CAS 409 – Depreciation of Tangible Capital Assets (Part 2 of 3)

*This is Part 2 of a 3-part blog. Each part addresses the fundamental requirements and techniques for application related to the standard, and provides specific examples.

 

  • This Part 2 addresses the areas of depreciation methods and the determination of estimated residual values.

 

 

Background:  This standard provides the criteria for assigning costs of tangible capital assets to cost accounting periods and for allocating such costs within such periods in an objective and consistent manner.  The basic concept is that the amount assigned to each accounting period should be a reasonable measure of the expiration of the service potential of the tangible capital asset.  The standard does not cover the amortization of intangible capital assets or the depletion of natural resources.

CAS 409 Depreciation Methods

Depreciation Methods

  • CAS 409-40(a)(3) requires that the method of depreciation selected for assigning the depreciation cost reflect the pattern of consumption of services over the life of the asset.  In accordance with CAS 409-50(f)(3)(i), an accelerated method of depreciation is appropriate where the expected consumption of asset services is significantly greater in the early years of the asset life.  Conversely, under CAS 409-50(f(3)(ii), the straight-line method of depreciation is appropriate when the expected consumption of the asset services is reasonably level over the service life of the asset.

EXAMPLE: A contractor purchases a building.  The building is expected to last 30 years.  The contractor proposes to use an accelerated method of depreciation.  However, the contractor is unable to demonstrate that the building will provide more services in the early years than in the later years.  The contractor’s proposed method is in noncompliance with CAS 409, since a straight-line rather than accelerated method of depreciation reflects the consumption of services over the life of the building.

 

  • CAS 409(f)(3) states that the expected consumption can be represented by the expected activity or expected physical output of the asset (e.g., hours of operation, number of units produced).  An acceptable surrogate for activity or output can be a monetary measure (e.g., estimated labor dollars).  When activity or output cannot be reliably measured, expected consumption can be measured by the passage of time.

EXAMPLE: Contractor K purchases three tangible capital assets:  a truck, a garment machine, and a building.  The contractor depreciates the truck based on miles driven per year (a measure of the activity of the asset), and the garment machine based on number of garments produced (physical output of the asset).  Since the building cannot be based on activity or output, the contractor proposes to depreciate it using the straight-line method of deprecation (passage of time).  The contractor’s depreciation practices comply with CAS 409, since activity (miles per year) is the best measure of consumption of services for the truck; output (number of garments produced) is the best measure of consumption of services for the garment machine; and the passage of time (straight-line depreciation) is the best measure of consumption of services for the building.

 

  • CAS 409-50(f)(1) requires that the method of depreciation be the method used for financial accounting purposes provided that method reflects a reasonable estimate of expected service consumption and is acceptable for Federal income tax purposes. 

EXAMPLE: A contractor purchases a delivery truck.  The contractor depreciates its delivery trucks for financial accounting purposes using the straight-line method of depreciation.  The contractor depreciates the truck for Federal income tax purposes using an accelerated method of depreciation.  However, the straight-line method is also acceptable for Federal tax purposes.  CAS 409 requires that the contractor use the straight-line method for depreciating the truck.  Note that while the method used for financial accounting purposes needs to be acceptable for Federal income tax purposes, it does not have to be the actual method used by the contractor for Federal income tax purposes. 

 

  • CAS 409-50(f)(1) states that if the method of depreciation used for financial accounting purposes does not reflect a reasonable estimate of expected service consumption or is not acceptable for Federal income tax purposes, the contractor must select the appropriate depreciation method based on the following criteria:

1) Use an accelerated method of depreciation when the expected consumption is significantly greater in the early years of asset life.

2) A straight-line method of depreciation when the expected consumption is reasonably level over the service life of the asset.

EXAMPLE: A contractor purchases a machine and uses the double declining method of depreciation for financial accounting purposes.  However, this method is not acceptable for Federal income tax purposes.  The expected consumption is significantly greater in the early years of the asset life and thus an accelerated method of deprecation is acceptable.  The contractor may use an accelerated method that reflects the expected consumption of the asset (note that this could be the double-declining balance method used for financial accounting purposes if that method reflects the expected consumption of the asset).

 

  • CAS 409-50(f)(2) requires that when a  method of depreciation for a newly acquired tangible capital asset is different from the methods being used for like assets in similar circumstances, the contractor must support this different method by showing the expected consumption of services of those assets to which the different methods of depreciation will apply.

EXAMPLE: A contractor maintains a line of production equipment, including four processing machines.  The processing machines have traditionally been depreciated using the straight-line method of depreciation.  The contractor is able to produce a study that shows the machines are significantly more productive in their early years of operation than in their later years.  Thus, the contractor changes its disclosed accounting practices to state that all new processing machines will be depreciated using an accelerated depreciation (double declining balance) method.  This is in compliance with the provisions of CAS 409, since the contractor has supported the use of the accelerated depreciation method with the historical study of the expected consumption of the assets.

 

Estimated Residual Values

  • CAS 409-50(h) requires that estimated residual values be determined for all tangible capital assets.

EXAMPLE: A contractor purchases a building for $30 million.  The building has an estimated useful life of 30 years.  The contractor proposes to depreciate the building at a rate of $1 million per year ($30 million/30 years).  Studies indicate that the residual value of the building after 30 years is $3 million.  The contractor is in noncompliance with CAS 409.  The contractor must determine the residual value and subtract that from the purchase price for purposes of determining depreciation charges.  In this example, the contractor would depreciate $27 million ($30 million less the $3 million residual) over 30 years, which would result in depreciation charges of $900,000 per year ($27 million divided by 30 years). 

