Long-Term Assets

Depreciation in Accounting

Depreciation

There are three major factors required to determine depreciation expense: initial cost, expected useful life, and residual value.

Fixed assets are recorded at initial cost on the balance sheet. These costs do not immediately flow through as an expense to the income statement. However, over time the cost of using the asset must be expensed on the income statement as the asset is used to produce revenue. Fixed assets decline in their usefulness over time. Depreciation is the process of allocating the cost of a fixed asset to an expense account over the life of the asset. Physical factors contributing to depreciation are wear and tear from normal use or exposure to the elements. Market factors contributing to functional depreciation are associated with the asset's usage diminishing after becoming outdated or changes in consumer demand. Depreciation is not cash set aside to replace an asset, nor is it exclusively a reduction in the asset's market value. Depreciation is the decline in the usefulness, functionality, and/or value of the asset and the resulting transfer of the costs to an expense account over the life of the asset.

The asset's initial cost, expected useful life, and estimated residual value are all necessary to compute depreciation. The asset's initial cost is the purchase price plus any costs associated with getting the asset ready for its intended purpose or use. The expected useful life of the asset is the number of years an asset is expected to remain in service for the company. The residual value is the anticipated value of a fixed asset at the end of its useful life to the company. Residual value is also known as scrap value, salvage value, or trade-in value. All these methods are used to determine depreciable costs. The depreciable cost is the fixed asset's initial cost minus its residual value, or the amount that will be allocated to the depreciation expense over the life of the asset. An asset should not be depreciated below its residual value.

Depreciation Methods

There are several methods that can be used to depreciate a fixed asset. Three common methods include straight-line, units-of-activity, and double declining balance.

There are three common depreciation methods: straight-line, units-of-activity, and double declining balance. The straight-line depreciation method provides a constant amount of depreciation expense over the life of a fixed asset. Double declining balance is an accelerated depreciation method that is twice the straight-line rate. An accelerated depreciation method provides higher depreciation costs early in the life of an asset when repairs and maintenance are often low and lower depreciation in later years. Units-of-activity methods spread the cost of the asset across its life based on the units of activity or units of production.

Of the three methods, straight-line depreciation is used most extensively because of its simplicity. Straight-line depreciation, which provides a consistent depreciation amount over the life of the asset, can be computed by using a formula.
Straight-line Depreciation=Initial CostsResidual ValueExpected Useful Life\text{Straight-line Depreciation}=\frac{\text{Initial Costs}-\text{Residual Value}}{\text{Expected Useful Life}}
Big Truck Company buys a new piece of equipment for $30,000 that is expected to have a useful life to Big Truck Company of 7 years and will likely be worth $2,000 at the end of its life. Big Truck Company will use the formula for straight-line depreciation to calculate $4,000 annual depreciation expense.
Straight-line Depreciation=Initial CostsResidual ValueExpected Useful Life=($30,000$2,000)7 Years=$4,000\begin{aligned}\text{Straight-line Depreciation}&=\frac{\text{Initial Costs}-\text{Residual Value}}{\text{Expected Useful Life}}\\&=\frac{(\$30\rm{,}000 - \$2\rm{,}000)}{\text {7 Years}}\\&= \$\text{4,000}\end{aligned}

Big Truck Company will make a journal entry to record depreciation expense at the end of each year.

Straight-Line Depreciation Expense Journal Entry

Date Description Debit Credit
Dec 31 Depreciation Expense $4,000
Accumulated Depreciation Equipment $4,000
To record depreciation expense for equipment

Note that assets will not always be purchased at the beginning of the year. Sometimes business entities will have to compute a partial year of depreciation. To compute a partial year of depreciation, simply multiply the annual amount by the period in which the asset was owned. For example, if an asset was purchased on April 1 and the fiscal year ends December 31, the time in service would be 9 months. As a result, the partial year period would be 9 out of 12 months of the annual amount charged to depreciation expense. For Big Truck Company, depreciation in the first year will be $3,000.
$4,000×9/12Rate=$3,000\$4\rm{,}000\times9/12 \text{\;Rate}=\$3\rm{,}000

The units-of-activity method is a depreciation method that bases depreciation expenses on the level of activity in a particular period. It is a functional depreciation method, providing a constant depreciation rate per unit. The estimated amount of total usage or activity can be expressed in miles, units produced, or hours instead of years. Computing depreciation expense using the units-of-activity method is a two-step process. The first step is to determine the depreciation rate per unit. The depreciation rate per unit can be computed by using a formula.

