11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs

Depreciation Methods and Capitalized Costs

Depreciation is how businesses spread the cost of a long-term asset over the years they expect to use it. Rather than recording the entire cost as an expense when purchased, you allocate a portion of that cost to each accounting period. This matters because it directly affects both the income statement (through depreciation expense) and the balance sheet (through the asset's book value).

Three key terms show up throughout this topic:

• Depreciable cost = Cost − Salvage Value (the total amount you'll depreciate over the asset's life)
• Book value = Cost − Accumulated Depreciation (what the asset is "worth" on the balance sheet at any point)
• Salvage value (also called residual value) = the estimated amount the asset will be worth at the end of its useful life

Calculation of Depreciation Expense Methods

Straight-Line Method

This is the simplest and most common approach. It assigns an equal amount of depreciation expense to each year of the asset's useful life. You'll see it used for assets that provide roughly the same benefit each period, like buildings and furniture.

$\text{Annual Depreciation} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}}$

Example: A company buys equipment for $50,000 with a $5,000 salvage value and a 9-year useful life. Annual depreciation = $\frac{50{,}000 - 5{,}000}{9} = \$5{,}000$ per year.

Units-of-Production Method

Instead of spreading cost evenly over time, this method ties depreciation to actual usage or output. It works well for assets like machinery and vehicles, where wear depends more on how much you use them than on how many years pass.

1. Calculate the per-unit depreciation rate:

$\text{Per-Unit Rate} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Estimated Total Units}}$

1. Multiply by the actual units produced (or hours used, miles driven, etc.) during the period:

$\text{Depreciation Expense} = \text{Per-Unit Rate} \times \text{Units Produced in Period}$

Example: A machine costs $80,000, has a $5,000 salvage value, and is expected to produce 150,000 units over its life. The per-unit rate is $\frac{80{,}000 - 5{,}000}{150{,}000} = \$0.50$. If the machine produces 20,000 units this year, depreciation expense = $0.50 \times 20{,}000 = \$10{,}000$.

Double-Declining-Balance (DDB) Method

This is an accelerated method, meaning it front-loads more depreciation expense into the early years and less into later years. It's commonly applied to assets that lose value quickly, like computers and electronic equipment.

1. Calculate the straight-line rate: $\frac{1}{\text{Useful Life}}$
2. Double it: $\frac{2}{\text{Useful Life}}$
3. Multiply by the asset's beginning book value for the period (not depreciable cost):

$\text{Depreciation Expense} = \text{Book Value at Beginning of Period} \times \frac{2}{\text{Useful Life}}$

Two important rules to remember with DDB:

• You do not subtract salvage value when calculating each year's depreciation. Salvage value only acts as a floor: you stop depreciating once book value reaches salvage value.
• In the final year(s), you may need to adjust the expense downward so that book value doesn't drop below salvage value.

Example: Equipment costs $10,000, salvage value is $1,000, useful life is 5 years. The DDB rate is $\frac{2}{5} = 40\%$. Year 1 depreciation = $10{,}000 \times 0.40 = \$4{,}000$. Year 2 depreciation = $(10{,}000 - 4{,}000) \times 0.40 = \$2{,}400$. And so on, until you hit the $1,000 floor.

Component Depreciation

Some assets have parts with different useful lives. Component depreciation treats each major part as a separate depreciable item. For instance, an airplane's engines might have a different useful life than its fuselage, so each component gets its own depreciation schedule.

Depreciation vs. Depletion vs. Amortization

All three do the same thing conceptually: they allocate the cost of a long-term asset over the periods that benefit from it. The difference is the type of asset involved.

• Depreciation applies to tangible assets like equipment, buildings, and vehicles. It reflects the decline in value from wear and tear, age, or obsolescence.
• Depletion applies to natural resources like oil reserves, mineral deposits, and timber. As units are extracted, you expense a proportional share of the resource's cost. The calculation mirrors the units-of-production method: $\frac{\text{Cost} - \text{Salvage Value}}{\text{Total Estimated Units}} \times \text{Units Extracted}$
• Amortization applies to intangible assets like patents, copyrights, and franchises. It typically uses the straight-line method over the asset's useful life or legal life, whichever is shorter.

Journal Entries for Long-Term Assets

Recording the initial purchase:

1. Debit the appropriate asset account (Equipment, Building, Vehicle, etc.) for the full capitalized cost
2. Credit Cash or Accounts Payable, depending on how you paid

Example: Purchased equipment for $50,000 on account:

Recording depreciation expense (at end of each period):

1. Debit Depreciation Expense to recognize the cost allocated to the current period
2. Credit Accumulated Depreciation, a contra-asset account that reduces the asset's book value on the balance sheet

Example: Recording $5,000 of annual straight-line depreciation:

Notice that you never credit the asset account itself. Accumulated Depreciation builds up over time as a separate account, so you can always see both the original cost and the total depreciation taken so far.

Additional Considerations

• Cost allocation is the broader principle at work here: systematically distributing an asset's cost across the periods that benefit from it. Depreciation, depletion, and amortization are all forms of cost allocation.
• Asset impairment occurs when an asset's market value drops suddenly below its book value (for example, a factory damaged by a flood). When this happens, you write the asset down to its fair value and record an impairment loss on the income statement. This is different from depreciation because it's not gradual or planned.
• Depreciation recapture is a tax concept. If you sell a depreciable asset for more than its book value, the IRS may treat part of the gain as ordinary income rather than a capital gain. You won't likely need to calculate this in Financial Accounting I, but you should know the term exists.