Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset.
Factors Involved in the Depreciation Process
1. What depreciable base is to be used for the asset?
2.What is the asset’s useful life?
3.What method of cost apportionment is best for the asset?
Depreciable Base for the Asset
The base established for depreciation is a function of two factors: the original cost, and the salvage or disposal value. Salvage value is the estimated amount that the company will receive when it sell the asset or removes it from service. It is the amount to which the company writes down or depreciates the asset during its useful life.
An asset is purchased for $10,000. The company believes that it has a salvage value of $1,000.
Original cost $10,000
Less: Salvage value 1,000
Depreciation base$ 9,000
Methods of Depreciation
The accounting profession requires that the depreciation method employed be “systematic and rational.” The following are examples of depreciation methods:
1. Activity method (units of use or production)
3.Decreasing charge methods (accelerated):
a. Sum-of-the-years’ digits
The following information will be used to illustrate each of the above methods:
Stanley Coal Mines recently purchased an additional crane for digging purposes. Cost of crane$500,000
Estimated useful life5 years
Estimated salvage value$50,000
Productive life in hours30,000 hours
The activity method (also called the variable-charge or units-of-production approach) assumes that depreciation is a function of use or productivity, instead of the passage of time. A company considers the life of the asset in terms of either the output if provides (units it produces), or an input measure such as number of hours it works.
The crane Stanley purchased poses no particular depreciation problem. Stanley can measure the usage (hours) relatively easily. If Stanley uses the crane for 4,000 hours the first year, the depreciation charge is: (Cost less salvage value) X hours this year
Total estimated hours
($500,000 - $50,000) X 4,000
The straight-line method considers depreciation a function of time rather than a function of usage. Companies widely use this method because of its simplicity. The straight-line procedure is often the most conceptually appropriate, too.
Stanley computes the depreciation charge for the crane as follows:
Cost less salvage
Estimated service life
The sum-of-the-years’-digits method results in a decreasing depreciation charge based on a decreasing fraction of depreciable cost (original cost less salvage value). Each fraction uses the sum of the years as a denominator (5+4+3+2+1=15). The numerator is the number of years of estimated life remaining as of the beginning of the year. In this method, the numerator decreases year by year, and the denominator remains constant. At the end of the useful life, the balance remaining should equal the salvage value.
YearDepreciation BaseRemaining life in yearsDepreciation FractionDepreciation ExpenseBook Value, End of Year 1$450,00055/15$150,000$350,000
For assets that have a long life span, the following formula can be used to determine the denominator:
For example, if an asset has a useful life of 51 years, you would calculate the denominator:
YearDepreciation BaseRemaining life in yearsDepreciation FractionDepreciation ExpenseBook Value, End of Year...