Step 1:
Depreciation per Unit Rate=Initial CostResidual ValueExpected Useful Life in Units\text{Depreciation per Unit Rate}=\frac{\text{Initial Cost}-\text{Residual Value}}{\text{Expected Useful Life in Units}}
Big Truck Company chooses to use the units-of-activity method for its new machine. The initial cost of the machine is $30,000, and the estimated value at the end of its life is $2,000, which means the asset has $28,000 of depreciable costs ($30,000$2,000\$30\rm{,}000-\$2\rm{,}000). The machine is estimated to have a useful life of 40,000 hours of operation. Big Truck Company calculates the depreciation per unit.
Depreciation per Unit Rate=Initial CostResidual ValueExpected Useful Life in Units=$30,000$2,00040,000Hours=$0.70Per Hour\begin{aligned}\text{Depreciation per Unit Rate}&=\frac{\text{Initial Cost}-\text{Residual Value}}{\text{Expected Useful Life in Units}}\\&=\frac{\$30\rm{,}000-\$2\rm{,}000}{40\rm{,}000\;\text{Hours}}\\&=\$0.70 \;\text{Per\; Hour}\end{aligned}
Step 2: In the current year, Big Truck Company uses its new machine for 3,000 hours. It calculates depreciation of $2,100.
Depreciation Expense=Depreciation Rate per Unit×Total Units of Output Used=$0.70 per Hour×3,000 Hours=$2,100\begin{aligned}\text{Depreciation Expense}&=\text{Depreciation Rate per Unit}\times\text{Total Units of Output Used}\\&=\text{\$0.70 per Hour}\times\text{3,000 Hours}\\&=\$2\rm{,}100\end{aligned}

The double declining balance method is an accelerated depreciation method that is twice the straight-line rate. Unlike other methods, the double declining balance method does not consider the residual value when computing depreciation. Computing double declining balance depreciation is a three-step process.

Step 1: Determine the straight-line rate as a percentage:
1Expected Useful Life\frac1{\text{Expected Useful Life}}
Step 2: Double the straight-line rate.

Step 3:
Depreciation Expense=Beginning of Year Book Value×Double Declining Rate\text{Depreciation Expense}=\text{Beginning of Year Book Value}\times\text{Double Declining Rate}
Note: in the final year of depreciation, the amount of depreciation expense must be calculated based on bringing the book value of the asset to the residual value of the asset.

Big Truck Company chooses to use the double declining balance method for its new machine, which is estimated to last 5 years under the straight-line method and has an estimated salvage value of $2,500.

Step 1: Determine the straight-line rate (percentage).
Straightline Rate=15=0.20or20%\text{Straightline Rate}=\frac15=0.20\;\text{or}\;20\%
Step 2: The double declining rate of depreciation is most often twice the straight-line rate.
Twice the Straightline Rate=20%×2=40%or0.40\text{Twice the Straightline Rate}=20\%\times2=40\%\;\text{or}\;0.40
Step 3:
Depreciation Expense=Beginning of Year Book Value×Double Declining Rate=30,000×40%=$12,000\begin{aligned}\text{Depreciation Expense}&=\text{Beginning of Year Book Value}\times\text{Double Declining Rate}\\&=30\rm{,}000\times40\%\\&=\$12\rm{,}000\end{aligned}

Double Declining Depreciation Calculations Example

Year Cost Beginning of Year Accumulated Depreciation Beginning of Year Book Value Double Declining Balance Rate Annual Depreciation End of Year Book Value
1 $30,000 $30,000 X 40% $12,000 $18,000
2 $30,000 $12,000 $18,000 X 40% $7,200 $10,800
3 $30,000 $7,200 $10,800 X 40% $4,320 $6,480
4 $30,000 $4,320 $6,480 X 40% $2,592 $3,888
5 $30,000 $2,592 $3,888 X 40% $1,388 $2,500*

*Note: An asset cannot be depreciated below its residual value, so in the fifth year we depreciate it down to its residual value.