What Is an Acquisition Cost?

An acquisition cost, also referred to as the cost of acquisition, is the total cost that a company recognizes on its books for property or equipment after adjusting for discounts, incentives, closing costs and other necessary expenditures, but before sales taxes. An acquisition cost may also entail the amount needed to take over another firm or purchase an existing business unit from another company. Additionally, an acquisition cost can describe the costs incurred by a business in relation to the efforts involved in acquiring a new customer.

Understanding Acquisition Costs

Acquisition costs provide a reflection of the true amount paid for fixed assets before sales tax is applied, for expenses related to the acquisition of a new customer, or for the takeover of other firms. Acquisition costs are useful because they recognize a more realistic cost on a company’s financial statements than using other measures. For instance, the acquisition cost of property, plant, and equipment (PP&E) recognizes any discounts or additional costs that the company will experience and is often referred to as the original book value of the asset in question.

Acquisition Costs for Fixed Assets

Besides the price paid for the asset itself, additional costs may also be considered part of acquisition when these costs are directly tied to the acquisition process. For example, if the asset in question requires legal assistance to complete the transaction, legal and regulatory fees are also included. Commissions associated with the purchase may also be included, such as those paid to a real estate agent when dealing with a property transaction, to a staffing company for placing an employee, to a marketing firm for acquiring customers, or to an investment bank for brokering a merger.

With regard to manufacturing or production equipment, any costs associated with bringing the equipment to an operational state may also be included in the cost of acquisition. This includes the cost of shipping & receiving, general installation, mounting, and calibration.

Acquisition Costs for Customers

Customer acquisition costs are those funds that are used to introduce new customers to the company’s products and services in hopes of acquiring the customer’s business. The customer acquisition cost is calculated by dividing total acquisition costs by total new customers over a set period.

Understanding customer acquisition costs is helpful in planning future capital allocations for marketing budgets and sales discounts. Costs traditionally associated with customer acquisition include marketing and advertising, incentives and discounts, the staff associated with those business areas, and other sales staff or contracts with external advertising firms. Incentives may be expressed in various formats, such as buy-one-get-one-free deals, receiving another product free with purchase, upgraded service at no additional cost to the customer, gift cards, or bill credits.

One business sector with a high occurrence of promotions directed at new customers is the wireless and cellular industry. Wireless companies often extend deals to new customers such as increased data packages, additional family phone lines for free, and discounts on the newest cellular phones. The purpose of these offerings is to entice customers to choose their business over their competitors.

What Is Advanced Internal Rating-Based (AIRB)?

An advanced internal rating-based (AIRB) approach to credit risk measurement is a method that requests that all risk components be calculated internally within a financial institution. Advanced internal rating-based (AIRB) can help an institution reduce its capital requirements and credit risk.

In addition to the basic internal rating-based (IRB) approach estimations, the advanced approach assesses the risk of default using loss given default (LGD), exposure at default (EAD), and the probability of default (PD). These three elements help determine the risk-weighted asset (RWA) that is calculated on a percentage basis for the total required capital.”

Understanding Advanced Internal Rating-Based Systems

Implementing the AIRB approach is one step in the process of becoming a Basel II-compliant institution. However, an institution may implement the AIRB approach only if they comply with certain supervisory standards outlined in the Basel II accord.

Basel II is a set of international banking regulations, issued by the Basel Committee on Bank Supervision in July 2006, which expand upon those outlined in Basel I. These regulations provided uniform rules and guidelines to level the international banking field. Basel II expanded the rules for minimum capital requirements established under Basel I, provided a framework for regulatory review, and set disclosure requirements for assessment of capital adequacy. Basel II also incorporates credit risk of institutional assets.

Advanced Internal Rating-Based Systems and Empirical Models

The AIRB approach allows banks to estimate many internal risk components themselves. While the empirical models among institutions vary, one example is the Jarrow-Turnbull model. Originally developed and published by Robert A. Jarrow (Kamakura Corporation and Cornell University), along with Stuart Turnbull, (University of Houston), the Jarrow-Turnbull model is a “reduced-form” credit model. Reduced form credit models center on describing bankruptcy as a statistical process, in contrast with a microeconomic model of the firm’s capital structure. (The latter process forms the basis of common “structural credit models.”) The Jarrow–Turnbull model employs a random interest rates framework. Financial institutions often work with both structural credit models and Jarrow-Turnbull ones, when determining the risk of default.

