Depreciation - All About Profit & Loss Statement

Updated: May 14



Welcome back to "All About The Profit & Loss Statement" series. We concluded the last session by discussing the similarities and differences between operating expenses (OPEX) and capital expense (CAPEX). A quick refresher before we start, OPEX is the articulation of long-term business objectives into short-term actionable plans while CAPEX is longer-term and a bigger commitment to the eventual realization of business goals.


As CAPEX requires a hefty upfront investment in an asset that produces economic benefits over lifespan, depreciation and amortization (for intangible assets) are the allocations of the upfront cost over its economic life. With that, let us embark on this exciting journey and do leave a Like or comment if you wish to leave feedback.


TABLE OF CONTENT

  1. What are Depreciation and Amortization?

  2. Unit-of-Production Method

  3. Straight-Line Method

  4. Accelerated Methods

  5. Revaluation Method

  6. Accounting for Depreciation & Capital Asset Transactions

  7. EBIT & EBITDA

  8. Depreciation and Amortization Related Ratios


WHAT ARE DEPRECIATION & AMORTIZATION (D&A)?


Is it representative of the company's actual finances when you purchase an expensive hardware to use over the next 5 years and instead of allocating the cost over the lifespan of the asset, you record the whole upfront investment as an expense in the first year, causing current profit to plunge and future profits for the next 4 years to be overstated?


Depreciation and amortization (for intangible assets with finite lives) account of long-term assets, by allocating its cost over its useful life. In addition to allocating its expenses in the P&L statement, it also attempts to model the asset’s wear and tear and decline in value as newer products come into the market. It is a requirement under the Matching Principle in which expense to be recorded during the periods when it is used to generate revenue.

Under the generally accepted principles of accounting (GAAP), a company is not required to state depreciation and amortization separately in the P&L statement. However, it can be found in the accompany COGS and OPEX footnotes.



Last but not least, we would like to reemphasize that D&A is a function of the firm's CAPEX and cost allocation decisions. CAPEX are investments made in assets and progressive steps taken to guide the company to achieve its long-term corporate goals. But the amount allocated to each period is subject to the method used. In this article, we will discuss 4 common GAAP methods.



UNIT-OF-PRODUCTION METHOD


This method depreciates the initial cost of an asset by its expected usage. It is relatively intuitive and is suitable for assets which usage pattern could be estimated with reasonable accuracy. It is best to illustrate the mechanics through the use of an example.


Michelle is the manager of Wanderlust Travels Inc. and recently bought a drone. It costs $4,900, is expected to last for 4 years and has a salvage value of $1,000. To familiarize herself with the functions of the camera, she paid $100 to attend product training. She expects to produce 10 videos for the first year, followed by 20, 30 and 40 for the 4 years.


  • Depreciable Cost = [Initial cost + Cost of Getting Asset Ready For Use] – Scrap Value

  • Depreciation Expense = Depreciable Cost x [Usage in Period ÷ Total Usage]

  • Accumulated depreciation measures the cumulative depreciation expense

  • The END carry amount at the life of its lifespan must equal to the salvage value.


The initial cost adds up to $5,000 as she spends $4,900 on the drone and an additional $100 to learn how to fly it. She then deducts the estimated resale value of $1,000 at the end of its 4-year economic life to arrive at the depreciable cost of $4,000.

STRAIGHT-LINE METHOD


This method depreciates the initial cost of an asset on a linear basis. It is straightforward and is also used to amortize intangible assets with finite lives such as IPR license, SaaS, lease agreements, etc.


  • Depreciable Cost = [Initial cost + Cost of Getting Asset Ready For Use] – Scrap Value

  • Depreciation Expense = Depreciable Cost ÷ Economic Lifespan


The result is a consistent depreciation expense of $1,000 each year, making the lives of managers and accountants easier.


ACCELERATED METHODS (SOYD & DDB)


These methods allocate a higher proportion of depreciation during the early periods. Higher depreciation expense in the early years translates to lower profits. This is a method favoured as it more accurate models the decline of an asset's market value.


In other tax jurisdictions, using the accelerated method of depreciation helps lower early tax expenses due to lower early taxable incomes. It helps the company better match its liquidity position subsequent to a hefty upfront investment. However, this approach is not applicable in Singapore as IRAS uses capital allowance, which will be discussed in our later article on tax.


SOYD DEPRECIATION


  • Sum of Year = 1 + 2 + 3 + 4 = 10

  • Fraction = Remaining Lifespan at Beginning of Period ÷ Sum of Year

  • Depreciable Cost = [Initial cost + Cost of Getting Asset Ready For Use] – Scrap Value

  • Depreciation Expense = Depreciable Cost ÷ Economic Lifespan


DDB DEPRECIATION


  • Fraction = 2 ÷ Lifespan

  • Depreciation Expense = Beginning Carry Amount x Fraction

  • NOTE: Stop depreciating once The END Carry Amount = Scrap Value


REVALUATION METHOD


This method requires the revaluation of assets at a periodic basis, typically at least once per year or immediately following a material event. Although it adds to the accounting workload, it is better reflects the company's financial performance if it is materially affected by the fluctuation of its asset portfolio, such as investment properties, which has a market.

