UNDERSTANDING THE INCOME STATEMENT
LOS 32.e: Demonstrate the depreciation of long-term assets using each
Depreciation expense can be computed under a number of different methods.
Straight-line depreciation (SL) allocates an equal amount of depreciation each year over the asset's useful life as follows:
. . COSt - Residual value SL Depreclatlon expense = - - - -
Useful life
Example: Calculating straight-line ~epreciationexpense
Littlefield Company recently purchased a machine at a cost of$12,000.The
machine is expected to have a residual value of$2,000at the end of its us(~tulli:te'.in;;',:;:
5years. Calculate depreciation expense using 'the straight-line method.
Answer:
The annual depreciation expense each year will be:
Cost - Residual value ($12,000 -$2,000) .l1'
- - - = =",,2,000
Usefullife 5
©2111)~Sch\\'<,s<,r
Swdy Se~~ion8
Cross-Reference to'CFA Institute Assigned Reading #32 - Underst;lnding the Income Statcmcnt
Accelerated depreciation speed~up the recognition or depreciation expense in a systematic wav to recognizc more depreciation expense:' in the early years of the asset's useful life and less depreciati~lll cxpe:'nse in the 1;1ter years of its life. Total depreciation expense over the life of the asset will he the same as it would be if straight-line depreciation were used.
The declining balance method (DB) applies a constant rate of depreciation to a declining book value.
The most common form of the declining balance method is double-declining balance (DDB), which uses 200% of the straight-line rate as the percentage rate applied to the declining balance. If an asset's life is ten years. the straight-line rate is 1110 or 10%.
The DDB rate for this asset is 2110 or 20%.
DDB depreciation= ( 2." J(COSt - accumulated depreciation)
\. usefullite
DB does not explicitly use the asset's residual value in the calculations, but depreciation ends once the estimated residual value has been reached. If the asset is expected to have no residual value, the DB method will never fully depreciate it, so the method has to
change (typically to straight-line) at some point in the asset's life.
Exdfuple: Calculating double-declining balance depreciation expense<ãã
. - ::"""'-;--:,.- . ,-.'.'... - ,:.-.<
Littl~fieldCompanyrecentlypurchased a machine at a'costof'$12,OOO.i'Yhe ..., : machine is expected to have a residual value of $2;000 at the end ofits usefulliFein :fiv~y~ars.Calculatedepreciacion expense ForaH five years using the d.c,Ub'le-
>df:cl..iil.ingbalancemetn6d. .
, " ," ' , 0 . __' . : ' . " ' ' - ' ' - ' ' , " ' ._;:.;-'. - - , " .
>~~~~:~j~•...
• Year 1: (2/5)($12,000) =$4,800
• Year 2: (2/5)($12,000 - $4,800)= $2,880
• Year 3: (2/5)($12,000 - $7,680)= $1,728
j}nye~.r~.lthrough3,the company has recognized.cumulativedeprecia:ti~~,expe~~e
~;'QÊ~P,~P.~:,SincethetotalJepreciationexpensei~1imited to$l 0,OOO{$12;OOO~-ã.
;~$2,qO(J$alvagevalue), the depreciationinyear 4 is limitedto$592,ratlleriliari'the rX2J.$)($'12,OOO-.$9,408) =$1,036.80 using theDDBformula.;;;ã~ã:>;fã:'
;'~dQ;:Depreciation expense is $0, since the asset is fully depreciated.
Note that the rate of depreciation is doubled (2/5) from straight-line, and rheonly thing that changes from year to year is the base amount (book value) used to calculate annual depreciation.
~ Professor's Note: we've been 'discussing the "double" declining balance method,
~ which uses a factor oftwo times the straight-line rate. :You can compute declining balance depreciation based on any factor (e.g., 1.5,double, triple). .
~-.
Page 56 (D200H Schwc:"c:r
Study Session 8 Cross-Reference to CFA Institute Assigned Reading #32 - Understanding the Income Statement Inventory Accounting Methods
Three methods of inventory accounting are:
1. FirstIn, First Out (FIFO)
The cost of inventory first acquired (beginning inventory and early purchases) is assigned to the cost of goods sold for the period.
e The COSt of the most recent purchases is assigned to ending inventory.
2. Last In, First Out (LIFO)
o The cost of inventory mostrecent1~purchased is assigned to the cost of goods sold for the period.
The COStS of beginning inventory and earlier purchases are assigned to ending Inventory.
3. Average cost
The cost per unit is calculated by dividing cost of goods available by total units available.
This average cost is used to determine both cost of goods sold and ending Inventory.
Average cost results in cost of goods sold and ending inventory values between LIFO and FIFO.
Tinll.:HV19 purchase Cost of goods available Units sold during January
3 units@$3 per unit= 5 units@$5 per unit=
10 units 7 units
$25
$38
Page 57
SlllChã S('SSiC)11 H
Cross-Rd'er~nce(0 CFA Institut(, Assig;ned Reading#32 - Understanding the Income Statcmcnt
Answer:
FIFOcosfo.{goods soLd:Value the seven units sold using the "unit cost of first units purchased, Start with the beginning inventory and the earliest units purchased and work down, as illuStrated in the following table.
FIFO COGS Calculation From beginning inventory From first purchase From second purchase . FIFO cost of goods sold-
2 units @ $2 per unit $4 3 units @ $3 per unit $9 2 units @ $5 per unit $10 7 units $23
E.nding invenrory 3 units @$5 per unit $15
. .
',LIFO cost ofgoods sold:Value the seven units sold at unit cost of last units purchased.
:S5ar~with~hemostrecently purchased units and work up, as illustrated in the Jfollo'wingi:~ble.
$6
$31 7 units
5 units @ $5 per unit 2units @ $3 per unit
units@ $2-I- 1unit @ $3
, " -., . "
~i..IF6COGSCalculation
i~?~fusecondpurchase
2~f2pi'£rs[purchase
t;:..:<
:~1f()Z~eOstof:goodssold
:-t:~~\ t_;i~"'-- ,t~ -:~~::;)~~:'~.t';':<.-
""-~::;-;;;<-;.
;-~"-;""<-F ";--'
'.Ji;~r~$e£ostofgoods soLd:Value the seven units sold at the average unit costofgooqs
available:
Weighted Average COGS Calculation
. Average unit cost $38/ 10 units $3.80 per unit
;,\X!eighted average cost of goods sold
;En~inginventory
7 units @ $3.80 per unit 3 units @ $3.80 per unit
$26.60
$11.40
l'ag~ 5R ({J200R SCllWCSCf
StllJySession H Cross-Referenceto eFA Institute Assigned Reading #32 - Understanding the Income Statement
The table below summarizes the calculations of COGS and ending inventory each method.
Summary:
Inventory system FIFO
LIFO
COGS
$23.00
Ending Inventory
$15.00
Amortization of Intangible Assets
Amonization expense is the allocation of (he COSt of an inrangible asset (such as a franchise agreemenr) over irs useful life. Suaigh(-line amorrization is calculated exacrly like suaight-line depreciation.
Inrangible assets with indefinite lives (e.g., goodwill) are nor amortized. However, (hey muse be tested for impairmenr at lease annually. If the asset value is impaired, an expense equal to (he impairment amounr is recognized on (he income seatemenr.