Financial Management Assignment

Dublin Institute of Technology

Faculty of the Engineering and Built Environment

I declare that the work contained in this submission is my own work and has not been taken from the work of others save to the extent that such work has been cited within the text of this submission.

Signed: (student)__________________ Date: 28/04/2014

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Course Code: DT133 2

Academic Year:2014/04

Semester: 1

Module: Finance – Financial Management 1

Lecturer: Gerald Flynn

Year: 1, 2, 3 ,4

Student’s Name:

Beniamin Miere

Student ID Number:

D05107946

Depreciation

Definition- A non-cash expense that reduces the value of an asset as a result of

wear and tear, age or obsolescence. Most assets lose their value over time ( in other words, they depreciate ), and must be replaced once the end of their useful life is reached.

- A decline in value of a given currency in comparation with other currencies. For instance, if the US dollar depreciates against the Euro, buyers would have to pay more dollars in order to obtain the original amount of euros before depreciation occurred.

Depreciation impact on a firm in the construction industry

Because it is a non-cash expense, depreciation lowers the firms reported earnings while increasing free cash flow.

Introduction:

Most businesses need to purchase some kind of durable equipment in order to operate. Equipment that lasts longer than one year is called a fixed asset. Property such as heavy equipment ( concrete pumps, cranes ), computers, vehicles, furniture and buildings contribute to the operating capacity of a firm over many years. Because of this long-term contribution, fixed assets are treated differently than many other business expanses. The purchase price of these fixed assets is typically expensed over a period of years, rather than in the year the purchase was made.

The assets mentioned above are often referred to as fixed assets, plant assets, depreciable assets, constructed assets, and property, plant and equipment. It is important to note that the asset land is not depreciated, because land is assumed to last indefinitely.

Accounting for assets and depreciation

Assets are treated differently to expenses in the firm’s accounts.In the firm’s accounts, assets are ‘capitalized’ and included in the firms balance sheet as assets, rather than written off to profit and loss account as expenses.

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Unlike valid expenses, which are 100% tax deductible, depreciation is treated differently. The firm cannot obtain the tax relive on the depreciation charges.Instead the firm can claim a ‘capital allowance’ on the cost of the equipment. These capital allowances are set each year in the budget and vary depending upon the type of equipment.

Effect on the Financial Statement

To get a true picture of the value of Fixed Assets in a firm it would therefore be necessary to calculate the depreciation every year and reflect it in the Financial Statement.

The depreciation will affect the value of Fixed Assets which is indicated in the Balance Statement.It will also affect the Profit and Loss Statement where the depreciation will be deducted as an expense.

What to depreciate

If you decide that you have to decrease the value of some of the Fixed Assets in your company, it must be larger things which represent a considerable value and which lose value by being used and/or getting old. Smaller things like hand tools are not depreciated.

The depreciation must be calculated for each machine individually.

How to depreciate

First you have to decide for how long time you can expect the machine to work for the firm before it will break down totally or you will want to replace it.

Secondly you must decide which price you can expect to get for it when you sell it.

The calculation and reporting of depreciation is based upon two accounting principles:

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1. Cost principle. This principle requires that the Depreciation Expense reported on the income statement, and the asset amount that is reported on the balance sheet, should be based on the historical (original) cost of the asset. (The amounts should not be based on the cost to replace the asset, or on the current market value of the asset, etc.)

2. Matching principle. This principle requires that the asset's cost be allocated to Depreciation Expense over the life of the asset. In effect the cost of the asset is divided up with some of the cost being reported on each of the income statements issued during the life of the asset. By assigning a portion of the asset's cost to various income statements, the accountant is matching a portion of the asset's cost with each period in which the asset is used. Hopefully this also means that the asset's cost is being matched with the revenues earned by using the asset.

Depreciation methods

As it is not required to use a single depreciation method for all the assets of the firm, it is on the judgment of the firm to select the method of its choice. It is also not mandatory to select only one depreciation method for all the assets, although it is necessary to select a method that will decrease the value of the asset in the proper manner.

There are several depreciation methods allowed for achieving the matching principle. The depreciation methods can be grouped into two categories:

Straight-line depreciation Reducing balance depreciation

Straight-line method of depreciation

Straight-line (SL) depreciation is the most commonly used depreciation method; it's also the simplest. It can be used for both book and tax depreciation. Under straight-line depreciation, the cost of a fixed asset is spread in equal amounts over its estimated useful life.

