When a company purchases something to aid their operations, such as a delivery truck or new manufacturing equipment, they are allowed to expense a portion of the purchase over time instead of all at once. This concept is known as depreciation, and there are three main types: straight line, accelerated, and the units of production method. Before we delve into these and go over some examples, it is important to understand what assets are allowed to be depreciated.
First, depreciable assets are those that provide economic benefits over a future period of time greater than one year and have a measurable useful life, which are called long-lived assets. This asset class includes assets that fall under the property, plant, and equipment category, as well as assets that lack physical substance (intangible assets) such as trademarks and copyrights. (Take note that the depreciation of intangible long-lived assets is actually called amortization.) As previously stated, in order to be able to depreciate something, you need to be able to accurately estimate its useful life, therefore land and intangible assets with indefinite useful lives are not depreciated.
IFRS vs. GAAP
Like with many accounting practices, there are differences between the IFRS and GAAP standards when it comes to depreciation/amortization. One of the first steps one must take before calculating the amount something is depreciated is determining the value of the asset. Under IFRS there are two methods, the cost model and the revaluation model. Under the cost model, the asset is reported at its cost less any accumulated deprecation. Under the revaluation model, the asset is reported at its fair value. Because GAAP does not allow valuing assets using the revaluation model, it will not be discussed further.
Another aspect that differs between the two standards is that under IFRS each component of an asset must be depreciated separately. For instance, if you were deprecating a building you will have to depreciate the roof, the siding, the air conditioning/heating system, and the elevator separately.
Straight Line Method
This deprecation method is the most straightforward and it allocates the same cost over every year of an asset’s useful life. To calculate the annual deprecation amount, you will first need to determine its useful life as well as the value the asset will still have at the end of its useful life – the salvage or residual value. (An example of an asset that could have a salvage value is a moving van that is sold after a company has held it for its useful life.) After the useful life and the salvage value is determined, simply subtract the salvage value from the asset’s cost, and divide that by the estimated useful life.
Example: Peter’s Pizzeria purchases a new vehicle for $16,000 that will be used to deliver pies to hungry customers. The estimated useful life of the delivery vehicle is 6 years and the owners believe that they will be able to sell the van for $2,000 when they are through using it. In order to estimate the annual depreciation expense on this vehicle, subtract the salvage value, $2,000, from the cost, $16,000, and arrive at $14,000. Next, divide this by the estimated useful life, 6 years, to come to an annual deprecation expense of $2,333.
While the straight line method of deprecation allocates an even expense throughout the life of the asset, accelerated methods allow the deduction in early years to be greater than later years. The logic behind this method is that many times when a new item is purchased it will be used more while it is new, and an accelerated method recognizes this. Additionally, choosing an accelerated depreciation method over the straight line method can affect net income: because there will be higher expenses paid when using an accelerated method, the company will report lower net income than under the straight line method. In the later years this reverses as the amount of depreciation under an accelerated method will be less than under a straight line method.
The calculations behind determining deprecation using an accelerated method is more complicated than the straight line method. First, you need to determine the acceleration factor, which is usually 150% or 200%. An acceleration factor of 200% means that you are depreciating the asset twice as fast as you would be if using the straight line method (which is where the name double declining balance comes from), or one-and-a-half times as fast if using a factor of 150%.
After determining the deprecation factor which is basically how quickly you will depreciate the asset:
- Determine what the straight line rate would be by dividing 1 by the estimated useful life, and take note of any salvage/residual value of the asset.
- Multiply this rate by the acceleration factor divided by 100 (if using a factor of 150% you would multiply the rate by 1.5, or 2 if using a factor of 200%) to find your depreciation rate.
- Multiply the cost of the asset being depreciated by the rate calculated the step 2, and subtract that amount from the cost, which will be the outstanding amount.
- Continue multiplying the depreciation rate by the outstanding amount and subtracting that amount from the cost. You will most likely not depreciate the total amount calculated for the last year because if you did, it would bring the outstanding balance under the salvage value.
Example: Peter’s Pizzeria decides to use the double declining method of deprecation for the purchase of a new vehicle which cost them $16,000. The estimated life is 6 years, and they think that they will be able to sell the delivery van for $2,000. The amount of deprecation following the double declining balance method is below:
Units of Production Method
The last depreciation method that we will discuss is called the units of production method, or the units of activity method. Under this method, the amount an asset is depreciated each year corresponds to its usage in a particular period. To calculate this, you first need to determine the asset’s salvage value and estimate its useful life in terms of units produced. You then will calculate the deprecation amount per unit, and multiply that by the number of units produced during the period to find the depreciation expense.
Example: Peter’s Pizzeria recently purchased a new pizza oven which cost them $22,000. They believe that its useful life is expected to end after producing 25,000 pies, and that the oven will have a salvage value of $1,500. To calculate the annual depreciation expense subtract the salvage value from the asset cost and divide this by the number of units the asset is expected to produce to determine the per unit deprecation expense: $22,000 – $1,500 = $20,500/25,000 = $0.82. Next, multiply the amount of units produced in each period by this per unit cost.
Deciding what deprecation method to use will affect your net income. For instance, under the accelerated depreciation methods there will be a higher depreciation expense in the early years compared to a straight line method. It is important to understand how each method will affect things such as taxes, as different methods recognize expenses at different times. Knowing the differences between these methods and understanding how to calculate them will be beneficial for anyone taking the CPA or CFA exams. Questions? Leave a comment.