Advanced Internal Rating-Based systems also help banks determine loss given default (LGD) and exposure at default (EAD). Loss given default is the amount of money to be lost in the event of a borrower default; while exposure at default (EAD) is the total value a bank is exposed to at the time of said default.

Advanced Internal Rating-Based Systems and Capital Requirements

Set by regulatory agencies, such as the Bank for International Settlements, the Federal Deposit Insurance Corporation, and the Federal Reserve Board, capital requirements set the amount of liquidity is needed to be held for a certain level of assets at many financial institutions. They also ensure that banks and depository institutions have enough capital to both sustain operating losses and honor withdrawals. AIRB can help financial institutions determine these levels.

What Is Accumulated Depreciation?

Accumulated depreciation is the cumulative depreciation of an asset up to a single point in its life. Accumulated depreciation is a contra asset account, meaning its natural balance is a credit that reduces the overall asset value.

Understanding Accumulated Depreciation

The matching principle under generally accepted accounting principles (GAAP) dictates that expenses must be matched to the same accounting period in which the related revenue is generated. Through depreciation, a business will expense a portion of a capital asset’s value over each year of its useful life. This means that each year a capitalized asset is put to use and generates revenue, the cost associated with using up the asset is recorded.

Accumulated depreciation is the total amount an asset has been depreciated up until a single point. Each period, the depreciation expense recorded in that period is added to the beginning accumulated depreciation balance. An asset’s carrying value on the balance sheet is the difference between its historical cost and accumulated depreciation. At the end of an asset’s useful life, its carrying value on the balance sheet will match its salvage value.

When recording depreciation in the general ledger, a company debits depreciation expense and credits accumulated depreciation. Depreciation expense flows through to the income statement in the period it is recorded. Accumulated depreciation is presented on the balance sheet below the line for related capitalized assets. The accumulated depreciation balance increases over time, adding the amount of depreciation expense recorded in the current period.

How to Calculate Accumulated Depreciation

There are several acceptable methods for calculating depreciation. These methods are allowable under Generally Accepted Accounting Principles (GAAP). A company may select the depreciation method they wish to use.

Straight-Line Method

Under the straight-line method of accounting, a company deducts the asset’s salvage value from the purchase price to find a depreciable base. Then, this base is accumulated evenly over the anticipated useful life of the asset. The straight-line method formula is:

Annual Accumulated Depreciation = (Asset Value – Salvage Value) / Useful Life in Years

Imagine Company ABC buys a building for $250,000. The building is expected to be useful for 20 years with a value of $10,000 at the end of the 20th year. The depreciable base for the building is $240,000 ($250,000 – $10,000). Divided over 20 years, the company would recognized $20,000 of accumulated depreciation every year. 

Declining Balance Method

Under the declining balance method, depreciation is recorded as a percentage of the asset’s current book value. Because the same percentage is used in every year while the current book value decreases, the amount of depreciation decreases each year. Even though accumulated depreciation will still increase, the amount of accumulated depreciation will decrease each year.

Annual Accumulated Depreciation = Current Book Value * Depreciation Rate

For example, imagine Company ABC buys a company vehicle for $10,000 with no salvage value at the end of its life. The company decided it would depreciate 20% of the book value each year. In Year 1, Company ABC would recognize $2,000 ($10,000 * 20%) of depreciation and accumulated depreciation. In Year 2, Company ABC would recognize $1,600 (($10,000 – $2,000) * 20%).

Double-Declining Balance Method

Under the double-declining balance (also called accelerated depreciation), a company calculates what it’s depreciation would be under the straight-line method. Then, the company doubles the depreciation rate, keeps this rate the same across all years the asset is depreciated, and continues to accumulate depreciation until the salvage value is reached. The percentage can simply be calculated as twice of 100% divided by the number of years of useful life.

Double-Declining Balance Method Rate = (100% / Useful Life In Years) * 2

Double-Declining Balance Method = Depreciable Amount * Double-Declining Balance Method Rate

Let’s imagine Company ABC’s building they purchased for $250,000 with a $10,000 salvage value. Under the straight-line method, the company recognized 5% (100% depreciation / 20 years); therefore, it would use 10% as the depreciation base for the double-declining balance method. The company would recognize $24,000 ($240,000 depreciable base * 10%) in Year 1, and would recognize $21,600 (($240,000 depreciable base – $24,000) * 10%).

