Cost of a long-term asset
Property, plant and equipment is recorded at historical cost, which includes every cost needed to get the asset ready for use: the purchase price, taxes, freight, insurance in transit, installation and testing. Costs after that are different. Repairs and maintenance that merely keep the asset in working order are expensed. Improvements that extend life or capacity are added to the asset (capitalised).
Land is not depreciated because it has an unlimited life.
What depreciation is
Depreciation spreads the cost of an asset over its useful life, to match expense with the revenue the asset helps earn. It is an allocation of cost, not a measure of market value.
Key inputs: cost, salvage value (expected value at the end of its life) and useful life. The depreciable base is cost minus salvage value.
Three methods
- Straight-line: the same amount each year = (cost − salvage) / life.
- Units-of-production: based on use = (cost − salvage) / total expected units × units used this period.
- Double-declining balance (accelerated): rate = 2 × (1 / life) applied to the book value at the start of each year. Salvage value is ignored in the calculation, but depreciation stops when book value reaches salvage value.
Book value
Book value = cost − accumulated depreciation.
Worked example
A delivery truck costs $38,000, plus $2,000 for delivery and signage, so cost = $40,000. Salvage value is $5,000; life is 5 years; expected total distance is 350,000 miles.
Straight-line: (40,000 − 5,000) / 5 = $7,000 per year. After 3 years accumulated depreciation is 21,000 and book value is 40,000 − 21,000 = $19,000.
Double-declining: rate = 2 × 20% = 40%. Year 1: 40% × 40,000 = $16,000. Year 2: 40% × (40,000 − 16,000) = 9,600.
Units-of-production: per mile = 35,000 / 350,000 = $0.10. If it drives 60,000 miles this year, depreciation is $6,000.
Disposal
On sale, compare proceeds with book value.
- Proceeds > book value: gain.
- Proceeds < book value: loss.
If the truck (book value $19,000 after 3 years on straight-line) is sold for $22,000, the gain is 22,000 − 19,000 = $3,000. The entry removes the cost and accumulated depreciation, records cash, and records the gain.
Natural resources and intangibles
Depletion allocates the cost of natural resources such as mines. Amortisation does the same for intangible assets like patents.
Common mistakes
- Depreciating land.
- Subtracting salvage value in the first year of double-declining balance.
- Treating depreciation as a cash outflow; it is a non-cash expense.