Question

Explain how estimation of service lives can result in unrealistically high carrying values for fixed assets.

Answer 1

Depreciation

Depreciation when you use an asset for revenue generating purpose you are actually losing the value of the asset due to wear and tare obsolescence etc so how much value of an asset loosed in a particular financial year by using it in the process is a loss for you and it has to treated as expense for that year and recognized in income statement.

It can be viewed In another way. For purchasing an asset you are making a huge cash outflow at the time of purchase of the asset. But you can’t treat it as your expenses for that particular year because you are not making such cash outflow for that year only, that’s why we treat that outflow in form of fixed asset in your balance sheet. but when time goes you will use that asset to produce the product and thereby earn revenue. Up to what amount you used the asset to make revenue for a particular year that is a loss of value for your asset and you should treat it as your expense for that year and recognize that as an expense in your income statement to find out your actual profit.

There are Mainly three types depreciation methods are used.

1. Straight line Method.
2. Unit of production Method.
3. Double declining Method.

Let Me explain to you how estimation of service life will Cause unrealistic Carrying value For Fixed asset. For that, I am putting a Question here.

The purchase price of the asset	$500,000
Useful life	5 years
Total Number units producible by Asset	1,000,000
Actual Number of units Produced in1st year.	450,000

   

Depreciation charged on asset under the straight-line method.

Total value of asset /Useful life =$500,000 / 5 =$100,000

Depreciation under unit of product method.

The total value of asset *(Unit produced in current year/ Total number of units producible)_

     =$500,000*(450,000/1,000,000) =$225,000

Summary Statement

	Straight line methods ($)	Unit of product method ($0
Purchase price (A)	500,000	500,000
Depreciation value (B)	100,000	225,000
Carrying value (A-B)	400,000	275,000

So actually the asset is having only value to produce 550,000 units that are $275,000.but based on straight line estimation we computed a carrying value of 400000. Which is unrealistic in nature.