What is depreciation, amortization and depletion? Watch this video for an overview of these terms each of which will be examined further.
Depreciation of plant assets
Companies record depreciation on all plant assets except land. Since the amount of depreciation may be relatively large, depreciation expense is often a significant factor in determining net income. For this reason, most financial statement users are interested in the amount of, and the methods used to compute, a company’s depreciation expense.
Depreciation is the amount of plant asset cost allocated to each accounting period benefiting from the plant asset’s use. Depreciation is a process of allocation, not valuation. Eventually, all assets except land wear out or become so inadequate or outmoded that they are sold or discarded; therefore, firms must record depreciation on every plant asset except land. They record depreciation even when the market value of a plant asset temporarily rises above its original cost because eventually the asset is no longer useful to its current owner. The entry to record depreciation is:
To compute the amount of depreciation expense, accountants consider four major factors:
1. Cost of the asset.
2. Estimated salvage value of the asset. Salvage value (or scrap value) is the amount of money the company expects to recover, less disposal costs, on the date a plant asset is scrapped, sold, or traded in.
3. Estimated useful life of the asset. Useful life refers to the time the company owning the asset intends to use it; useful life is not necessarily the same as either economic life or physical life. The economic life of a car may be 7 years and its physical life may be 10 years, but if a company has a policy of trading cars every 3 years, the useful life for depreciation purposes is 3 years. Various firms express useful life in years, months, working hours, or units of production. Obsolescence also affects useful life. For example, a machine capable of producing units for 20 years, may be expected to be obsolete in 6 years. Thus, its estimated useful life is 6 years—not 20. Another example, on TV you may have seen a demolition crew setting off explosives in a huge building (e.g. The Dunes Hotel and Casino in Las Vegas, Nevada, USA) and wondering why the owners decided to destroy what looked like a perfectly good building. The building was destroyed because it had reached the end of its economic life. The land on which the building stood could be put to better use, possibly by constructing a new building.
4. Depreciation method used in depreciating the asset. We describe the three common depreciation methods next.
Straight-line method Straight-line depreciation has been the most widely used depreciation method in the United States for many years because, as you saw in Chapter 3, it is easily applied. To apply the straight-line method, a firm charges an equal amount of plant asset cost to each accounting period. The formula for calculating depreciation under the straight-line method is:
Depreciation Expense = ( Cost – Salvage ) / Useful Life
Let’s watch an example:
Using the straight-line method for assets is appropriate where (1) time rather than obsolescence is the major factor limiting the asset’s life and (2) the asset produces relatively constant amounts of periodic services. Assets that possess these features include items such as pipelines, fencing, and storage tanks.
Units-of-production (output) method The units-of-production depreciation method assigns an equal amount of depreciation to each unit of product manufactured or service rendered by an asset. Since this method of depreciation is based on physical output, firms apply it in situations where usage rather than obsolescence leads to the demise of the asset. Under this method, you would compute the depreciation charge per unit of output. Then, multiply this figure by the number of units of goods or services produced during the accounting period to find the period’s depreciation expense.
The units of production method requires a 2-step process:
- Step 1: Calculate Depreciation per Unit:
Depreciation per unit = ( Cost – Salvage) / expected # units over lifetime
- Step 2: Calculate Depreciation Expense:
Depreciation Expense = Number of units produced this period x Depreciation per unit.
For our video example:
Double-declining-balance method To apply the double-declining-balance (DDB) method of computing periodic depreciation charges you begin by calculating the straight-line depreciation rate. To do this, divide 100 per cent by the number of years of useful life of the asset. Then, multiply this rate by 2. Next, apply the resulting double-declining rate to the declining book value of the asset. Ignore salvage value in making the calculations. At the point where book value is equal to the salvage value, no more depreciation is taken.
The double declining balance method requires a 3-step process:
- Step 1: Calculate the Straight line (S/L) rate
S/L rate = 1 / useful life in years
- Step 2: Calculate the double declining (DD) rate
DD rate = 2 x S/L rate calculated in Step 1
- Step 3: Calculate Depreciation Expense
Depreciation Expense = Beginning Book Value x DD rate
Remember, book value is calculated as Asset Cost – Accumulated Depreciation.
Let’s look at a video example:
So far we have assumed that the assets were put into service at the beginning of an accounting period and ignored the fact that often assets are put into service during an accounting period. When assets are acquired during an accounting period, the first recording of depreciation is for a partial year. Normally, firms calculate the depreciation for the partial year to the nearest full month the asset was in service. For example, they treat an asset purchased on or before the 15th day of the month as if it were purchased on the 1st day of the month. And they treat an asset purchased after the 15th of the month as if it were acquired on the 1st day of the following month.