As the reader has already been informed, when dealing with a long-term fixed asset, one cannot simply note down the expense for the asset’s cost and record the entire cash outflow within a single accounting period. Similar to other assets, the acquisition or purchase of a long-term asset requires it to be recorded at its original (historical) cost, encompassing all expenses incurred to obtain and put the asset into operation. The initial recording of an asset involves two distinct steps:
- On the date of purchase, the initial acquisition is recorded, which adds the asset to the balance sheet under the category of property, plant, and equipment, at its cost. This amount is then documented as either notes payable, accounts payable, or a cash outflow;
- At the end of each accounting period, an adjusting entry is made to acknowledge the depreciation expense. Companies have the flexibility to record the depreciation expense on an annual, quarterly, or monthly basis.
By adhering to the Generally Accepted Accounting Principles (GAAP) and the expense recognition principle, the depreciation expense is distributed over the estimated useful lifespan of the asset.
When an asset is put into service, estimations of its useful life and salvage value are made. These estimations are subject to uncertainty due to the inherent difficulty in predicting the future. Occasionally, however, a company may try to manipulate the estimates of salvage value and useful life in order to enhance its earnings. By assigning a higher salvage value and longer useful life, the company can reduce the annual depreciation expense and inflate the annual net income. A notorious case of such behavior is exemplified by Waste Management, which faced disciplinary action from the Securities and Exchange Commission for fraudulently altering its estimates to decrease depreciation expense and overstate net income.
The expense recognition principle, which necessitates the allocation of an asset’s cost over its useful life, is accomplished through the process of depreciation. For instance, if a delivery truck is purchased for a projected usage of five years, the cost of the truck and the corresponding depreciation expense will be spread out over the entire five-year period. The calculation of depreciation expense for a given period is not influenced by expected changes in the asset’s fair market value; instead, it is based on the allocation of the cost of owning the asset throughout its useful life.
It should be noted that these estimates of useful life and salvage value are made at the time of asset acquisition and are subject to revision as more information becomes available during the asset’s lifespan. Such revisions are made in accordance with the accounting standards and guidelines to ensure accurate financial reporting.
Several factors
Several factors play a crucial role in determining and documenting depreciation, including:
- Book value: This refers to the original cost of the asset minus the accumulated depreciation. It represents the remaining value of the asset on the balance sheet;
- Useful life: It signifies the duration during which the asset will be utilized effectively within the company’s operations. It is an estimation of how long the asset will contribute productively;
- Salvage (residual) value: This indicates the anticipated selling price or trade-in value of the asset once its useful life comes to an end. Estimating the salvage value can be challenging since it involves predicting future outcomes. Often, past experiences with similar assets are used to estimate the salvage value;
- Depreciable base (cost): It denotes the portion of the asset’s cost that will be subject to depreciation over its useful life. For example, if an asset was purchased for $50,000 and the expected salvage value is $10,000, the depreciable base would be $40,000. The company expects to depreciate this $40,000 amount over the asset’s period of use, after which it will be sold for $10,000.
Depreciation serves to record an expense for the value of the asset that has been utilized and subtracts that corresponding portion from the balance sheet. The following journal entry illustrates the recording of depreciation:
The process of recording depreciation is vital for reflecting the asset’s consumption and maintaining accurate financial statements.
Depreciation expense is a regular operational cost that appears on an income statement. To account for this expense, a contra account called accumulated depreciation is used. Accumulated depreciation is linked to the main account that records the total depreciation expense for a fixed asset throughout its lifespan. In this situation, the asset account retains its historical value, but on the balance sheet, it is counterbalanced by accumulated depreciation. By subtracting accumulated depreciation from the asset’s historical cost, the asset’s book value is presented on the balance sheet. The book value represents the portion of the asset’s value that has not been allocated to expenses through depreciation.
In this particular case, the asset has a book value of $20,000, calculated as the historical cost of $25,000 minus the accumulated depreciation of $5,000.
It is worth noting that not all long-term assets undergo depreciation. For instance, land is not subject to depreciation because depreciation involves distributing the expense of an asset over its useful life. Determining a useful life for land is impractical since land is assumed to have an unlimited useful life. Therefore, land remains recorded on the books at its historical cost without any depreciation adjustments.
Once it is determined that depreciation should be accounted for, there are three commonly used methods to calculate the allocation of depreciation expense: the straight-line method, the units-of-production method, and the double-declining-balance method. Additionally, there is a fourth method called the sum-of-the-years-digits method, which is an accelerated option but has been losing popularity over time. In this scenario, the following case involving Kenzie Company will be used to illustrate these three methods.
Selection methods
The selection of an appropriate depreciation method depends on various factors, such as the nature of the asset, its expected usage, and the company’s financial objectives.
