficult to estimate the amount of recoverable resources and changes in estimates are common (handled exactly like change in useful life for depreciation).

Interesting tax law issues with oil & gas and most minerals (including gravel). Tax law allows for deduction of cost or percentage-depletion based on gross revenue, whichever is greater! % varies from 5-22%. This means that depletion can exceed the cost of some natural resources!

Very interesting history of an accounting controversy on pages 539-541 of the text, re: successful-efforts versus full-cost for the oil and gas industry. The story underscores the political nature of accounting rules.

1977—SFAS #19, must use successful efforts.

1978—outrage by small O&G companies, SEC wants Reserve Recognition Accounting which is a current value vs. cost approach.

1979—FASB issues #25—suspends #19.

1981—SEC drops RRA, FASB issues #69 (requires current value disclosure).

Currently, back to pre-1977 GAAP, either full or successful-efforts is allowed. Full cost has a ceiling (PV of company reserves).

4.5 Income Tax Depreciation 1981—ACRS, assets placed in service 1981-1986 1986—MACRS, for assets placed in service 1987 and later.

(1) All depreciable assets are placed into property classes. This determines the tax life, which is generally shorter than the useful life.

(2) Depreciation rate depends on class, most are declining-balance.

(3) Salvage value = 0. Depreciate for tax to zero value.

(4) half-year convention.

(5) Switch to SL when it gives more depreciation.

Optional approach is allowed for tax—Straight-line.

Only point (2) above would change.

Because companies use a different method for financial reporting and tax, a difference exists in tax expense and tax payable. This will be dealt with in Acctg. 303.

Analysis of PPE and Natural Resources

4.6 Rate of return on total assets (ROA) Rate of Return on Total Assets

= Profit Margin on sales x Asset turnover = Net Income Net Sales =

x

Net Sales Average Total Assets

Net Income Average Total Assets

Example (in millions of $): Net sales Total Assets (1/1) Total Assets (12/31) Net Income ROA = $150 x $1,500 = 0.10 x 1.15 = 11.5%

$1,500 (1,200 + 1,400) / 2

$1,500 1,200 1,400 150

5. OIL AND GAS ACCOUNTING: ► Two generally accepted methods to account for oil and gas exploration costs are: • The successful efforts method requires that exploration costs that are known not to have resulted in the discovery of oil or gas (sometimes referred to as dry holes) be included as expenses in the period the expenditures are made.

•

The full-cost method allows costs incurred in searching for oil and gas within a large geographical area to be capitalized as assets and expensed in the future as oil and gas from the successful wells are removed from that area.

The Shannon Oil Company incurred $2,000,000 in exploration costs for each of 10 oil wells drilled in 2000 in West Texas. Eight of the 10 wells were dry holes.

The accounting treatment of the $20 million in total exploration costs will vary significantly depending on the accounting method used. The summary journal entries using each of the alternative methods are as follows: Successful Efforts Oil deposit Exploration expense Cash

Full Cost 4,000,000 16,000,000

Oil deposit Cash 20,000,000

20,000,000 20,000,000

steps into the textile sector with establishment of its first unit Textiles Ltd. in 1997. A year later, step on to its second unit. In the same premises, established its third unit on 2000.

Year of Establishment Unit 1 : 1994 ; Unit 2 : 1998 ; Unit 3 : 2000 Manufacturing Business 100% Cotton Ring Spun Yarn for Hosiery Target Market Export Oriented Readymade Garments Industry Investment Unit 1 : US$ 20.00 mln ; Unit 2 : US$ 13.50 mln ; Unit 3 : US$ 12 mln Capacity Unit 1 : 36,288 spindles with daily production capacity of 20,000 kgs.

