We first introduced the concept of depreciation in Chapter 3. We will now expand that discussion to address such topics as residual values, alternative depreciation methods,and depreciation (or cost recovery) for income tax purposes
Allocating the Cost of Plant and Equipment over the Years of Use
Earlier in this chapter, we described a delivery truck as a stream of transportation services to- be received over the years that the truck is owned and used. The cost of the truck initially is debited to an asset account, because the purchase of these transportation services will benefit many future accounting periods. As these services are
received, however, the cost of the truckgradually is removed from the balance sheet and allocated to expense, through the process of depreciation.
The journal entry to record depreciation expense consists of a debit to Depreciation Expense and a credit to Accumulated Depreciation. The credit portion of the entry removes from the balance sheet that portion of the asset’s cost estimated to have been used up during the current period. The debit portion of the entry allocates this expired cost to expense
Separate Depreciation Expense and Accumulated Depreciation accounts are maintained for different types of depreciable assets, such as factory buildings, delivery equipment, and office equipment. These separate accounts help accountants to measure separately the costs of different business activities, such as manufacturing, sales, and administration:
Depreclatlon differs from most other expenses in that it does not depend on cash payments at or near the time the expense is recorded. For this reason, depreciation often is called a “noncash” expense. Bear in mind, however, that large cash payments usually are required at the time depreciable assets are purchased.
Plant assets are shown in the balance sheet at their book values (or carrying values). The book value of a plant asset is its cost minus the related accumulated depreciation. Accumulated depreciation is a contra-asset account, representing that portion of the asset’s cost that has already been allocated to expense. Thus book value represents the portion of the asset’s cost that remains to be allocated to expensein future periods.
The term obsolescence means the process of becoming out of date or obsolete. An airplane, for example, may become obsolete even though it is in excellent physical condition; it becomes obsolete because better planes of superior design and performance have become available
Methods of Computing Depreciation
In preceding chapters, we have computed depreciation only by the straight-Hne depreciation method. Companies actually may use any of several different depreciation methods. Generally accepted accounting principles require only that a depreciation method result in a rational and systematic allocation of cost over the asset’s useful life
The differences between the straight-line methods and accelerated methods are illustrated in the following graphs
There is only one straight-line method. But there are several accelerated methods, each producing slightly different results. Different depreciation methods may be used for different assets. Of course, the depreciation methods in use should be disclosed in notes accompanying the, financial statements
Depreciation for Fractional Periods
When an asset is acquired in the middle of an accounting period, it is not necessary to compute depreciation expense to the nearest day or week. In fact, such a computation would .give a misleading impression of great precision. Since depreciation is based on an estimated useful life of many years, the depredation applicable to anyone year is only an approximation.
Assume that S&G Wholesale Grocery uses straight-line depreciation with the half- . year convention. Depreciation on the $17,000 delivery truck with the 5-yearlife is summarized as follows:
When the half-year convention is in use, we ignore the date on which the asset was actually purchased. We simply recognize one-half year’s depreciation in both the first year and last year of the depreciation schedule. Notice that our depreciation schedule now. includes depreciation expense in 6 years, instead of 5: Taking only a partial year’s depreciation in the first year always extends the depreciation program into one additional year.
The half-year convention enables us to treat similar assets acquired at different dates during the year as a single group. For example, assume that an insurance company purchases hundreds of desktop computers throughout the current year at a total cost of $600,000. The company depreciates these computers by the straight-line method, assuming a 5-year life and no residual value. Using the half-year convention, the depreciation expense on all of the computers purchased during the year may be computed as follows: $600,000 -;- 5 years x 0/12 = $60,000. Ifwe did not use the half-year convention, depreciation would have to be computed separately for computers purchased in different months
The Declining-Balance Method
By far the most widely used accelerated depreciation method is called fixed-percentageof. decUning-balance depreciation. However, the method is used primarily in income. lax returns, rather than financial statements
Under the declining-balance method, an accelerated depreciation rate is computed as a specified percentage of the straight-line depreciation rate. Annual depreciation expense then is computed by applying this accelerated depreciation rate to the undepreciated cost (current book value) of the asset,. This computation may be summarized as follows:
Depreciation _ Remaining Accelerated
Expense – Book Value x Depreciation Rate
The accelerated depreciation rate remains constant throughout the life of the asset. Hence, the rate represents the “fixed-percentage” described in the name of this depreciation method. The book value (cost minus accumulated depreciation) decreases every year and represents the “declining-balance
Tax rules, however, often specify a lower percentage, such as 150% of the straight-line rate. This version of the declining-balance method may be described as “150%-declining-balance.