Quick Guide to Depreciation – Part 1

Depreciation is the process of allocating the cost of long-lived plant assets other than land to expense over the asset’s estimated useful life. For financial reporting purposes, companies may choose from several different depreciation methods. Before studying some of the methods that companies use to depreciate assets, make sure you understand the following definitions.

• Useful life is an estimate of the productive life of an asset. Although usually expressed in years, an asset’s useful life may also be based on units of activity, such as items produced, hours used, or miles driven.
• Salvage value equals the value, if any, that a company expects to receive by selling or exchanging an asset at the end of its useful life.
• Depreciable cost equals an asset’s total cost minus the asset’s expected salvage value. The total amount of depreciation expense assigned to an asset never exceeds the asset’s depreciable cost.
• Net book value is an asset’s total cost minus the accumulated depreciation assigned to the asset. Net book value rarely equals market value, which is the price someone would pay for the asset. In fact, the market value of an asset, such as a building, may increase while the asset is being depreciated. Net book value simply represents the portion of an asset’s cost that has not been allocated to expense.

There are some depreciation method used, the most common methods are:

• Straight Line Depreciation
• Units-of-activity depreciation
• Sum-of-the-years’-digits depreciation
• Declining-balance depreciation

Straight-line depreciation

There are many depreciation methods available to companies. Straight-line depreciation is the method that companies most frequently use for financial reporting purposes. If straight-line depreciation is used, an asset’s annual depreciation expense is calculated by dividing the asset’s depreciable cost by the number of years in the asset’s useful life.

Another way to describe this calculation is to say that the asset’s depreciable cost is multiplied by the straight-line rate, which equals one divided by the number of years in the asset’s useful life.

Calculating Straight-Line Depreciation

Suppose a company purchases a $90,000 truck and expects the truck to have a salvage value of $10,000 after five years. The depreciable cost of the truck is $80,000 ($90,000 – $10,000), and the asset’s annual depreciation expense using straight-line depreciation is $16,000 ($80,000 ÷ 5).

The following table summarizes the application of straight-line depreciation during the truck’s five-year useful life.

At the end of year five, the $80,000 shown as accumulated depreciation equals the asset’s depreciable cost, and the $10,000 net book value represents its estimated salvage value.
To record depreciation expense on the truck each year, the company debits depreciation expense–vehicles for $16,000 and credits accumulated depreciation–vehicles for $16,000.

If another depreciation method had been used, the accounts that appear in the entry would be the same, but the amounts would be different.
Companies use separate accumulated depreciation accounts for buildings, equipment, and other types of depreciable assets. Companies with a large number of depreciable assets may even create subsidiary ledger accounts to track the individual assets and the accumulated depreciation on each asset.

Units-of-activity depreciation

The useful life of some assets, particularly vehicles and equipment, is frequently determined by usage. For example, a toy manufacturer may expect a certain machine to produce one million dolls, or an airline may expect an airplane to provide ten thousand hours of flight time. Units-of-activity depreciation, which is sometimes called units-of-production depreciation, allocates the depreciable cost of an asset based on its usage. A per-unit cost of usage is found by dividing the asset’s depreciable cost by the number of units the asset is expected to produce or by total usage as measured in hours or miles. The per-unit cost times the actual number of units in one year equals the amount of depreciation expense recorded for the asset that year.

Calculating Units-of-Activity Depletion

If a truck with a depreciable cost of $80,000 ($90,000 cost less $10,000 estimated salvage value) is expected to be driven 400,000 miles during its service life, the truck depreciates $0.20 each mile ($80,000 ÷ 400,000 miles = $0.20 per mile). The following table shows how depreciation expense is assigned to the truck based on the number of miles driven each year.

Please find the guide of other depreciation method in our next article “Quick Guide to Depreciation – part 2″