Unit 2 : 23,184 spindles with daily production capacity of 12,000 kgs 768 rotors with daily production capacity of 8,000kgs Unit 3 : 3,192 open end heads with daily production capacity of 20,000kgs

Technical Details Machinery Details Blow room, Carding, Drawing and Combing :

Riete r- Switzerland

Simplex / Fly Frame :

Toyoda – Japan

Ring Frame :

Toyoda – Japan

Auto cone Winding :

Schlafhorst - Germany

QC Equipment :

Uster Technologies AG

Humidification Plant :

Luwa - Switzerland

Air Cooling / Chiller :

McQuay – USA

Auto Coro :

Schlafhorst - Germany

Rahim textile mills Ltd, a Public Limited Company has been envisaged by a group of dynamic entrepreneurs who have been immense contribution to development of the textile sector of Bangladesh. The sponsors have a very long history in industrial management with the earlier generation starting in Bombay in the early 20th century and then moving to Bangladesh in 1974.

The Company was incorporated in Bangladesh on November 02, 1989 as Private Limited Company. Subsequently the company was converted into a Public Limited Company on September 14, 2008 under the Companies Act 1994. The existing project is located at Shafipur, Kaliakoir, Gazipur and started its commercial operation on January 01, 1991.

Presently the project has in total 63,624 spindles with daily production capacity of 32 tons of Combed and Carded Cotton Yarn. MSML is a deemed exporter and majority of its goods are supplied to Knit industries for export.

Recommendation:  Basically the garments industry use depreciation under straight-line method which may not give exact result.

 The garments industry does not show details system of depreciation method in annual report.

 Depreciation methods simply provide an alternative way of allocating the total depreciation charge over several accounting periods which may not be correct.

 Companies can use depreciation to manipulate earnings. A company can extend the use of its assets by claiming a longer useful life. When looking at depreciation, it is useful to compare depreciation practices of a company along with its peers. A company's assets may be outdated or in need of repair if it is depreciating assets too slowly.

 Mark-to-market in accounting refers to the valuation of assets based on current market prices rather than book value. A major distortion occurs in depreciation based on an assets book value versus the actual market value of an asset.

 It is useful to compare a company's depreciation methods with that of its peers.

Usually, companies within the same industry use similar depreciation methods. If a company is using DDB, convert this to the more conservative straight-line depreciation method.

Conclusion: In the conclusion of depreciation as per law of lexicon is defined as positive decline in the real value of a tangible asset because of consumption, wear and tear or obsolescence.

The concept of depreciation is widely used for the purpose of writing off the cost of an asset against profit over an extended period (its depreciable life), irrespective of the real value of the asset. Depreciation is charged against income or the profit and loss account, and there are different methods of calculating it like straight line method or written down value method. The Income-tax Act save and except for undertaking engaged in generation and/or distribution of power the method of computing the depreciation is WDV method.

Bibliography: Text Book:

• Intermediate Accounting [Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield] • Intermediate Accounting (Volume 2) [Donald E. Kieso, Jerry J. Weygandt, Terry

D. Warfield] • Intermediate Accounting, 6 edition (May 6, 2010), Irwin/McGraw-Hill, A Division of The McGraw-Hill Companies, Burr Ridge, Illinois. (Authors: James F. Sepe - Accounting Department Santa Clara University, J. David Spiceland Accounting Department University of Memphis, Mark Nelson Accounting Department Cornell University, Lawrence A. Tomassini - Accounting Department Ohio State University) Annual Reports:  

Generation next fashion Ltd.: 2010-11 Rahim Textile Mills Ltd.: 2010-11

References: I.

http://en.wikipedia.org/wiki/Depreciation

II.

Kiesco, et al, p. 521. See also Walther, Larry, Principles of Accounting Chapter 10.

III.

A charge for such impairment is referred to in Germany as depreciation.

IV.

www.Google.com

V. VI. VII. VIII.

www.textile.squaregroup.com/sqtextile.html www.envoytextiles.com http://wirc-icai.org/wirc_referencer/income%20tax%20&%20wealth %20tax/Depreciation.htm www.networkchinese.com/nantah/e_books/nantah64.../part_12.pdf