Sum-of-the-Years’ Digits Method

Under the sum-of-the-years’ digits method, a company strives to record more depreciation earlier in the life of an asset and less in the later years. This is done by adding up the digits of the useful years, then depreciating based on that number of year.

Annual Accumulated Depreciation = Depreciable Base * (Inverse Year Number / Sum of Year Digits)

Company ABC purchased a piece of equipment that has a useful life of 5 years. The asset has a depreciable base of $15,000. Since the asset has a useful life of 5 years, the sum of year digits is 15 (5+4+3+2+1). The depreciation rate is then the quotient of the inverse year number (Year 1 = 5, Year 2 = 4, Year 3 = 3, etc.) divided by 15. In Year 1, the company will recognize $5,000 ($15,000 * (5/15)) of depreciation and will recognize $4,000 ($15,000 * (4/15)) in Year 2.

Units of Production Method

Under the units of production method, a company estimates the total useful output of an asset. Then, the company evaluates how many of those units were consumed each year to recognize accumulated depreciation variably based on use. The formula for the units of production method is:

Annual Accumulated Deprecation = (Number of Units Consumed / Total Units To Be Consumed) * Depreciable Base

For example, a company buys a company vehicle and plans on driving the vehicle 80,000 miles. In the first year, the company drove the vehicle 8,000 miles. Therefore, it would recognize 10% (8,000 / 80,000) of the depreciable base. In the second year, if the company drives 20,000 miles, it would recognize 25% of depreciable base as an expense in the second year, with accumulated depreciation now equal to $28,000 ($8,000 in the first year + $20,000 in the second year).

Accumulated Depreciation vs. Accelerated Depreciation

Though similar sounding in name, accumulated depreciation and accelerated depreciation refer to very different accounting concepts. Accumulated depreciation refers to the life-to-date depreciation that has been recognized that reduces the book value of an asset. On the other hand, accelerated depreciation refers to a method of depreciation where a higher amount of depreciation is recognized earlier in an asset’s life.

Since accelerated depreciation is an accounting method for recognizing depreciation, the result of accelerated depreciation is to book accumulated depreciation. Under this method, the amount of accumulated depreciation accumulates faster during the early years of an asset’s life and accumulates slower later. The philosophy behind accelerated depreciation is assets that are newer (i.e. a new company vehicle) are often used more than older assets because they are in better condition and more efficient. 

Accumulated Depreciation vs. Depreciation Expense

When an asset is depreciated, two accounts are immediately impacted: accumulated depreciation and depreciation expense. The journal entry to record depreciation results in a debit to depreciation expense and a credit to accumulated depreciation. The dollar amount for each line is equal to the other.

There are two main differences between accumulated depreciation and depreciation expense. First, depreciation expense is reported on the income statement, while accumulated depreciation is reported on the balance sheet. 

Second, on a related note, the income statement does not carry from year-to-year. Activity is swept to retained earnings, and a company “resets” its income statement every year. Meanwhile, its balance sheet is a life-to-date running total that does not clear at year-end. Therefore, depreciation expense is recalculated every year, while accumulated depreciation is always a life-to-date running total.

Special Considerations

Accounting Adjustments/Changes in Estimate

Because the depreciation process is heavily rooted with estimates, it’s common for companies to need to revise their guess on the useful life of an asset’s life or the salvage value at the end of the asset’s life. This change is reflected as a change in accounting estimate, not a change in accounting principle. For example, say a company was depreciating a $10,000 asset over its five year useful life with no salvage value. Using the straight-line method, accumulated depreciation of $2,000 is recognized.

After two years, the company realizes the remaining useful life is not three years but instead six years. Under GAAP, the company does not need to retroactively adjust financial statements for changes in estimates. Instead, the company will change the amount of accumulated depreciation recognized each year. 

In this example, since the asset now has a $6,000 net book value ($10,000 purchase price less $4,000 of accumulated depreciation booked in the first two years), the company will now recognized $1,000 of accumulated depreciation for the next six years. 

Half-Year Recognition

A commonly practiced strategy for depreciating an asset is to recognize a half year of depreciation in the year an asset is acquired and a half year of depreciation in the last year of an asset’s useful life. This strategy is employed to more fairly allocate depreciation expense and accumulated depreciation in years when an asset may only be used part of a year. 

