Different Depreciation Methods for Property, Plant, and Equipment

Depreciation refers to the process of allocating the cost of a tangible asset over its useful life.

Based on the cost model of reporting long-lived assets, the capitalized costs of long-lived tangible assets, other than land, are allocated to subsequent periods as depreciation expenses. In the alternative revaluation model, however, a company reports the long-lived asset at fair value rather than at acquisition cost less accumulated depreciation.

Alternative Depreciation Methods

There are three primary methods of depreciation: the straight-line method, the accelerated method, and the units-of-production method. Regardless of the method used, the carrying amount of the asset is not reduced below the estimated residual value.

Straight-line Method

In the straight-line method, the cost of an asset is allocated to expense evenly over its useful life.

Depreciation expense is calculated as depreciable cost divided by the asset’s estimated useful life and is the same for each period.

The depreciable cost is the historical cost of the tangible asset minus the estimated residual (salvage) value or estimated amount that a company will obtain from the disposal of the asset at the end of its useful life.

In the form of an equation,

Depreciation expense = (Historical cost of the asset – Estimated residual value) / Estimated useful life

Accelerated Method

In the accelerated method, the allocation of cost is greater in earlier years.

A commonly used accelerated method is the declining balance method. In this method, the amount of depreciation expense for a period is calculated as a percentage of the carrying amount, i.e., the cost net of accumulated depreciation at the beginning of the period.

The depreciable cost is not used to calculate the depreciation expense. Nevertheless, the carrying amount should not be reduced below the estimated residual value.

In the form of an equation,

Depreciation expense = x% × Carrying amount at the beginning of the period

Unit-of-production Method

In the Units-of-production Method, the allocation of cost corresponds to the actual use of an asset in a particular period.

The amount of depreciation expense for a period is based on the proportion of the asset’s production during the period compared with the total estimated productive capacity of the asset over its useful life. The depreciation expense is calculated as depreciable cost times production in the period divided by the estimated productive capacity over the life of the asset. It is also possible to estimate a depreciation cost per unit, i.e., the depreciable cost divided by the estimated productive capacity.  The depreciation expense can then be calculated as depreciation cost per unit times production in the period.

In the form of an equation,

Depreciation expense = (Depreciable cost * Production) / Estimated total productive capacity

Question 1

Company XYZ purchases a piece of equipment for $10,000. Given the following assumptions and estimates, what are the depreciation expenses for company XYZ for the first year under the straight line, double declining balance, and units-of-production methods?

Estimated residual (salvage) value = $100

Estimated useful life = 5 years

Total estimated productive capacity = 100 cartons

Production in each of the 5 years: 20 cartons

$$ \begin{array}{|c|c|c|c|}
\hline
{} & \text{Straight-line} & \text{Double declining balance} & \text{Units-of-production} \\ \hline
\text{A.} & {$2,000} & {$4,000} & {$2,300}\\ \hline
\text{B.} & {$1,980} & {$4,000} & {$1,980}\\ \hline
\text{C.} & {$1,980} & {$5,000} & {$2,000} \\ \hline
\end{array} $$

Solution

The correct answer is B.

Under the straight-line method, depreciation expense = ($10,000-$100)/5 = $1,980.

Under the double declining balance method, the depreciation rate is twice that under the straight-line method. Since the depreciation method’s depreciation rate is 100%/5 = 20%, the depreciation rate under the double declining balance method is 2 × 20% = 40%. Therefore, depreciation expense = 40% × $10,000 = $4,000.

Under the units-of-production method, the total depreciable cost/total productive capacity = ($10,000 – $100)/100 = $99 cost per unit. The depreciation expense in the first year = $99 × 20 units produced = $1,980.

Question 2

Which of the following depreciation methods would result in a depreciation expense that most likely corresponds with the actual use of the machine used in the production of a normal good?

1. Straight line method.
2. Declining balance method.
3. Units of production method.

Solution

The correct answer is C.

Under the units of production depreciation method, the more units produced, the higher the depreciation expense would be and vice versa.