Accounting: The Language of Business (Part 58)

“10 out of 9 accountants can’t count!” —Unknown

Fixed Assets and Intangible Assets (Part B)

by

Charles Lamson 

Accounting for Depreciation

Three factors are considered in determining the amount of depreciation expense to be recognized each period. These three factors are (a) the fixed asset's initial cost, (b) its expected useful life, and (c) its estimated value at the end of its useful life. This third factor is called the residual value, scrap value, salvage value, or trade-in value. Exhibit 4 shows the relationship among the three factors and the periodic depreciation expense.

A fixed asset's residual value at the end of its expected useful life must be estimated at the time the asset is placed in service. If a fixed asset is expected to have little or no residual value when it is taken out of service, then its initial cost should be spread over its expected useful life as depreciation expense. If, however, a fixed asset is expected to have a significant residual value, the difference between its initial cost and its residual value, called the asset's depreciable cost, what is the amount that is spread over the asset's useful life as depreciation expense. 

A fixed asset's expected useful life must be estimated at the time the asset is placed in service. Estimates of expected useful lives are available from various trade associations and other publications. For federal income tax purposes, the Internal Revenue Service has established guidelines for useful lives. These guidelines may also be helpful in determining depreciation for financial reporting purposes. 

In practice, many businesses use the guideline that all assets placed in or taken out of service during the first half of a month are treated as if the event occurred on the first day of that month. That is, these businesses compute depreciation on these assets for the entire month. Likewise, all fixed asset additions and deductions during the second half of a month are treated as if the event occurred on the first day of the next month. We will follow this practice in the next several posts.

It is not necessary that a business use a single method of computing depreciation for all its depreciable assets. The methods used in the accounts and financial statements may differ from the methods used in determining income taxes and property taxes. The three methods used most often are (1) straight line, (2) units of production, and (3) declining balance. Exhibit 5 shows the extent of the use of these methods in financial statements.

EXHIBIT 5 Use of Depreciation Methods

Straight-Line Method

The straight-line method provides for the same amount of depreciation expense for each year of the asset's useful life. For example, assume that the cost of a depreciable asset is $24,000, its estimated residual value is $2,000, and it's estimated life is 5 years. The annual depreciation is computed as follows:

$24,000 cost - $2,000 estimated residual value / 5 years estimated life = $4,400 annual depreciation

When an asset is used for only part of a year, the annual depreciation is prorated. For example, assume that the fiscal year ends on December 31 and that the asset in the above example is placed in service on October 1. The depreciation for the first fiscal year of use would be $1,100 ($4,400 * 3 / 12).

For ease in applying the straight-line method, the annual depreciation may be converted to a percentage of the depreciable cost. This percentage is determined by dividing 100% by the number of years of useful life. For example, a useful life of 20 years converts to a 5% rate (100% / 20), 8 years converts to a 12.5% rate (100% / 8), and so on. In the above example, the annual depreciation of $4,000 can be computed by multiplying the depreciable cost of $22,000 by 20% (100% / 5).

The straight-line method is simple and is widely used. It provides a reasonable transfer of costs to periodic expense when the asset's use and the related revenues from its use are about the same from period to period. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 397-399*

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