Lesson 57: Straight Line and Declining Balance Methods
In this lesson, we will discuss how costs,
salvage value and useful life are used in
depreciation calculation. We will then learn about two methods of calculation:
the straight line method and 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.
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Let's first review three things that
will be used to
calculate the amount of depreciation: costs, salvage value and useful life.
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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.
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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.
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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.
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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%.
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100% / 10 years = 10%
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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.
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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.
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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.
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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.