Depreciation is defined as the portion of the cost of a fixed asset that is charged to expense for a particular year or period. Except for land, all property and equipment is subject to depreciation. Depreciation is the decrease in the asset’s utility through use.
The straight-line method is one of the methods of calculating depreciation that results in the equal distribution of charges over the useful life of the asset. The formula is: Depreciation = cost – scrap value / estimated useful life.
Cost is the price paid for the asset. Scrap value or salvage value is the estimated amount assigned to the asset or that can be received from the sale of the asset after its estimated life. The useful life is the estimated useful life of the asset.
Suppose the Bed Linens Company purchased machinery to manufacture your bed linens for $10,000. Its accountant and management estimated that the machine tool is expected to have a rescue value or salvage value of $1,000 at the end of its five-year life.
In this case, the total amount of depreciation that must be taken on Bed Linens Company’s books over the useful life of the asset is only $9,000 or $1,800 for each year of useful life.
When the salvage value is estimated and subtracted from the cost of a fixed asset, the result is called the estimated net cost. Thus, if a car purchased for $40,000 is expected to have a useful life of six years and a salvage value of $4,000 at the end of its useful life, $40,000 is called cost or gross cost and $36,000 is called cost. estimated net.
Writing off an equal fraction of the asset’s cost each year is called the straight-line method of depreciation.
Using the straight-line method, the percentage of the original cost written off each year, called the depreciation rate, is found by dividing 1 by the number of years. For example, if an asset is to be retired in five years, the depreciation rate is 20%.
Under the straight-line method, the amount of depreciation expense for a given year is determined by multiplying the estimated net cost by the depreciation rate. Therefore, if the estimated net cost is $9,000 and the depreciation rate is 10%, the annual amount of depreciation expense will be $900. It is recorded charging depreciation expense… $900 and crediting accumulated depreciation-machine tool… $900.
The factors that are relevant to the depreciation of an asset are:
(1) original cost;
(2) estimated salvage value; and
(3) useful life.
Under the straight-line method, equal amounts of depreciation expense are taken each year. The concept behind this method is that the availability of a fixed asset to render service is the same from one year to the next during its life.
The date of the asset must be considered when determining the depreciation expense. If the asset was acquired on July 1, 2009, the depreciation will be half a year, that is, if the accounting year of the business ends on December 31.
Depreciation expense will be shown within operating expenses in the Income Statement, while accumulated depreciation will be shown in the Balance Sheet as a deduction from the respective asset.
There are other methods of contributing to depreciation besides the straight-line method. One of these methods takes into account the fact that many assets provide more service in their early years than in later years, due to declining mechanical efficiency, increased maintenance costs, and the increasing probability of obsolescence.