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Market factors contributing to functional depreciation are associated with the asset's usage diminishing after becoming outdated or changes in consumer demand.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.
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.
Big Truck Company will make a journal entry to record depreciation expense at the end of each year.
Straight-Line Depreciation Expense Journal Entry
|Dec 31||Depreciation Expense||$4,000|
|Accumulated Depreciation Equipment||$4,000|
|To record depreciation expense for equipment|
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:
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:
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).
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|