2.2. Depreciation

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Core Concepts of Accounting – Numbers and People

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Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

7 ratings

Course 3 of 5 in the Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

From the lesson

Operational Assets. Depreciation. Short-Term Investments. Long-Term Liabilities. Shareholders’ Equity. Some Tax Issues

Week 2 is devoted to long-term assets and liabilities. We start with operational assets and see the role of depreciation and amortization in financial accounting and compare it to the way depreciation is used in valuation of investment projects. Then we discuss how financial investments in securities – stocks and bonds – are treated in accounting dependent upon goals and time horizon of holding and/or issuing of these securities. You will see how financial concepts (present values) are used in accounting for bond premium/discount amortization. Finally, an overview of the accounting approach to taxes is provided. On an example, you will study the core idea of deferred taxes.

2.1. Operational assets – types and accounting approach13:17

2.2. Depreciation11:14

2.3. Depreciation tax shield8:53

2.4. Intangible assets – accounting and amortization7:22

2.5. Short-term investments in bonds10:19

2.6. Short-term investments in stocks12:33

2.7. Bonds (1) – parameters and accounting approach10:31

2.8. Bonds (2) – amortization of premium/discount13:34

2.9. Equity (1) – accounting for common and preferred stock11:37

2.10. Equity (2) – treasury stock and stock dividends12:15

2.11. Accounting for taxes – an overview9:11

2.12. Deferred taxes – an example8:32

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now let's talk about depreciation in somewhat more detail.

So we said that help with depreciation.

So we talk here primarily about property, plant and equipment, tangible assets.

So, the idea this is matching.

And also we have to realize

that this cost must be

properly allocated.

In the very end of the previous episode, I told you that, not at the very end,

somewhere in that episode, we said that if we recognize the full cost of the machine,

immediately that would result in the wrong estimate total income.

So, therefore what we have to do,

we have to keep in mind two aspects.

True income And then the tax purposes.

Because as we will see, depreciation plays a very special role,

because this is the expense.

But this is not a cash expense.

And this is why depreciation's so important in finance too,

because it reduces the taxable income, and

therefore actually produces some savings.

And we will see what these savings are in this very episode.

Well, sometimes for people use different approaches.

One for two income reporting and the other for tax purposes.

You can say, well wait a minute.

When we talked about FIFO and LIFO we said that this is a wrong way.

But we will, later on we will see at the very end of this week,

that there's some special ideas, how people approach accounting for taxes.

That will be just an overview, because this is a very advanced and special

area that goes well beyond the scope of this course, and this specialization.

But here we will also make a small mark.

And we'll come back to that somewhat later.

Now, let's see, we have to

select a method of depreciation.

Well, the most simplistic and

the most natural way is, if this is the cost of equipment.

And there's a useful life of X years.

So you take this cost, divide this by this number X.

And then the equivalent equal portion,

you use it as depreciation expense for each year.

That's called a straight line depreciation.

So let me put here methods

of depreciation.

Like I said, first this is the straight line

in which depreciation expense for Year t is just the cost

less the salvage value, if it costs anything when we disposed of that.

It may be zero.

In most cases, the more conservative approach would be to put that as zero.

And then you divide by the number of years in its useful life.

And each and every year you use the same.

Now the next method is the unit of output, units of output.

Well, so the idea here is as follows.

Let's say that you use a truck and

this truck can run for 200,000 miles.

So then you say that these 200,000 lives,

you take its useful life or whatever, three, four years.

And then you say that now the depreciation per unit,

Is equal to, again, cost minus salvagability

divided by estimated useful life in units.

And then, for example, if, in this period, the truck would run 20,000 miles,

you use this unit and then multiply by 20,000.

And that is the expense that you charge for that.

But the most interesting, so

these are sort of clear, but the most interesting approach is less trivial.

And this is called accelerated depreciation.

The idea here is that you recognize

the higher portion of the total cost earlier.

Why is that allowed to be done so?

The main idea is that if the people change the equipment

more frequently, that contributes to efficiency, or, at least in theory.

So this approach allows the people to recognize the cost earlier.

And then when the equipment is very cheap on the balance sheet, it's easier,

most of that psychologically though, to replace this equipment.

We will talk about equipment replacement in much greater detail in the second part

of this course when we talk about managerial accounting.

But for now we may keep this in mind.

And again, there are some examples.

Let's say sum of years digits.

Let's say that the equipment has a useful life of four years.

Then what you do?

You add the number of years.

1 plus 2 plus 3 plus 4.

That makes 10.

In the first year you take the last number, 4, divide it by 10.

In the first year you recognize 40%.

In the second year, 30%.

In third year, 20%.

And in the final year, 10%.

So basically you recognize the higher percentage earlier.

But then also, there are some other very special accelerated methods,

of which I will recognize only ACRS.

This is accelerated cost recovery system.

That is widely used very frequently in the United States.

And most pieces of equipment, they qualify for so-called

5-year, ACRS class.

And for that, they're special numbers.

So the schedule for depreciation expenses such in the first year, it's 20%.

In the second year it's 32%.

Then in the third year it's 19.2%.

In Years 4 and 5, it's equal 11.5%.

And then finally in the sixth year it's the remaining 5.8%.

So that shows to you basically you strictly speaking start with one fifth.

But then from the second year you start

recognizing your depreciation expenses earlier.

And then finally this is what do we do for recording.

So we open up the asset account, property, plant and equipment.

And here we debit it with the cost.

Now then we open a special account that is called accumulated depreciation.

And this is a counter account for property, plant and equipment.

So when in the first year this is depreciation for year one.

Now we put it here.

And then at the same time we open up the account of depreciation expense.

And we debit it for the same thing.

So that's about how this goes.

So after the first year,

the net cost of property, plant and equipment will be this less that.

And then, it's called accumulated.

So in the second, third and

so on years and so on the depreciation expenses, they accumulate here.

And at some point in time, the property, plant and

equipment may go to the zero cost.

Now there are some special things here.

What if we do some repairs to this equipment?

If it's ordinary then it goes just as

a periodic expense of income statement.

But if this is something improvement, or

some extraordinary repairs then they get capitalized.

And they are added to this cost.

Let me give you an example.

So you have a boat.

And then, over some period of time, the body is fine.

But the engine is no longer fine, so you replace the engine.

Then your boat may be well fully depreciated by that time,

let's say in ten years.

But when you add the cost of a new engine, then in this amount jumps up.

And then you'll start to depreciate that in accordance with the rules that are used

for engines.

Well, maybe the rules for the depreciation,

the method, I mean for boats in general and for engines are different.

But in most cases they are close.

And then finally, just one final thing here.

This is the disposal of the asset.

Then in this case we have its cost at this moment.

It's not the initial cost, cost.

Cost less all accumulated depreciation.

So this is the balance sheet cost at this time.

And then you sell it at some price, S.

Let's say S or P.

And then if you happen to sell it over this balance cost, then you get the gain.

And you pay taxes on this gain.

If you have a loss then you have some take credit on that.

Now finally for this episode, the important thing is, why is that,

the depreciation then we talked about [INAUDIBLE] is important to us.

And that leads us to the next episode, in which we see how depreciation contributes

to actual cash savings by means of the so-called depreciation tax shield.

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