 

  • In accordance with CAS 409-50(h), for personal property, only estimated residual values that exceed ten percent of the capitalized cost of the asset need to be used in computing depreciation costs.

EXAMPLE: A contractor maintains a fleet of trucks.   The contractor uses the straight-line method of depreciation for the trucks.  The average cost of the trucks is $70,000, with a historical useful life of seven years.  Historically, the contractor has been able to sell a truck for about $5,000 at the end of the seven year period.   Since the estimated residual value of $5,000 is less than ten percent of the $70,000 purchase cost ($7,000 would be ten percent), the contractor may depreciate the trucks at a rate of $10,000 per year (the purchase price of $70,000 divided by 7 years).  The contractor is not required to deduct the $5,000 from the purchase price of the truck in computing the annual depreciation charges.  However, the contractor may not depreciate the asset below its estimated residual value of 5,000 (to achieve this, the depreciation costs for the final year would only be $5,000, rather than the $10,000 used for the first six years of the assets life).

 

  • CAS 409-50(h) states that estimated residual values are also not required when using either the declining balance method of depreciation or the class life asset depreciation range system.

EXAMPLE: A contractor that has a calendar year for its fiscal year purchases a machine for $200,000 on January 1, 2013.  The machine has an estimated service life of five years and an estimated residual value of $15,000.  The contractor uses the double-declining balance method of depreciation.  A straight-line method for an asset with a service life of five years would depreciate the asset at a rate of 20% per year (100 percent divided by 5 years).  A double declining balance method therefore depreciates the asset using a rate of 40% per year.  The contractor will apply the 40% rate to the $200,000 (the $200,000 is not reduced by the estimated residual value of $15,000).  The computation of depreciation using the double-declining balance method is as follows:

Fiscal Year Beginning Book Value Depreciation Ending Book Value
2013 $200,000 $80,000

 (40% x $200,000)

$120,000
2014 $120,000 $48,000

 (40% x $120,000)

$72,000
2015 $72,000 $28,800

(40% x $72,000)

$43,200
2016 $43,200 $14,680

(40% x 43,200)

$17,280
2017 $25,920 $ 10368

(40% x $25,920)

$15,552

Note that under the double-declining balance method of depreciation, the book value of the asset never reaches zero. However, as noted at CAS 409-50(h) (see next bullet), the book value cannot fall significantly below the estimated residual value, which in this case was $15,000. Thus, if the contractor retained the machine in 2018, it would charge depreciation costs of $552 ($15,552 less the estimated residual value of $15,000).

 

  • CAS 409-50(h) states that no depreciation costs may be charged that would significantly reduce the book value of a tangible capital asset below its residual value. 

EXAMPLE: At the beginning of its fiscal year, on January 1, 2013, a contractor purchases a machine with an estimated service life of four years for $80,000.  The machine has an estimated residual value of $6,000.  Since the estimated residual value is less than ten percent of the total value of the machine, the contractor does not have to include the $6,000 for purposes of determining annual depreciation.  However, the contractor still may not depreciate the machine below its residual value.  The annual deprecation charges would be computed as follows:

 Fiscal Year Beginning Book Value Depreciation Ending Book Value
2013 $80,000 $20,000

 ($80,000/4)

$60,000

($80,000 – $20,000)

2014 $60,000 $20,000

 ($80,000/4)

$40,000

($60,000 – $20,000)

2015 $40,000 $20,000

 ($80,000/4)

$20,000

($40,000 – $20,000)

2016 $50,000 $14,000

 ($20,000 book value less $6,000 estimated residual value)

$6,000

 

Note that in 2016, the depreciation costs are limited to $14,000 (rather than the $20,000 assigned to prior years) so that the book value of the asset is not depreciated significantly below its estimated residual value.

 

  • CAS 409-50(i) requires that estimates of service life, residual value, and depreciation methods be reexamined whenever circumstances change.

EXAMPLE: A contractor has historically used a service life of ten years for its assembly machines.  However, the manufacturer of the machine has developed a series of parts that extend the service life of the assembly machines from ten to fifteen years.  The contractor must begin using an estimated service life of fifteen years for all new machines purchased from this manufacturer.  The contractor must also prospectively adjust the estimated service life of its existing machines. 

 

  • In accordance with CAS 409-50(i), when there is a change in the estimated service life, residual value, or method of depreciation during the life of an asset, the change is applied prospectively only, i.e., depreciation costs for past years are not revised. 

EXAMPLE: A contractor has historically used a service life of ten years for its assembly machines.  However, on January 1, 2014, the manufacturer of the machine announces it has developed a series of parts that extend the service life of the assembly machines from ten to fifteen years.  The contractor must prospectively adjust the estimated service life of its existing machines.  As of January 1, 2014, the contractor had two machines that were being depreciated using the fifteen year life.  Machine A had been purchased for $100,000, was being depreciated at a value of $10,000 per year for five years, and had a book value of $50,000 on 1/1/2014.  Machine B had been purchased for $200,000, was being depreciated at a value of $20,000 per year for two years, and had a remaining book value of $160,000.  The adjustment for these two machines is computed as follows (for purposes of this example, assume the estimated residual value of both machines is zero):

Machine Book Value – 1/1/14 Annual Depreciation Cost Before Adjustment Remaining Years of Depreciation Revised Annual Depreciation Cost
A $ 50,000 $10,000 10 (15 years less five years depreciated) $5,000

($50,000/10)

B $160,000 $20,000  13 (15 years less two years depreciated) $12,307

($160,000/13)

Thus, beginning in fiscal year 2014, the contractor will charge annual depreciation costs of $5,000 for Machine A and $12,307 for Machine B.

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