Change in Useful life or Salvage Value
All depreciation methods estimate both the useful life of an asset and its salvage value. As time passes the useful life of a company's equipment may be cut short (due to new technology, for example), and its salvage value may also be affected. Once this happens there is asset impairment.
Companies can do two things:
1) They can accelerate the asset's depreciation and fix the reduction in useful life or salvage value over time.
2) They can do the recommended thing, which is to recognize the impairment and report it on the income statement right away.
Changes in useful life and salvage value are considered changes in accounting estimates, not changes in accounting principle. As a result, there is no need to restate past financial statements.
Sale, Exchange or Disposal of Depreciable Assets
Companies that are in the business of exploring, extracting and/or transforming natural resources such as timber, gold, silver, oil and gas are known as "natural resource companies." The main assets these companies have are their inventory of natural resources. These assets must be reported at their carrying cost (or cost of carry). The carrying costs for natural resources include the cost of acquiring the lands or mines, the cost of timber-cutting rights and the cost of exploration and development of the natural resources. These costs can be capitalized or expensed. The costs that are capitalized are included in the cost of carry. The cost of carry does not include the cost of machinery and equipment used in the extraction process.
When a resource company purchases a plot of land, it not only pays for the physical asset but also pays a large premium because of what is contained in the plot of land. However, once a company starts extracting the oil or natural resource from the land, the land loses value, because the natural resources extracted from a plot of land will never regenerate. That loss in value is called "depletion." That is why cost of carry is depleted over time. The depletion of these assets must be included in the income statement's accounting period. This is the only time land can be depleted.
The carrying costs of natural resources are allocated to an accounting period by means of the units-of-production method.
A company acquired cutting rights for $1 million. With these cutting rights, the company will be able to cut 5,000 trees. In its first year of operation, the company cut 200 trees.
Certain types of assets are amortized rather than depreciated. Amortization describes the deduction of capital expenses over a specific period of time (usually over the asset's life). More specifically, this method measures the consumption of the value of intangible assets, such as a patent or a copyright.
What is the difference between amortization and depreciation? Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally expensed based on the time period over which the asset was used. Depreciation and amortization (as well as depletion) methods are used to prorate the cost of a specific type of asset to the asset's life. Remember, these methods are calculated by subtracting the asset's salvage value from its original cost.
Amortization usually refers to spreading an intangible asset's cost over that asset's useful life. For example, a patent on a piece of medical equipment usually has a life of 17 years. The cost involved with creating the medical equipment is spread out over the life of the patent with each portion being recorded as an expense on the company's income statement.
The Relationship Between Financial Statements
Depreciation, on the other hand, refers to prorating a tangible asset's cost over that asset's life. For example, an office building can be used for a number of years before changes in circumstances result in it being sold. The cost of the building is spread out over the predicted life of the building, with a portion of the cost being expensed each accounting year.
Depletion refers to the allocation of the cost of natural resources over time. For example, an oil well has a finite life before all of the oil is pumped out. Therefore, the oil well's setup costs are spread out over the predicted life of the oil well.
It is important to note that in some countries, such as Canada, the terms amortization and depreciation are often used interchangeably to refer to both tangible and intangible assets.
Here is an example of how amortization works. Suppose XYZ Biotech spent $30 million dollars on a piece of medical equipment and that the patent on the equipment lasts 15 years. The business would record $2 million each year as an amortization expense.
While amortization and depreciation are often used interchangeably, technically this is an incorrect practice because amortization refers to intangible assets and depreciation refers to tangible assets.
Amortization can be calculated easily using most modern financial calculators, spreadsheet software packages such as Microsoft Excel, or amortization charts and tables.
To learn more about amortization and depreciation, read Financial Statements: Long-Lived Assets.