21-2: Calculating Depreciation Expense
Plant assets are assets you purchase that you plan on using for a long period of time (more than a year). Examples of plant assets include vehicles, computers, photocopiers, furniture, etc. When you purchase the asset, you debit the appropriate asset account. That purchase gives value to your company. Let's say you purchase an automobile for deliveries that cost $25,000. You would debit an asset account for $25,000. If an outsider would look at your books, you have $25,000 of value with that vehicle. However, in reality, shortly after you purchase the vehicle, the value begins going down. Why do values decrease?
- Wear and tear (the more mileage you put on a vehicle, the less valuable it is) Models change; newer models are worth more than older models Eventually the car may not work anymore, it may become obsolete (a good example of something that becomes obsolete is a computer--you probably know someone who still has an old computer that they can't give away)
Here is our problem. Back to our example of the $25,000 vehicle. Our asset account says we have value of $25,000. In reality, two years later, it will not be worth $25,000. An adjustment needs to be made to an asset account to record the decrease in value. That is what depreciation is. The amount the vehicle depreciates (or decreases) should be recorded as an expense (and at the same time, reduce the value of the asset account).
To account for this decrease in value, a business will develop a systematic way to decrease the value and charge a portion of the decrease to an expense account every year. That is called depreciation expense (the portion of a plant asset's cost that is transferred to an expense account in each fiscal period during a plant asset's useful life). There are many ways to calculate depreciation. In this chapter we will learn two methods: Straight-line depreciation and the Double-Declining Balance Method. In this section, we will learn to calculate depreciation using the Straight-line method.
There are three factors that go into determining annual depreciation for the Straight-Line Method:
- Original cost --the amount you paid for the asset. This includes the price of the asset and any additional costs to make the item useable. For example, where I use to work, the business bought a machine in Texas for around $4,000. However, it cost about $25,000 to move it from Texas to Michigan. The cost would have been the original purchase price plus the transportation cost or $29,000. Estimated salvage value --what you think the asset will be worth when you are done using it. This is an estimate. How does a business estimate? Sometimes it is a guess, but other times they can look to past experience with purchasing assets and try
and determine the salvage value. Estimated useful life --the amount of time (in years) that the business thinks they will use the asset. Once again, this is an estimate. Many businesses will look to past experience to determine how long they may use an asset, trade associations for suggestions, or even the Internal Revenue Service for guidelines. From my past experience, computers last for about three years, then they start to become obsolete. The computer begins getting slow, new software won't work on it, etc. If I were to purchase a computer and estimate how long I would use it, I would say three years.
Straight-line depreciation decreases the value of an asset the same amount every year of the plant asset's useful life. Here is how Straight-line depreciation is calculated for the following asset:
Original cost: $25,000
Estimated salvage value: $3,000
Estimated useful life: 4 years
Original cost - salvage value / useful years=Straight-line depreciation per year
$25,000 - $3,000 / 4 = $5,500 annual depreciation
For this example, the business will decrease (or charge to an expense account) $5,500 for every year of the useful life of the asset. If a business wants to charge monthly depreciation, they would take the annual amount and divide by 12. A month is the smallest measure of time that depreciation will be calculated. If an asset is purchased in the middle of a month, the business would round to the closest beginning date. For example, if an asset is purchased on June 20, the next closest beginning month would be July 1. If an asset were purchased on June 10, the next closest beginning month date would be June 1.
Note. You can only use a year's worth of depreciation if the asset was in use by the business for one full year. For example, if the asset were purchased on January 1, it can be depreciated for 12 months on December 31. However, if an asset was purchased on June 1, it can only be depreciated for the amount of time the asset was used. According to the example above, the asset's annual depreciaton is $5,500. But if the asset was purchased on June 1, we would have to do two more calculations:
- What is monthly depreciation for this asset ($5,500 / 12 = $458.33) How many months did we actually use it this year (June, July, August, September, October, November, December = 7 months).
How much then can the business depreciate this asset in the first year it purchased it?
$458.33 x 7 months = $3,208.31
Before we begin the Work Together Problem, there are two more concepts we need to address. When we record depreciation, there will be two accounts affected: Depreciation Expense and Accumulated Depreciation.