Ch. 8: Capital Assets8.3 Depreciation (Pt. II):

Methods of Computing Depreciation

BAT 4MINote 4-2

Methods of Depreciation

• In this course we are going to focus our discussion around 3 main methods of depreciation

• Straight-Line Depreciation

• Declining-Balance Depreciation

• Units-of-Production (Output) Depreciation

Straight Line Method

• This is the method which we both learned earlier in the course and in Gr. 11 Accounting

• The straight-line method simply spreads out the cost of the asset equally

over the life of the asset

• The formula for straight-line is as follows:

Straight Line Method: An Example

• For example... imagine we have a truck which cost us $6,500 who’s useful

life is decided to be 10 years at the point its salvage value will be $500.

Using the formula:

Dep/Yr ! = (6,500 - 500)/10! ! ! ! = $600

Therefore our truck would depreciate at a rate of $600 per year.

Depreciation for Fractional Periods

• As you might say, we might get an asset during the middle of an accounting period. How would we account for the depreciation then?

• Well instead of trying to calculate depreciation to the day, usually accountants round depreciation up to the next whole month

• This keeps them from having messy calculations to do and is still conservative

• An even more widely used approach, called the half-year convention, is to record six months depreciation on all assets acquired during the year.

• This approach assumes that all the assets’ depreciation amounts will “average out” over the course of the year.

The Declining-Balance Method

• The fixed-percentage-of-declining balance (diminishing balance) is the

most widely used method of depreciation

• This method takes a predetermined percentage rate and uses that to determine the depreciation on an asset for the year

• The formula for the declining-balance method is:

Declining-Balance: An Example

• For example... go back to our truck for a second. Imagine now that the truck

we bought for $6,500 is now going to depreciate at a declining-balance rate of 30%

Using the formula:

Dep Ex. (Yr. 1) != 6,500 x 30% = 1,950

Book Value (Yr. 1) = 6,500 - 1,950 = 4,550

Dep. Ex. (Yr. 2) = 4,550 x 30% = 1,365

Book Value (Yr. 2) = 4,550 - 1,365 = 3,185

Declining Balance vs. Straight-Line

Cost: $6,500.00

Straight Line: Declining Balance:

Yrs of Life 10 Rate 30%

Salvage Value $500.00

Year Depreciation Book Value Year Depreciation Book Value

1 600 $5,900.00 1 $1,950.00 $4,550.00

2 600 $5,300.00 2 $1,365.00 $3,185.00

3 600 $4,700.00 3 $955.50 $2,229.50

4 600 $4,100.00 4 $668.85 $1,560.65

5 600 $3,500.00 5 $468.20 $1,092.46

6 600 $2,900.00 6 $327.74 $764.72

7 600 $2,300.00 7 $229.42 $535.30

8 600 $1,700.00 8 $160.59 $374.71

9 600 $1,100.00 9 $112.41 $262.30

10 600 $500.00 10 $78.69 $183.61

Depreciation Expense Per Year

0

500

1000

1500

2000

2500

3000

1 2 3 4 5 6 7 8 9 10

Year

Dep

recia

tio

n

Straight-Line Declining Balance

Book Value Per Year

$0.00

$2,000.00

$4,000.00

$6,000.00

$8,000.00

$10,000.00

$12,000.00

1 2 3 4 5 6 7 8 9 10

Year

Bo

ok V

alu

e

Straight-Line Declining-Balance

Double-Declining Method

• The double-declining method of depreciation is simply a way to generate a

depreciation rate for the declining method.

• All we simply do is take the straight-line depreciation, turn it into a percentage rate, and double it.

• It would look as follows:

• This would then become our rate in the Declining-Balance Method rate

Double-Declining Method: An Example

• For Example... If we had our truck from yesterday...

• The truck cost us $6,500, it was going to last 10 years, and it had a salvage value of $500.

Rate! = (1/10) x 2 = 20%

• We would then use this rate as our declining-balance rate:

Depreciation (Yr. 1)! = 6,500 x 20%! ! ! ! ! ! ! ! ! = 1,300

Units of Output Method

• For some assets, we might be able to assess it’s useful life based on how much of something it will produce, or by some other measure than time

• In these cases we would use the following formula, which is very similar to the straight line formula:

• We can use any unit we wish for the “unit” in this formula just as long as it is somewhat measurable

Units of Output: An Example

• For example... going back to our truck. Imagine now if it could be estimated

that the truck we purchase will be good for 600,000 kilometres, still costing us 6,500 with a salvage value of $500

Using the formula:

Dep/Unit! = (6,500 - 500) / 600,000! ! ! ! = $0.01/km

Dep Exp. != 83,400 x 0.01! ! ! ! = $834

• Now imagine... that in our first year we find that we have driving the truck

83,400 kilometres.

Which Depreciation Methods Do Most Businesses Use?

• For financial statements

• Most businesses would choose straight-line as this would show us as having a higher net income earlier on.

• For Income Tax Purposes

• If we are concerned about how much income tax we are paying. The declining-balance method will make our net income lower earlier on reducing the tax we will pay

• But remember consistency!

Are These Differences “Real”

• The short answer is no...

• Once again, just like inventory valuation methods, if Company A and Company B were exact replicas only one used straight-line and the other used declining-balance there would be no real change in performance

• The only exception being that Company B may have more in tax savings

Disclosures to the Financial Statements

• In order to meet full disclosure with regards to depreciation, companies must

include the following in the notes to the financial statements

• The estimates of useful lives of the assets

• Consistency Changes

• Revision of Estimated Useful Lives

• See Pg. 362 for an example of Revision of Estimated Useful Lives --

Know how to recalculate

The Impairment of Plant Assets

• Sometimes it becomes necessary to recognize that we will not be able to sell a certain asset for its realizable value

• Possibly due to obsolescence or specialization

• At this time it is necessary to write down the value of the asset with the following entry

Loss resulting from obsolescence! ! ! ! ! ! ###

! ! Accumulated Depreciation - Equipment! ! ! ! ! ###

• This will reflect the loss in the book value of the equipment

Homework!

• Exercise 8.4 (Declining Balance Method)

• Exercise 8.5 (Units-of-Production Method)

• Exercise 8.6 (Depreciation Methods)

• Problem 8.2 (Determine the Cost of Plant Assets and Depreciation)