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4.3
Depreciation Is Only
an Estimate
The appropriate
amount of depreciation expense is only an estimate. After all,
we cannot look at a building or a piece of equipment and
determine precisely how much of its economic usefulness has
expired during the current period.
The most widely used
means of estimating periodic depreciation expenses is the
straight – line method of depreciation. Under the straight –
line approach, an equal portion of the asset's cost is allocated
to depreciation expense in every period of the asset's estimated
useful life. The formula for computing depreciation expense
by the straight- line method is shown below.
Cost of the asset
Depreciation expense
(Per period) = --------------------------------
Estimated useful life
The use of an
estimated useful life is the major reason that depreciation
expense is only an estimate. In most cases, management does not
know in advance exactly how long the asset will remain in use.
How long does a
building last? For purposes
of computing depreciation expense, most companies estimate
about 30 or 40 years, but the empire state building was
built in 1931, and it's not likely to be torn down anytime soon.
And how about Windsor Castle? While these are not typical
examples, they illustrate the difficulty in estimating in
advance just how long depreciable assets may remain in use.
Example 4.1
Depreciation of
Summit's Building:
Summit purchased its
building for $36,000 on January 22. Because the building was
old, its estimated remaining useful life is only 20 years.
Therefore the building's monthly depreciation expense is $150
($36,000) cost ÷ 240
months). We will assume that summit did not record any
depreciation expense in January because it operated for only a
small part of the month. Thus the building's $1.500 depreciation
expense reported in summit's trail balance. An additional $150
of depreciation expense is still needed on the building for
December (bringing the total to be reported in the income
statement for the year to $1,650)
The
adjusting entry to record depreciation expense on summit
building for the month of December appears below:
Dec 31
Depreciation Expense: Building 150
Accumulated Depreciation: Building
150
Monthly depreciation on building
($36.000 ÷ 240 mo.).
The
depreciation expenses: Building account will appear in summit
income statement along with other expenses for the year ended
December 31, 2004. The balance in the Accumulated
Depreciation: Building account will be reported in the
December 31 balance sheet as a deduction from the Building
Account. As shown in the following:
Depreciation is not an attempt to record changes in the asset's
market value. In the short run, the market value of some
depreciable assets may even increase, but the process of
depreciation continues anyway. The rationale for depreciation
lies in the
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Building
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$ 36,000 |
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Less : Accumulated
Depreciation Building |
(1,650) |
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Book Value
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$ 34,350 |
Accumulated Depreciation:
building is an example of a contra – asset account because (1)
it has a credit balance, and (2) it is offset against an asset.
Accountants often use the term book value (or carrying value) to
describe the net valuation of an asset in a company's accounting
records. For depreciable assets, such as building and
equipment, book value is equal to the cost of the asset, less
the related amount of accumulated depreciation. The end result
of crediting the Accumulated Depreciation: Building account is
much as if the credit had been made directly to the Building
account: so that the book value reported in the balance sheet
for the building is reduced from $36,000 to $34,350.
Book value is of significance primary for accounting purposes.
It represents costs that will be offset against the revenue of
the future periods. It also gives users of financial statements
an indication of the age of a company's depreciable assets
(older assets tend to have larger amounts of accumulated
depreciation associated with them than newer assets). It is
important to realize that the computation of book value is based
upon an asset's historical cost. Thus, Book value is not
intended to represent asset's current market value.
Example
4.2
Depreciation of Tools and Equipment
Summit depreciates
its tools and equipment over a period of five years (60 months)
using the straight – Line method. The December 31 trial balance
shows that the company owns tools and equipment that cost
$12,000 therefore, the adjusting entry to record December's
depreciation expense is:
Dec 31
Depreciation Expense: Tools and Equipment
Accumulated Depreciation: Tools and
Equipment
Monthly deprecation of tools and
equipment
($12.000 ÷ 60 months = $ 200
mo.)
Again, we assume that Summit did not record depreciation expense
for tools and equipment in January because it operated for only
a small part of the month. Thus, the
related $2,000 depreciation expense reported in. The tools and
equipment still require an additional $200 of depreciation for
December (Bringing the total to be reported in the income
statement for the year to $2,200).
What is the book value of Overnight's tools and equipment at
December 31, 2004? If you said $9,800, you're right.
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Accounting for
Management and Decision Making(4)
