Let’s have a look at one of the most interesting items of the accounting statements that is directly linked to all statements we have looked at (Balance Sheet, Income Statement, and Cash Statement).

Pretty much every asset that we have on the left side of the Balance Sheet has its useful life expectancy. The first example that comes to mind is a computer or a phone that you read this article from. It is not going to last you forever, most of the modern electronics are replaced within two to three years.

Let’s say you read this from a new iPhone 13 you have bought for $1,000 and you expect it to last you 24 months. At the time of purchase (given you bought it for cash) you would decrease ‘Cash’ on your balance sheet by $1,000 and add an item iPhone (or communication devices or any other category you assign it to) worth $1,000. If you were a firm, you would prorate this money over 24 months at $41.67 and add this as an expense to your Income Statement, simultaneously decreasing the value of your asset. So, by the end of year 1, your phone is worth $500, and you would incur an expense of $500 for that year. You are planning on using this over time, hence it would be misleading to bulk all expenses on one date, today. What is interesting though, this decrease in assets would have a negative effect on Operating Cash today with decrease of $1,000, however it would positively impact Cash from Investing one year from now.

Similar approach is taken by the firms to account for the assets that do not have infinite life and their accounting would be based on the expected life of these assets. Such expenses include machinery, plants and are typically included under property, plant, and equipment (PP&E) line of the balance sheet.

Depreciation Approaches

The example with an iPhone above refers to the most used straight-line depreciation, where the assets are depreciated by equal instalments over each of the time periods.
There are additional types that firms may consider:

• Declining Balance. This one is linked to the percentage depreciation of the total balance. Instead of dividing the value of the asset by years, it is multiplied by the percentage set and then applied annually to the carrying amount. This would result in a larger depreciation in the earlier years.
• Double Declining Balance (DDB). It is much like the declining balance; however, it uses the adjustment value that can either double the standard rate or possibly applied with a different accelerated constant that results in even larger depreciation in the earlier years.
• Sum of Years Depreciation. This approach weights up the weights of years and reverses them. So, if the asset’s expected life expectancy is three years. The depreciation would be 3/6 in the first year, 2/6 in the second year and 1/6 in the final year.
• Units of Production. This one is an exception compared to other items. Instead of being linked to the years of useful life, this approach calculates it based on total number of output units that can be output by the asset

Accumulated Depreciation and Salvage Value

Depreciation is accumulated over time on the balance sheet, and it is a counter account to the asset it relates to. So, for our iPhone example, after one year, the accumulated depreciation would amount to $500, decreasing the value of our asset to a net of $500.

Salvage Value is the minimum amount to which we aim to depreciate the asset. Some assets might have an expected value that is higher than 0. For the examples listed above the calculation with the salvage value would be the same, but all formulas would need to be applied to Depreciable Amount:

Total Value – Salvage Value = Depreciable Amount

Please note, none of the information on this blog represents the opinion of my employer and all information does not represent a financial advice.