For example, Company A buys a company vehicle in Year 1 with a five year useful life. Regardless of the month, the company will recognize six months worth of depreciation in Year 1. The company will also recognize a full year of depreciation in Year 2 – 5. Then, the company will recognize the final half year of depreciation in Year 6. Although the asset only had a useful life of five years, it is argued that the asset wasn’t used for the entirety of Year 1 nor the entirety of Year 6.

Example of Accumulated Depreciation

Company A buys a piece of equipment with a useful life of 10 years for $110,000. The equipment is estimated to have a salvage value of $10,000. The equipment is going to provide the company with value for the next 10 years, so the company expenses the cost of the equipment over the next 10 years. Straight-line depreciation is calculated as (($110,000 – $10,000) / 10), or $10,000 a year. This means the company will depreciate $10,000 for the next 10 years until the book value of the asset is $10,000.

Each year the contra asset account referred to as accumulated depreciation increases by $10,000. For example, at the end of five years, the annual depreciation expense is still $10,000, but accumulated depreciation has grown to $50,000. That is, accumulated depreciation is a cumulative account. It is credited each year as the value of the asset is written off and remains on the books, reducing the net value of the asset, until the asset is disposed of or sold. It is important to note that accumulated depreciation cannot be more than the asset’s historical cost even if the asset is still in use after its estimated useful life.

The Bottom Line

Many companies rely on capital assets such as buildings, vehicles, equipment, and machinery as part of their operations. In accordance with accounting rules, companies must depreciate these assets over their useful lives. As a result, companies must recognize accumulated depreciation, the sum of depreciation expense recognized over the life of an asset. Accumulated depreciation is reported on the balance sheet as a contra asset that reduces the net book value of the capital asset section. 

What is an Actuarial Gain Or Loss?

Actuarial gain or loss refers to an increase or a decrease in the projections used to value a corporation’s defined benefit pension plan obligations. The actuarial assumptions of a pension plan are directly affected by the discount rate used to calculate the present value of benefit payments and the expected rate of return on plan assets. The Financial Accounting Standards Board (FASB) SFAS No. 158 requires the funding status of pension funds to be reported on the plan sponsor’s balance sheet. This means there are periodic updates to the pension obligations, the fund performance and the financial health of the plan. Depending on plan participation rates, market performance and other factors, the pension plan may experience an actuarial gain or loss in their projected benefit obligation.

While those accounting rules require pension assets and liabilities to be marked to market on an entity’s balance sheet, they allow actuarial gains and losses, or changes to actuarial assumptions, to be amortized through comprehensive income in shareholders’ equity rather than flowing directly through the income statement.

Understanding Actuarial Gain Or Loss

Actuarial gains and losses are best understood in the context of overall pension accounting. Except where specifically noted, this definition addresses pension accounting under U.S. generally accepted accounting principles (GAAP). While U.S. GAAP and International Financial Reporting Standards (IFRS) prescribe similar principles measuring pension benefit obligations, there are key differences in how the two standards report pension cost in the income statement, particularly the treatment of actuarial gains and losses.

Funded status represents the net asset or liability related to a company’s defined benefit plans and equals the difference between the value of plan assets and the projected benefit obligation (PBO) for the plan. Valuing plan assets, which are the investments set aside for funding the plan benefits, requires judgment but does not involve the use of actuarial estimates. However, measuring the PBO requires the use of actuarial estimates, and it is these actuarial estimates that give rise to actuarial gains and losses.

There are two primary types of assumptions: economic assumptions that model how market forces affect the plan and demographic assumptions that model how participant behavior is expected to affect the benefits paid. Key economic assumptions include the interest rate used to discount future cash outflows, expected rate of return on plan assets and expected salary increases. Key demographic assumptions include life expectancy, anticipated service periods and expected retirement ages.

Actuarial Gains and Losses Create Volatility in Results

From period to period, a change in an actuarial assumption, particularly the discount rate, can cause a significant increase or decrease in the PBO. If recorded through the income statement, these adjustments potentially distort the comparability of financial results. Therefore, under U.S. GAAP, these adjustments are recorded through other comprehensive income in shareholders’ equity and are amortized into the income statement over time. Under IFRS, these adjustments are recorded through other comprehensive income but are not amortized into the income statement.

Footnote Disclosures Contain Useful Information About Actuarial Assumptions

Accounting rules require detailed disclosures related to pension assets and liabilities, including period-to-period activity in the accounts and the key assumptions used to measure funded status. These disclosures allow financial statement users to understand how a company’s pension plans affect financial position and results of operations relative to prior periods and other companies.