This method assumes the asset provides constant benefits. If an asset is expected to be used in the business for 10 years, then each year 1/10 of

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that asset's depreciable value is expensed. The euro amount of depreciation remains constant from year to year.

Cost - salvage valueAnnual depreciation expense = ----------------------------- Estimated useful life

Cost = how much cost the firm to purchase the itemSalvage value =when firm done with asset, how much can firm get out of Estimated useful life = assets life expressed in years

Cost price: 60.000 E 60.000 E – 5.000 E Useful life: 10 years annual depreciation = ------------------------- Salvage value 5.000 E 10 years

= 5.500 ENet Income = Revenue – Expenses And so, 5.500 E will be part of expenses for the next 10 years.

Book Value = Assets – Liabilities And so, since this equipment is part of assets, and is depreciating every year, assets will decrease every year by 5.500 E and in turn, reduce book value on the balance sheet.

Reducing balance method of depreciation

Declining balance method of depreciation is a technique of accelerated depreciation in which the amount of depreciation that is charged to an asset declines over time. In other words, more depreciation is charged during the beginning of the life time and less is charged during the end.

Why more depreciation is charged in beginning years? The reason is that assets are usually more productive when they are new and their productivity declines gradually. Thus, in the early years of their life time, assets generate more revenue as compared to the revenue generated in later years of their life. According to the matching principle of accounting, we should depreciate more of the asset's cost in early years to match the depreciation expense with the revenue earned from the use of the asset.

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It can be advantageous to begin depreciating under DDB and switch to the straight-line method some years into the asset's useful life.

Declining balance depreciation is calculated using the following formula:

Depreciation = Depreciation Rate × Book Value of Asset

Depreciation rate is given by the following formula:

Depreciation Rate = Accelerator × Straight Line Rate

In the above formula, accelerator is a multiplication factor which accelerates depreciation. Book value is the difference between cost of an asset and its accumulated depreciation. During the first accounting period, accumulated depreciation is zero so book value is equal to cost. Since the book value decreases after each depreciation charge, depreciation expense declines in successive charges.

Depreciation is charged according to the above method as long as book value is less than the salvage value of the asset. No more depreciation is provided when book value equals salvage value.

Double Declining Balance Depreciation Method

Double declining balance depreciation method is a type of declining balance depreciation method in which depreciation rate is double the straight-line depreciation rate. For straight-line depreciation rate of 8%, double declining balance rate will be 2 × 8% = 16%.

Examples

Example 1: An asset costing 20,000E has estimated useful life of 5 years and salvage value of 4,500E. Calculate the depreciation for the first year of its life using double declining balance method.

SolutionStraight-line Depreciation Rate = 1 ÷ 5 = 0.2 = 20%Declining Balance Rate = 2 × 20% = 40%Depreciation = 40% × 20,000E = 8,000E

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Example 2: Referring to Example 1, calculate the depreciation of the asset for the second year of its life.

SolutionDeclining Balance Rate = 40%Book Value = Cost − Accumulated Depreciation = 20,000E − 8,000E = 12,000EDepreciation = 40% × 12,000E = 4,800E

Example 3: Calculate the depreciation of the asset mentioned in the above examples for the 3rd year.

SolutionDeclining Balance Rate = 40%Book Value = 20,000E − 8,000E − 4,800E = 7,200EDepreciation = 40% × 7,200E = 2,880E

The depreciation calculated above will decrease the book value of the asset below its estimated residual value (7,200E − 2,880E = 4,320E < 4,500E). Therefore depreciation would only be allowed up to the point where book value = salvage value. Thus,Depreciation Allowed = 7,200E − 4,500E = 2,700E

When does depreciation ends:

The firm must stop clamming depreciation as soon as:

- the estimated useful life is up.

- Firm stops using the asset in own business.

- Firm sell or dispose of the asset.

- Book value equals salvage value.

Conclusion

Depreciation is when the cost of an asset is spread across its useful life.

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Depreciation is a part of expenses and effects net income and also affect book value by reducing assets values.

References

Financial Management / An Irish Text /second edition / TP,SW,PO

Ready Ratios / Financial Statements / analysis software

Moneyterms.co.uk

Contractor calculator.co.uk

Thomsen Business Information

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