I'm Larry Walther and this is principlesofaccounting.com, Chapter 10.
In this module, we will look at service life and depreciation and
then begin to consider concepts and terminology related to depreciation.
First of all recognize that depreciation is not a process of valuation,
it is a process of cost allocation, we want to spread the cost of an asset over
its service life, the period of expected benefit in other words.
And many factors drive or effect service life, physical deterioration
such as wear and tear, or the effects of wear and tear, obsolescence.
New technology may render something out of date.
Or indeed, we can have inadequacy that arises.
The machine is no longer large enough or big enough or
fast enough to meet our particular needs.
So we will take all of those factors into account in determining what we expect
the estimated service life of an asset to be.
I recognize that some assets have an indefinite life such as land, so
we will not be depreciating those particular type of assets.
Now, this gives rise to spreading the cost of the asset
over the service life through a process known as depreciation.
And the pattern by which the cost is allocated in each of the periods involved
is dependent upon the depreciation methods selected.
There are a number of methods such as the straight line that you've already been
exposed to but
we'll also look at units of output and double-declining balance methods.
But before we look at specific methods in subsequent modules, let's consider issues,
let's assume, very simply, we have a $100 asset with a four year service life.
And we're going to assume under straight-line depreciation
that we'll allocate $25 to each accounting period.
And so graphically we see that our depreciation's uniform over each time
period, and that may seem very logical.
However, if we also consider maintenance costs,
if you think about an automobile, as it gets older,
you expect maintenance costs to rise, things start to break and wear out.
And so over time, you might not have any maintenance costs in the first year and
then it may go up in subsequent years.
And when you put depreciation and maintenance costs together, what you see
is, we actually might be showing even though the usage of an asset is uniform
over its service life, we might actually see that our total reported costs,
the depreciation plus the maintenance cost, is going up.
Well was that logical?
Well it may be but it may not be.
If we instead use an accelerated depreciation method where we take
more depreciation in earlier years and less in later years.
When we couple that with maintenance costs and
look at a combined picture you can see we might actually have a more uniform
recognition of costs through an accelerated depreciation.
Initially, straight line may seem logical, and it is indeed a popular method.
But when you consider the total cost of utilizing an asset over a service life,
there are justifications for alternative patterns of depreciation,
which gives rise to these other methods that will be considered and
looked at in subsequent modules.
In this case, accelerated depreciation was a better choice.
Professional judgement must be applied in selecting the method we use.
There are almost an infinite number of scenarios.
Accountants must weigh many variables to determine the prefered choice
under any given circumstance.
Let's move on and consider some terminology.
This terminology because very important as we move forward and consider depreciation.
First of all, the cost of an asset,
that's the dollar amount assigned to a particular asset.
Remember the earlier modules where we talked about what costs are appropriately
capitalized and what costs or not?
So now we have the total cost assigned to an asset.
It's an ordinary and necessary amount expended to get an asset in place and
in condition for its intended use.
The service life is the useful life of an asset.
It usually relates to the anticipated period of productive use.
And salvage value is the amount expected to be realized at the end of
the service life.
The anticipated future sales price for used equipment, for example,
is called the residual or salvage value.
Depreciable Base, it's the cost minus the salvage value.
That's the cost that we're gonna allocate over the service life,
the amount to be depreciated.
Book Value or Net Book Value, that's the balance sheet amount that reveals the cost
minus the accumulated depreciation.
Here's an example,
here we have the cost of an asset found on the balance sheet for buildings,
less the accumulated depreciation gives us the book value or net book value.
In terms of service life we don't see it on the face of the balance sheet but
typically footnotes will disclose the service life.
In this case let's assume it has a 20 year service life.
The salvage value may not be disclosed at all.
It's used in the calculations but
you may not be able to identify it in the financial statements at all.
Let's assume it's $300,000 in this particular case.
And the depreciable base would be the cost
of 2 million 3 minus the $300,000 salvage value.
So we have a $2 million depreciable base in this particular example.
Now as we close this example, I want to ask a question.
Can you, from the information, determine, say,
how old the asset is at this balance sheet date?
We had our $2,300,000 asset.
It had $300,000 of salvage value so we had a $2,000,000 depreciable base and
we were given a service life of 20 years.
That means the annual depreciation is $100,000 per year assuming straight
line of course.
And we had in the accumulated depreciation $1,500,000.
So we know there's $100,000 a year for
15 years to come up to $1.5, so the asset is 15 years old in that case.
So you can actually glean that type of information by looking at the balance
sheet disclosure relative to the cost of the asset.
And its accumulated depreciation,
you can pretty good estimation of how old
a business's particular assets are.