LO7–4 Calculate depreciation of property, plant, and equipment.

What does “depreciation” mean in everyday language?

A decrease in the value of an asset (e.g., a car losing value over time).

What does “depreciation” mean in accounting?

Allocating the cost of a long‑term asset to expense over its service life.

Is accounting depreciation a valuation process?

No — it does not measure market value. It allocates cost over time.

Why don’t companies adjust long‑term assets to fair value each period?

It would be too subjective and difficult to estimate reliably.

Why do we record depreciation?

Because long‑term assets provide benefits over multiple periods, so their cost must be spread across those periods.

What is the journal entry to record depreciation?

Debit: Depreciation Expense

Credit: Accumulated Depreciation

What type of account is Accumulated Depreciation?

A contra‑asset account that reduces the asset’s book value.

What is book value (carrying amount)?

Asset cost − Accumulated Depreciation.

Starbucks buys equipment for $1,200 with a 4‑year life. What is annual depreciation?

$300 per year (= $1,200 ÷ 4).

After one year, what is the book value?

$900 (= $1,200 − $300).

After two years, what is the book value?

$600 (= $1,200 − $600).

What is the book value at the end of year four?

$0 — the asset’s cost has been fully allocated.

Does depreciation affect the Equipment account directly?

No — Equipment stays at original cost; Accumulated Depreciation increases.

What does depreciation represent?

The portion of the asset’s cost used up during the period.

What does depreciation NOT represent?

It does not represent a decline in market value or selling price.

What is amortization?

The cost‑allocation process for intangible assets (same idea as depreciation).

What three factors must be established before recording depreciation?

Service life, residual value, and depreciation method.

What is service life (useful life)?

The estimated time or activity the company expects to use the asset before disposal.

How can service life be measured?

In units of time (years) or units of activity (miles, hours, etc.).

Another name for service life

Useful life.

What is residual value?

The expected selling or trade‑in value of the asset at the end of its service life.

Why is residual value often assumed to be zero?

It is difficult to estimate reliably.

it’s extremely hard to estimate what an asset will be worth many years from now, and using zero avoids overstating the asset’s value.

Another name for residual value

Salvage value.

What is a depreciation method?

The pattern used to allocate an asset’s depreciable cost over time.

What is depreciable cost?

Cost − Residual value.

What is the straight‑line depreciation method?

Allocates equal depreciation each year over the asset’s service life.

When is straight‑line used?

When the asset provides even benefits over time; most common method.

What is the declining‑balance method?

An accelerated method that records more depreciation in early years and less later.

Why is declining‑balance considered accelerated?

It front‑loads depreciation to match higher early‑year usage.

Where is declining‑balance commonly used?

Often used for tax purposes.

What is the activity‑based depreciation method?

Allocates depreciation based on usage, such as miles driven or hours used.

When is activity‑based depreciation most appropriate?

When asset wear‑and‑tear depends on actual activity, not time.

What types of assets commonly use activity‑based depreciation?

Vehicles, machinery, and natural resources.

What do all depreciation methods have in common?

They allocate the asset’s cost (not value) over the periods benefited.

What is straight‑line depreciation?

A method that allocates equal depreciation expense each year over an asset’s service life.

Formula for straight‑line depreciation

Depreciable cost: Cost - residual value

Then take that and divide by the service life to get amount per year

Why is straight‑line the most common method?

It is simple and assumes the asset provides even benefits each year.

What happens to book value each year under straight‑line?

It decreases by the depreciation expense until it reaches residual value.

Is residual value ever depreciated?

No — depreciation stops once book value equals residual value.

How do you calculate partial‑year depreciation?

If you buy a truck for $40,000 on November 1st, you only used 2/12 months
40,000 - 5,000 = $35,000

35,000 / 5 = $7,000 per year

7,000 × 2/12 = $1,167 for that 1st year then all other years get $7,000

Year 1 only used 2 months, so year 6 will have the remaining 10 months (7,000 × 10/12)

Do we depreciate land?

No — land is not used up over time.

Do we depreciate land improvements?

Yes — they have limited useful lives.

What estimates can change over time?

Service life and residual value.

