Explain depreciation in the balance sheet

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A few years ago, the United States Bureau of Economic Analysis announced a change in the way it estimates gross domestic product (GDP). In the future, he would include intangibles in his calculations of investments in the economy.

The change has significantly boosted economic growth over the past 50 years and made the economy nearly $ 560 billion larger than expected. Now that intangibles are considered long-lived assets in the economy, accountants will need to amortize their amount over time when preparing financial statements.

Depreciation is an important concept not only for economists, but for any business that determines its balance sheet.

Amortization

Depreciation is the process of capitalizing the value of an intangible asset over time. It’s similar to depreciation, but this term refers more to tangible capital assets.

Depreciation occurs when the value of an asset, typically an intangible asset, such as research and development (R&D) or a brand, is reduced over a specific period of time, which is typically the estimated useful life. of the asset.

A good way to think about this is to think of depreciation as the cost of an asset as it is consumed or used while generating sales for a business. In addition to the useful life, the main inputs into the depreciation process include the residual value and the allocation method, the latter of which may be straight-line.

A more specialized amortization case occurs when a bond purchased at a premium is amortized to its face value as the bond matures. When a bond is bought at a discount, the term is called accretion. The concept again refers to the adjustment of the value of overtime on a company’s balance sheet, with the amount of depreciation reflected in the income statement.

A rule of thumb about this is to depreciate an asset over time if the resulting benefits will be realized over a period of several years or longer. With a short expected duration, such as days or months, it is probably better and more efficient to expense the cost through profit or loss and not count the item as an asset at all.

Explain depreciation in the balance sheet

Examples of intangible assets

Other examples of intangible assets include customer lists and relationships, license agreements, service contracts, computer software, and trade secrets (such as the Coca-Cola recipe). Another major intangible asset is goodwill. It was previously amortized over time but must now be reviewed annually for any possible adjustment.

A good example of how depreciation can have a huge impact on a company’s finances is the 2000 purchase of Time Warner by AOL during the dot-com bubble. AOL paid $ 162 billion for Time Warner, but AOL’s value fell in the following years, and the company took on a goodwill impairment charge of $ 99 billion. In previous years, this amount would have been amortized over time, but it must now be assessed annually and depreciated if, as in the case of AOL, the value is no longer there.

GAAP vs IFRS

Businesses should account for depreciation as stipulated in significant accounting standards. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) both have similar definitions of what is considered an intangible asset, but there are differences in how their values ​​should be adjusted. over time.

For example, development costs to create new products are expensed under GAAP (in most cases) but capitalized (amortized) under IFRS.GAAP does not allow the value of an intangible asset to be reassessed, unlike IFRS. This means that changes in value under GAAP can be accounted for by changing amortization schedules or potentially reducing the value of an intangible asset, which would be considered permanent.Finally, GAAP stipulates that advertising expenses are expenses as they are incurred, but IFRS allows for the recognition of a prepayment of these expenses as an asset, which would be capitalized or amortized over time. extent of their subsequent use.

The bottom line

Amortization reflects the fact that intangible assets have a value that must be monitored and adjusted over time. The concept of amortization is the subject of classifications and estimates that must be carefully considered by the accountants of a firm and by the auditors who must approve the financial statements.


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