In our last post we clarified the concept of depreciation. In this and the next two posts we want to take a look at the most common methods of calculating the amount of depreciation to be included in a business’ operating expenses.
There are several ways in which depreciation can be calculated but the most common is called the straight-line method. This results in a fixed amount of depreciation being calculated each year as the cost of the asset less its residual value (if any) is divided by the number of years of its expected useful life.
Take the example of a business purchasing equipment. The equipment will operate for 5 years and over that time will improve the business’s production efficiency (thereby possibly reducing expenses) and increase outputs (thereby possibly increasing their revenue). Obviously, the business will benefit financially from owning the equipment for the full 5 years.
Let’s assume that the purchase price of the equipment was 100,000. Is it reasonable to expect that the entire cost of the equipment should be included as an expense in the accounting period in which it was purchased? Clearly not, as the business will generate profits in future years as a result of owning the equipment.
To make the calculation, the business would need to determine;
- The cost of the asset
- The expected useful life of the asset measured by time
- Any residual value – this is an estimate of what the asset’s value would be at the end of its useful life, e.g. scrap value if the asset is a piece of equipment
Let’s say that in our example of equipment costing 100,000, the directors of the business estimate a residual value of 20,000 and a useful life of 5 years. The value of the asset to be depreciated (i.e. its depreciable value) is therefore, 100,000 minus the 20,000 residual value = a depreciable value of 80,000.
The depreciation calculation would be;
80,000 (depreciable value) / 5 (years of useful life) = 16,000
The amount of depreciation that would be included in the list of operating expenses for this particular asset would then be R16,000 per year for 5 years.
How does that impact the balance sheet? The asset is brought onto the balance sheet at its cost of acquisition, in our example that’s 100,000. The amount of depreciation calculated for each financial year and included as an operating expense in the income statement is then deducted from that initial value to arrive at the asset’s net book value.
Let’s assume for the sake of simplicity that our example business acquired its asset on the first day of its financial year. At the end of that period, the amount of depreciation is 16,000 so the net book value of the asset is the initial cost of 100,000 less accumulated depreciation (in this case, for the first year) of 16,000 = 84,000.
In the following financial year’s balance sheet the net book value of the asset changes since another year’s depreciation has been included in that year’s operating expenses. Now the figure in the balance sheet will be the initial cost of 100,000 less accumulated depreciation of 32,000 (that’s two full years’ depreciation) = a net book value of 68,000. And the process continues for the useful life of the asset or until it is disposed of.