How do companies handle changes in depreciation estimates?

Apply changes to current and future years only, not past years.

Cost: $40,000

Original residual value: $5,000

Original life: 5 years

35,000 / 5 = $7,000 per year

After 3 years, accumulated depreciation: $7,000 per year so $21,000 for all 3. Book value is now 40,000 - 21,000 = $19,000

Management updates estimates:

• New residual value: $3,000

• New total life: 7 years (4 left)

19,000 - 3,000 = $16,000

16,000 / 4 = $4,000 for rest of the remaining years

FUTURE DEPRECIATION IS ONLY ADJUSTED

What does straight‑line depreciation assume about asset usage?

That the asset provides equal benefits each year.

When might straight‑line NOT be appropriate?

When an asset provides greater benefits in early years, making accelerated depreciation more appropriate.

What is declining‑balance depreciation?

An accelerated depreciation method that records more depreciation in early years and less in later years.

Do straight‑line and declining‑balance result in the same total depreciation?

Yes — both methods depreciate the asset down to residual value.

What is the most common declining‑balance rate?

Double‑declining‑balance (DDB), which uses TWICE of the straight‑line rate.

Formula for double‑declining‑balance rate

Year 1: $40,000 —> beginning book value

Rate: 40% since 20% is the rate for straight line

Depreciation = 0.40 × 40,000 = $16,000

• End of year 1: 40,000 - 16,000 = $24,000

Year 2: $24,000 —> beginning book value

Depreciation = 0.40 × 24,000 = $9,600

• End of year 2: 40,000 - 25,600 = $14,400

Why is residual value ignored in early years of DDB?

Because depreciation is based on book value, not depreciable cost.

What happens if residual value is high?

The asset may reach residual value before the end of its service life.

What is activity‑based depreciation?

Depreciation based on usage, not time (e.g., miles, hours, units produced).

Other names for activity‑based depreciation

Units of production or units of output.

Steps of activity based depreciation

Cost: $40,000

Residual value: $5,000

Depreciable cost: $35,000

Expected miles to be driven: 100,000

35,000 / 100,000 = 0.35 per mile

Year 1, driven 30,000 miles

Year 1: 0.35 × 30,000 = $10,500

What happens if the asset is used less than expected?

Depreciation continues past the expected years until total units are reached.

What happens if the asset is used more than expected?

Depreciation ends early, once book value reaches residual value.

What is the stopping point for activity‑based depreciation?

When book value reaches residual value, regardless of time.

Straight‑line vs. Declining‑balance

Straight‑line = equal each year; DDB = higher early, lower later.

Declining‑balance vs. Activity‑based

DDB = based on time; Activity‑based = based on usage.

Which method best matches wear‑and‑tear?

Activity‑based, because it ties depreciation to actual use.

What does activity-based assume?

Depreciation is tied to use

What is the total depreciation under all three methods (straight‑line, DDB, activity‑based)?

$35,000 — equal to cost ($40,000) minus residual value ($5,000).

How does straight‑line depreciation behave over time?

Produces equal depreciation expense each year.

How does double‑declining‑balance depreciation behave over time?

Higher depreciation in early years, lower in later years.

How does activity‑based depreciation behave over time?

Varies based on actual usage (e.g., miles driven).

Which method best matches assets that wear out evenly over time?

Straight‑line.

Which method best matches assets that lose value faster in early years?

Double‑declining‑balance (accelerated).

Which method best matches assets whose wear depends on usage?

Activity‑based.

Which depreciation method do companies usually use for financial reporting?

Straight‑line.

Which depreciation method do companies usually use for tax purposes?

MACRS, an accelerated method.

Why do companies prefer accelerated depreciation for taxes?

It reduces taxable income in early years.

What is MACRS?

A tax depreciation system combining declining‑balance early and straight‑line later

Who created MACRS rules?

Congress, to encourage investment in long‑term assets.

Are straight‑line, DDB, and activity‑based all acceptable for financial reporting?

Yes — all three are acceptable under GAAP.

Why might managers prefer straight‑line for financial reporting?

It produces higher net income in early years.

Why might managers prefer accelerated depreciation for taxes?

It produces lower taxable income in early years.