- In a production and warehouse facility located in Pennsylvania, the accountant responsible for the fixed assets subsidiary ledger is employed by Georgia-Pacific. The facility is currently undergoing updates and replacements in various asset categories, such as warehouse storage units, fork trucks, and production line equipment;
- The accountant’s role is to ensure the fixed assets subsidiary ledger remains accurate and up to date. This involves gathering information related to the original historical cost, estimated useful life, salvage value, depreciation methods, and any additional capital expenditures;
- The accountant is enthusiastic about the new purchases and upgrades that will enhance the company’s ability to serve its customers effectively. However, the accountant realizes that overseeing extensive updates is a new experience and will require gathering a substantial amount of information promptly to maintain accurate accounting records. Initially feeling overwhelmed, the accountant takes a moment to collect their thoughts and considers the available resources and personnel to handle the project effectively;
- They contemplate whom to collaborate with and how to go about obtaining the necessary information;
- Moving on to straight-line depreciation, it is a depreciation method that evenly allocates the depreciable amount over the asset’s useful life. In this case, the depreciable base of $50,000 is divided by the economic life of five years, resulting in an annual depreciation expense of $9,600. The journal entries illustrating the first two years of expenses are provided, along with the corresponding balance sheet information.
As the accountant embarks on implementing straight-line depreciation, they recognize the importance of accurately recording the depreciation expenses to reflect the gradual reduction in the asset’s value over time, thereby maintaining financial transparency and compliance with accounting standards.
Additionaly
In contrast to straight-line depreciation, which is suitable for assets utilized consistently over their lifespan, there are cases where assets are not utilized uniformly. This raises the question of how to account for depreciation when an asset’s usage, rather than its time in service, determines its lifespan. In such scenarios, the units-of-production depreciation method comes into play. This method calculates depreciation based on the actual usage or output of the asset. For instance, it can be applied to depreciate a printing press, where the depreciable base remains $50,000 (as in the straight-line method), but now the number of pages printed by the press becomes a significant factor.
The units-of-production depreciation method ensures that the depreciation expense is directly linked to the actual productivity or usage of the asset, providing a more accurate representation of the asset’s decreasing value over its operational life.
The double-declining-balance depreciation method is the most intricate among the three depreciation methods. It incorporates both time and usage factors and results in higher expenses during the initial years of an asset’s life. This method considers the passage of time by determining the depreciation expense percentage that would be applicable under straight-line depreciation. To calculate this percentage, one divides 100% by the estimated lifespan of the asset in years.
A distinctive characteristic of the double-declining-balance method is that, unlike other methods, the estimated salvage value is not deducted from the total asset cost when calculating the depreciation expense for the first year. Instead, the total cost of the asset is multiplied by the determined percentage. However, it is important to note that the depreciation expense cannot reduce the book value of the asset below its estimated salvage value, as exemplified in the following passage.
The double-declining-balance method requires careful consideration and monitoring to ensure that the depreciation expense is allocated appropriately throughout the asset’s life, reflecting its decreasing value while adhering to the limitations imposed by the estimated salvage value.
- The double-declining-balance depreciation method is a powerful tool in the hands of accountants and financial professionals. Its ability to capture the accelerated depreciation pattern of certain assets can greatly impact financial statements and decision-making processes within organizations;
- Implementing the double-declining-balance method requires a thorough understanding of the asset’s characteristics and estimated useful life. The depreciation rate is calculated by multiplying the straight-line rate by two, enabling a faster allocation of expenses in the early years of an asset’s life. This method recognizes that many assets experience higher wear and tear and technological obsolescence during their initial years of use;
- By utilizing the double-declining-balance method, companies can accurately reflect the decreasing value of their assets over time. This aligns with the principle of matching expenses with revenues, as it ensures that the cost of using the asset is distributed in a manner that corresponds to its actual consumption.
However, it is important to note that the double-declining-balance method may not be suitable for all assets. Assets with longer useful lives or those that do not experience rapid depreciation in their early years may require alternative methods to more accurately allocate depreciation expenses.
One of the unique features of the double-declining-balance method is that the estimated salvage value is not subtracted when calculating the initial year’s depreciation expense. This means that the depreciation expense for the first year may exceed what would be calculated using the straight-line method. However, it is crucial to ensure that the depreciation expense does not reduce the asset’s book value below the estimated salvage value.
To wrap up
To successfully implement the double-declining-balance method, accountants must gather relevant information, including the asset’s original cost, estimated useful life, and salvage value. Collaboration with operations teams and other stakeholders is vital to obtain accurate data regarding asset usage and performance. Utilizing modern accounting software and tools can streamline calculations and generate comprehensive reports, aiding in the accurate allocation of depreciation expenses.
Furthermore, ongoing monitoring and periodic reassessment of an asset’s useful life and salvage value are essential. Market conditions, technological advancements, and unexpected events can all impact an asset’s value and lifespan. Regular evaluations will ensure that depreciation expenses remain aligned with the asset’s actual performance.
In conclusion, the double-declining-balance depreciation method offers a valuable approach to asset depreciation. By considering both time and usage factors, this method provides a more accurate representation of an asset’s decreasing value over time. With careful implementation, accurate record-keeping, and collaboration with relevant stakeholders, accountants can effectively apply the double-declining-balance method to provide transparent and reliable financial statements, facilitating informed decision-making within organizations.