Discussion

Calculating depreciation is made difficult by many factors. First, the value of an asset can change over time in many complicated ways. Age, wear and tear, and functional changes all have their effects, and are often unpredictable. A 30-vear old VW Beetle, for example, can suddenly increase in value because a new Beetle is introduced by the manufacturer.

A second complication is created by tax laws that make it desirable for companies to depreciate things quickly, while at the same time restricting the way thev calculate depreciation. Tax laws require that companies, at least for tax purposes, use specific methods of calculating depreciation that may bear little relevance to market value or remaining life.

A third complication is that, in real life, it is sometimes hard to determine what is an asset and what is not. If some costly item is recognized as an expense, a company can claim the costs early and offset profits to reduce taxes. However, as in the case of the software in Guyana, new rules can suddenly change an expense into an asset, which then has to be depreciated over time at higher cost to the company. Companies and tax departments often conflict because of ambiguity about assets and expenses.

In the end, depreciation calculations are simply estimates that are useful only with a clear understanding of the assumptions underlving them.

Questions

1. For each of the following, indicate whether the straight-line method or the declining-balance method would likely give the most accurate estimate of how the asset's value changes over time, or explain why neither method is suitable.

(e) An engineering degree

(f) A Van Gogh painting

2. V"hat differences occur in the balance sheet and income statement of a company in Guyana now that a software acquisition is considered to be a capital expenditure as opposed to an expense? Is the company's profit greater or less in the first year? How does the total profit over the life of the asset compare?

EXTENDED CASE: PART 1 Welcome to the Real World

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