Fixed Assets

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Assets purchased for continued and long-term use in earning profit and not intended for resale are called Fixed Assets. An asset must be used over more than one accounting period to be classified as Fixed Asset. It includes assets which cannot be easily converted into cash. Fixed Assets must be classified in the company?s balance Sheet as Tangible, Intangible or Investments. This group normally include items such as land and buildings, motor vehicles, furniture, office equipment, computers, fixtures and fittings, plant and machinery, tools, patents, copyrights, goodwill and certain wasting resources e.g., timberland and minerals.

The cost of a fixed asset is its purchase price, including import duties and other deductible trade discounts and rebates. In addition, it also includes cost attributable to bringing and installing the asset in its needed location and the initial estimate of dismantling and removing the item if they are eventually no longer needed on the location.

During each accounting period a portion of the cost of these assets is being used up. The portion being used up is reported as Depreciation Expense on the income statement. It is usefully spread over the economic life of the asset. Calculation and reporting of depreciation is based upon two accounting principles:

Ø 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.

Ø Matching principle: This principle requires that the asset's cost be allocated to Depreciation Expense over the life of the asset. By assigning a portion of the asset's cost to various income statements, the accountant is in fact matching a portion of the asset's cost to the revenues earned by using the asset in each period in which the asset is used.

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

Straight line Depreciation

The most common method of depreciating assets for financial statement purposes is the straight-line method. Under this depreciation method, the depreciation for each full year is the same amount.

The depreciation expense for a full year when computed under the straight-line method can be given by the following formula:

Cost of Fixed Asset - Salvage Value

Annual Depreciation Expense = --------------------------------------------------------

Estimated Useful Life (Years)

For example, a machine that depreciates over 5 years, is purchased at a cost of US $50,000, and has a salvage value of US $5000, will depreciate at US $9,000 per year: ($50,000 - $5,000)/ 5 years = $9,000 annual straight-line depreciation expense. In other words, it is the depreciable cost of the asset divided by the number of years of its useful life.

Accelerated Depreciation

Compared to the straight-line method, accelerated depreciation methods provide for more depreciation in the early years of an asset's life but then less depreciation in the later years. The difference in depreciation methods involves when the depreciation is reported. However, the total depreciation during the life of the asset is the same regardless of the method used. Most companies use the straight-line method for their financial statements and accelerated depreciation on its income tax returns.

There are various methods of accelerated depreciation. Most commonly used are:

Declining balance method

Under this method the Book Value is multiplied by a fixed rate.

Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year

The most common rate used is double the straight-line rate. For this reason, this technique is referred to as the double-declining-balance method (also known as the 200% declining balance). Companies may also use 150% or 125% declining balance. 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

Taking the same case as above - a business has an asset with $50,000 Original Cost, $5000 Salvage Value, and 5 years useful life. First, calculate straight-line depreciation rate. Since the asset has 5 years useful life, the straight-line depreciation rate equals (100% / 5%) 20% per year. With double-declining-balance method, as the name suggests, double that rate, or 40% depreciation rate is used. Following schedule indicates the depreciation expense and the book value at the end of each year

Book Value at the beginning	Depreciation rate	Depreciation expense	Accumulated Depreciation	Book Value at the end of the Year
50000	40%	20000	20000	30000
30000	40%	12000	32000	18000
18000	40%	7200	39200	10800
10800	40%	4320	43520	6480
6480	6480 - 5000	1480	45000	5000

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. The process continues until the Salvage Value, or the end of the asset's useful life, is reached.

Sum-of-Years' Digits Method

Sum-of-Years' Digits is a depreciation method that results in a more accelerated write-off than straight line, but less than declining-balance method. Under this method 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 $50000, a useful life of 5 years and a Salvage Value of $5000, 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

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.

It is important to note that the asset land is not depreciated, because land is assumed to last indefinitely. Also note that Intangible assets are not depreciated but instead are written off using the method of Amortization. Depreciation and its related concept, amortization are non-cash expenses. Neither depreciation nor amortization will directly affect the cash flow of a company.