Lesson Objectives:- How costs, salvage value and useful life are used in depreciation calculation
- Using the straight line method
- Using the declining balance method
Now that you know the difference between depreciation, amortization and depletion; let's talk about how the straight-line and declining balance methods are used to calculate depreciation. Both of these methods are used for tangible, physical assets such as vehicles, equipment and buildings.
Let's first review three things that will be used to calculate the amount of depreciation: costs, salvage value and useful life.
1. Costs include any expense associated with preparing the tangible asset for its intended use. These costs include things such as legal fees, title costs, freight expenses and transfer taxes.
If for example the base cost was $20,000 and each of the four types of costs mentioned above were $5,000 each, the full cost recorded on the balance sheet would be $40,000.
2. Salvage value is the value of the asset at the end of its useful life. This figure will help to determine how much depreciation can be expensed each year.
3. Useful life is the amount of time that the asset will provide a benefit to the company. This span of time is not the same as the life of the asset because an asset may have a longer life span but not be of use to the company after a certain period of time.
We will start by reviewing the straight-line depreciation method with a real world example.
Let's say we have a piece of equipment worth $500,000 with a salvage value of $100,000. The useful life for the equipment is 10 years.
We would use the equation above to subtract the salvage value from the cost and divide by the useful life figure. This would net us a $40,000 per year depreciation expense.
If we were to chart this expense on a graph, the expense would be a straight line because it remains at a constant amount of $40,000 each year for 10 years.
The straight-line method demonstrates a constant use of the asset over its useful life as the expense amount remains constant. If the sales are constant, the net income will also be constant given the fact that there are no other expenses.
The straight-line method is very simple, we will now get into the declining balance method which does not reflect a constant expense.
The expense will be declining each year as opposed to remaining constant as it did with the straight-line method. The declining balance method takes 100 percent of the asset divided by the useful life. For the example of the piece of machinery, we would divide 100% by 10 years to come up with a rate of 10%.
100% / 10 years = 10%
Next, we will take the cost of $500,000 and multiply by the 10% in order to come up the first year depreciation expense of $50,000. To come up with our net realizable value, we would simply subtract the $50,000 from the total cost of $500,000.
We would continue to calculate the rest of the depreciation values until the end of the useful life.
You can see that the depreciation expense is slowly decreasing over time. The net income figures will be lower in the beginning because the expense amounts are higher. Over time given that the sales amounts are constant, the net income figure will increase as the expense accounts are decreasing.
Let's look at what would happen with the salvage value when using the declining balance method. We mentioned earlier in the lesson that the salvage value for the example piece of equipment was $100,000.
As we depreciate over time, we finally get to a net realizable value of $106,000. We would then take 10% of that figure which is $10,600 and subtract the amount to come up with a $95,400 net realizable value. The only problem with this figure is that we cannot expense the depreciation below the salvage value. In this case, we would only expense $6,000 for that accounting period.
If we were to use the double declining balance method, we would simply multiply the depreciation rate by 2 to come up with a 20% rate. There is also the triple declining balance method that would multiply the rate by 3. These methods would be used if the asset would be used more in the beginning, hence accelerating the rate of depreciation.
The choice to use either the straight-line or declining balance method relies on how the company is using the asset. If the tangible asset is used constantly over its useful life, the company would use the straight-line method as the use is spread out evenly. In contrast, if a large amount of the asset is being used in the beginning, the company would use the declining balance method.