INFORMATION NEEDED

  1. Valuation at End of Year 1: $6,000 <<< Excellent review in the market + Limited edition

  2. Valuation at End of Year 2: $3,000 <<< Newer model launched + Wear & tear

  3. Revalue at End of Year 3: $150 <<< Drone is damaged in a flight accident


  • (A) BGN Carry Amount = (D) Valuation carried out at the end of the last period

  • (B) Depreciation Expense = (A) BGN Carry Amount ÷ Remaining Lifespan

  • (E) Revaluation Gain (Loss) = (D) Updated Valuation - (C) END Carry Value

  • Revaluation Surplus = Beginning Revaluation Surplus + (E) Revaluation Gain (Loss)

  • (E) Revaluation Gain (Loss) is recorded under Other Comprehensive Income (OCI)

  • Revaluation Surplus is recorded under Accumulated OCI, in the balance sheet as Equity

  • Revaluation Surplus cannot be less than 0.

  • If the Revaluation Loss loss exceeds Revaluation Surplus, the excess over Revaluation Surplus is recorded in the Income Statement as an Impairment Loss, a non-operating expense which lowers net profit and retained earnings.


ACCOUNTING FOR DEPRECIATION & CAPITAL ASSET TRANSACTIONS


1 - RECORD ASSET PURCHASE

After Michelle purchases the drone for $5,000, she records the following journal entry after assigning a fixed asset code, 3050SN. She expects the drone to have a service lifespan of 4 years, a $1,000 scrap value and her firm's policy mandates the SL depreciation method.




2 - RECORD DEPRECIATION EXPENSE


At the end of the period, Michelle closes the accounting book by recording the depreciation expense of $1,000 for the year. At this point, if she wants to find out the book value of the drone, she has to deduct accumulated depreciation of $1,000 from the initial cost of $5,000 to derive $4,000.


3 - RECORD IMPAIRMENT LOSS


Subsequently, Michelle damages her drone in a flight accident. She proceeds to do the test for impairment and derives a value of $1,500. Prior to the accident, the drone has a carrying value of $4,000, accumulated depreciation of $1,000 and remaining life of 3 years. Michelle also estimates that the scrap value is likely to worth $0 after the accident.



The updated annual depreciation expense going forward is $1,500 ÷ 3 years, or $500.


4 - SELLING THE ASSET


Michelle takes the drone to the repairman the following day, She receives a repair quotation of $1,000. Alternatively, she is also told that the repairman is willing to purchase the damaged drone for $800. She then does an online search and found that an interested buyer is willing to buy the damaged drone for $1,600. Michelle takes a moment to consider the offers.


Scenario A - She will incur $700 loss if she was to sell for $800 to the repairman.



Scenario B - She will earn $100 gain if she was to sell for $1,600 to the online buyer.


5 - WRITE-UP OF ASSET SUBSEQUENT TO IMPAIRMENT


Michelle decides to repair the drone instead and negotiates the repair price to $800. After the repair is completed, she conducts another test for impairment and the value turns out to be $2,400. She then proceeds to record the recovery in value.


It is not prohibited under IFRS to write-up a previously impaired asset up to its original carry amount. The updated depreciation expense is $800 ($2,400 ÷ 3 years) for the next 3 years. This carrying value is revised upwards to $2,400, which is still below the original carry amount of $4,000. Accumulated depreciation and impairment stands at $2,600.


6 - ASSET DISPOSAL


After the repair, the camera worked well for the next 3 years. Towards the end of its service life, it starts to lag behind in terms of technology and capabilities. Therefore, Michelle decides to donate the camera to a photography club and dispose of it at no-cost. The accounting treatment is to remove the asset and its associated accumulated depreciation from the accounting books.



INTERNAL CONTROL & RISK MANAGEMENT


Depreciation, amortization and CAPEX are intrinsically linked with the budgeting process, which is the allocating resources to achieve strategic objectives. As CAPEX represents a future commitment and upfront investment outlay, if the decision is built on shaky assumptions and inadequate risk planning, it could negatively impact financial performance going forward.


Fixed assets are bought using the monies from shareholders and lenders, it is imperative to safeguard them with the proper internal control mechanisms to prevent theft and misuse. It is also good to transfer risk to the insurer by purchasing insurance against unexpected events.


As the business grows in size and complexity, it is equally important to standardize the accounting treatment for capital assets. Standardization encourages accountability, transparency, improves accounting consistency, and help creates an audit trail.



EBIT & EBITDA



Operating margin (EBIT or Earnings Before Interest and Tax) is computed after deducting production and operating expense. It is indicative of the business's ability to generate earnings from its everyday activities.


As the EBITDA (or Earnings Before Interest, Tax, Depreciation and Amortization) is a non-GAAP measure, so do not expect to find it being presented in the profit and loss statement. However, one can easily calculate it by adding the D&A expenses found in the COGS and OPEX footnotes to operating income. This key metric is valued by lenders as it suggests the ability to repay by providing a quick and dirty approximation of the business's cash flow from everyday operating activities by excluding non-cash depreciation and amortization expenses from EBIT.

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