Measuring the depreciation of plant assets
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MEASURING THE DEPRECIATION OF PLANT ASSETS. Depreciation is the allocation of a plant asset’s cost to expense over the period the asset is used The matching principle matches an asset’s expense against the revenue generated over the asset’s life. Estimated useful life, 20 years.

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Measuring the depreciation of plant assets
MEASURING THE DEPRECIATION OF PLANT ASSETS

  • Depreciation is the allocation of a plant asset’s cost to expense over the period the asset is used

  • The matching principle matches an asset’s expense against the revenue generated over the asset’s life


Estimated useful life, 20 years

$32 million cost

Depreciation and the Matching of Expense with Revenue

Annual revenue generated, $9 million

minus

Annual depreciation expense, $1.6 million*

*$32 million/20 yrs. = $1.6 million per year


Measuring the depreciation of plant assets1
MEASURING THE DEPRECIATION OF PLANT ASSETS

  • Depreciation

    • Is nota process of valuation

    • Does not mean that the business sets aside cash to replace assets as they wear out

  • Accumulated depreciation does not represent a growing amount of cash


Measuring the depreciation of plant assets2
MEASURING THE DEPRECIATION OF PLANT ASSETS

  • The causes of depreciation are

    • Physical wear and tear

    • Obsolescence

      • An asset is obsolete when another asset can do the job better or more efficiently


Measuring the depreciation of plant assets3
MEASURING THE DEPRECIATION OF PLANT ASSETS

  • To measure depreciation for an asset one must know the

    • Cost

    • Estimated useful life

      • The length of service the business expects to get from the asset--an estimate of how long an asset will be useful

      • Useful life may be expressed in years, units of output, miles, or another measure


Measuring the depreciation of plant assets4
MEASURING THE DEPRECIATION OF PLANT ASSETS

  • Estimated residual value (scrap value)

    • The expected cash value of an asset at the end of its useful life

    • Estimated residual value is not depreciated because the business expects to receive this amount from disposing of the asset


Measuring the depreciation of plant assets5
MEASURING THE DEPRECIATION OF PLANT ASSETS

A plant asset’s depreciable cost:

Depreciable cost = Asset’s cost - Estimated residual value


Measuring the depreciation of plant assets6
MEASURING THE DEPRECIATION OF PLANT ASSETS

  • We will look at two methods for computing depreciation

    • Straight line

    • Declining-balance


MEASURING THE DEPRECIATION OF PLANT ASSETS

The following data will be used to illustrate depreciation computations of a Home Depot truck with the two methods.

Cost of truck $41,000

Less: Estimated residual value (1,000)

Depreciable cost $40,000

Estimated useful life :

Years 5 years


Measuring the depreciation of plant assets7
MEASURING THE DEPRECIATION OF PLANT ASSETS

Straight-line Method

Straight-line depreciation per year

Cost - Residual value

=

Useful life, in years

=

$41,000 - $1,000

5

=

$8,000

An equal amount of depreciation is assigned to each year of asset use


MEASURING THE DEPRECIATION OF PLANT ASSETS

The entry to record depreciation is

DR CR

Depreciation expense - Truck 8,000

Accumulated depreciation - Truck 8,000


MEASURING THE DEPRECIATION OF PLANT ASSETS

  • Assume that the truck was purchased on January 1, 2001, and that Home Depot’s fiscal year ends on December 31

  • A straight-line depreciation schedule is presented on the next slide

  • The final column shows the asset’s book value, the asset’s cost less accumulated depreciation


Straight-Line Depreciation Schedule for the Home Depot Truck

Depreciation for the Year

Asset Book Value

Accumulated Depreciation

Date

Asset Cost

Depreciation Expense

1- 1-2001 $41,000 $41,000

12-31-2001 $8,000 $ 8,000 33,000

12-31-2002 8,000 16,000 25,000

12-31-2003 8,000 24,000 17,000

12-31-2004 8,000 32,000 9,000

12-31-2005 8,000 40,000 1,000


MEASURING THE DEPRECIATION OF PLANT ASSETS

  • Is an accelerated depreciation method

    • A method that writes off a relatively larger amount of the asset’s cost nearer the start of its useful life than the straight-line method

  • Computes annual depreciation by multiplying the asset’s book value by a constant percentage

Declining-Balance (DB) Method


In the DB depreciation schedule, the fifth and final year’s depreciation is $4,314 (the $5,314 book value less $1,000 residual value):

Depreciation for the Year

Asset Book Value

Asset Book Value

Asset Cost

DB Rate

Depreciation Expense

Accumulated Depreciation

Date

1- 1- 2001 $41,000 $41,000

12-31-2001 0.40 x $41,000 = $16,400 $16,400 24,600

12-31-2002 0.40 x 24,600 = 9,840 26,240 14,760

12-31-2003 0.40 x 14,760 = 5,904 32,144 8,856

12-31-2004 0.40 x 8,856 = 3,542 35,686 5,314

12-31-2005 4,314* 40,000 1,000

*Last-year depreciation is the amount needed to reduce asset book value to the residual value ($5,314 - $1,000 = $4,314).


MEASURING THE DEPRECIATION OF year’s depreciation is $4,314 (the $5,314 book value less $1,000 residual value):PLANT ASSETS

  • The DB method differs from other methods in two ways:

    • The asset’s residual value is ignored initially; in the first year depreciation is computed on the asset’s full cost

    • Depreciation expense in the final year is whatever amount is needed to reduce the asset’s book value to its residual value


Comparing the Depreciation Methods year’s depreciation is $4,314 (the $5,314 book value less $1,000 residual value):

Straight-Line

Declining-Balance

Year

1 $ 8,000 $16,400

2 8,000 9,840

3 8,000 5,904

4 8,000 3,542

5 8,000 4,314

Total $40,000 $40,000


MEASURING THE DEPRECIATION OF year’s depreciation is $4,314 (the $5,314 book value less $1,000 residual value):PLANT ASSETS

  • The straight-line method best meets the matching principle for a plant asset that generates revenue evenly over time

  • The Declining Balance method (DB) applies best to those assets that generate greater revenue earlier in their useful lives


Straight-Line year’s depreciation is $4,314 (the $5,314 book value less $1,000 residual value):

Declining Balance

$ of Annual Depreciation

$ of Annual Depreciation

1 2 3 4 5

1 2 3 4 5

Time, in years

Time, in years

Depreciation Patterns Through Time


Use of the Depreciation Methods by 600 Companies year’s depreciation is $4,314 (the $5,314 book value less $1,000 residual value):

*Most of these are probably declining-balance methods because depreciation for income tax purposes is based on the declining-balance concept. Some companies use the same depreciation method for financial statement purposes and for tax purposes.


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