Financial Accounting: Depreciation

• Financial accounting involves summarizing, analyzing, and reporting financial transactions of a business.
• Depreciation is the systematic allocation of the cost of a tangible asset over its useful life.
• It reflects the reduction in the asset's value due to wear and tear, obsolescence, or other factors.
• Depreciation is an accounting concept, not a cash outflow.

Purpose of Depreciation

• Matching principle: To match the expense of an asset with the revenue it generates over its useful life.
• Accurate financial statements: To provide a more realistic view of a company's financial performance and position.
• Tax benefits: Depreciation expense reduces taxable income.

Factors in Calculating Depreciation

• Cost of the Asset: The original cost includes all expenses incurred to acquire the asset and make it ready for its intended use.
• Useful Life: The estimated period over which the asset is expected to be used.
• Salvage Value (Residual Value): The estimated value of the asset at the end of its useful life.

Depreciation Methods

• Straight-Line Depreciation
  • The cost of the asset, less its salvage value, is evenly spread over its useful life.
  • It provides a consistent depreciation expense each year.
  • Calculation: (Cost - Salvage Value) / Useful Life
• Double-Declining Balance Depreciation
  • An accelerated method where depreciation expense is higher in the early years and lower in the later years of an asset's life.
  • It applies a constant rate to the asset's declining book value.
  • Calculation: (2 / Useful Life) * Book Value of the Asset
  • The book value is the cost of the asset less accumulated depreciation.
  • Depreciation stops when the book value equals the salvage value.
• Units of Production Depreciation
  • Depreciation is based on the actual use or output of the asset.
  • It allocates the cost based on the asset's activity rather than time.
  • Calculation: ((Cost - Salvage Value) / Total Estimated Production) * Actual Production
  • Total Estimated Production represents the total units the asset can produce over its life.
  • Actual Production is the number of units produced in a given period.
• Sum-of-the-Years' Digits Depreciation
  • An accelerated method similar to double-declining balance, but uses a different formula.
  • It results in higher depreciation expense in the early years and lower expense in later years.
  • Calculation: (Cost - Salvage Value) * (Remaining Useful Life / Sum of the Years' Digits)
  • Sum of the Years' Digits = n(n+1)/2, where n is the useful life of the asset.

Straight-Line Depreciation: Detailed Explanation

• Simplest and most widely used method.
• Suitable for assets that contribute evenly to revenue generation over their useful life.
• Calculation example:
  • Asset cost: $50,000
  • Salvage value: $10,000
  • Useful life: 5 years
  • Annual Depreciation Expense: ($50,000 - $10,000) / 5 = $8,000 per year
• Results in a constant depreciation expense, making it easy to forecast and understand.

Double-Declining Balance Depreciation: Detailed Explanation

• An accelerated method that recognizes higher depreciation expense in the early years.
• Suitable for assets that lose value more rapidly in their early life or become obsolete quickly.
• Calculation example:
  • Asset cost: $50,000
  • Salvage value: $10,000
  • Useful life: 5 years
  • Depreciation Rate: (2 / 5) = 40%
  • Year 1: Depreciation Expense = 40% * $50,000 = $20,000; Book Value = $30,000
  • Year 2: Depreciation Expense = 40% * $30,000 = $12,000; Book Value = $18,000
  • Year 3: Depreciation Expense = 40% * $18,000 = $7,200; Book Value = $10,800
  • Year 4: Depreciation Expense = 40% * $10,800 = $4,320; Book Value = $6,480
  • Year 5: Depreciation Expense = $800, Book Value = $10,000 (equal to Salvage Value)
• Note: Depreciation is limited such that book value does not fall below salvage value.
• In the last year, depreciation may need to be adjusted to ensure the book value equals the salvage value.

Units of Production Depreciation: Detailed Explanation

• Allocates depreciation based on actual usage or output.
• Best suited for assets whose usage varies significantly from period to period.
• Calculation example:
  • Asset cost: $50,000
  • Salvage value: $10,000
  • Total estimated production: 100,000 units
  • Depreciation per unit: ($50,000 - $10,000) / 100,000 = $0.40 per unit
  • If, in Year 1, 15,000 units are produced: Depreciation Expense = 15,000 * $0.40 = $6,000
• Depreciation directly relates to the level of asset utilization.

Sum-of-the-Years' Digits Depreciation: Detailed Explanation

• Accelerated method, but less aggressive than double-declining balance.
• Also results in higher depreciation expense during the early years.
• Calculation example:
  • Asset cost: $50,000
  • Salvage value: $10,000
  • Useful life: 5 years
  • Sum of the Years' Digits: 1 + 2 + 3 + 4 + 5 = 15
  • Year 1: Depreciation Expense = ($50,000 - $10,000) * (5/15) = $13,333.33
  • Year 2: Depreciation Expense = ($50,000 - $10,000) * (4/15) = $10,666.67
  • Year 3: Depreciation Expense = ($50,000 - $10,000) * (3/15) = $8,000
  • Year 4: Depreciation Expense = ($50,000 - $10,000) * (2/15) = $5,333.33
  • Year 5: Depreciation Expense = ($50,000 - $10,000) * (1/15) = $2,666.67
• The fraction decreases each year, reducing the depreciation expense.

Impact on Financial Statements

• Income Statement: Depreciation expense reduces net income.
• Balance Sheet: Accumulated depreciation is a contra-asset account that reduces the book value of the asset.
• Statement of Cash Flows: Depreciation is added back to net income in the operating activities section when using the indirect method because it is a non-cash expense.

Choosing a Depreciation Method

• Management selects the method that best reflects the pattern of asset use.
• Consider the nature of the asset.
• Consider industry practices.
• Methods can be changed, but changes must be disclosed and justified.

Partial-Year Depreciation

• When an asset is purchased or sold during the year, depreciation must be calculated for the portion of the year the asset was in service.
• Calculation: (Annual Depreciation Expense) * (Number of Months Asset Was in Service / 12)
• This applies to all depreciation methods.