Define "Depreciation Expense"
Depreciation refers to the portion of an asset that is used up in an accounting period, such as a year, quarter or month. When assets are expected to last for more than a year, the cost of the asset is not shown as an immediate expense; rather, it is spread over the asset's life using depreciation. Physical assets such as buildings, vehicles, furniture, machinery and equipment are depreciated each year according to a predefined depreciation schedule.
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Useful Life
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An asset's useful life is an important consideration in calculating depreciation expense. Useful life refers to how many years the company expects to derive the asset's services. If a company acquired a new piece of equipment in January 2010, and expects to use it until December 2014, the asset's useful life is five years. Assets such as buildings, machinery and equipment have longer useful lives than assets such as computers and vehicles.
Salvage Value
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Oftentimes, management may decide to use an asset for a time and dispose of it before the asset becomes worthless. Salvage value, also referred to as residual value, is how much the company expects to be able to sell the asset for at the end of its planned use. If a business buys a photocopy machine for $2,000 and expects to sell it for $400 after using it for five years, the asset's salvage value is $400 and useful life is five years. The difference, $1,600, is the asset's depreciable basis, and refers to how much the asset will be depreciated by over its life.
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Straight-Line Depreciation
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The simplest way to depreciate an asset is to prepare a depreciation schedule based on straight-line depreciation. Under this method, a fixed sum is depreciated each accounting period during the asset's life. Information required to prepare a straight-line depreciation schedule is cost of the asset, useful life and salvage value. For example, if a company acquired a new truck for $80,000 at the beginning of a year, expects to use the truck for 10 years, and then dispose of it for $10,000 at the end of 10 years, depreciation expense on the truck will be $7,000 each year. This is calculated by dividing $70,000 ($80,000 minus $10,000) by 10. In other words, depreciation expense for straight-line depreciation is determined by dividing the difference between asset cost and salvage value by useful years.
Net Book Value
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An asset's net book value at any point in time is determined by subtracting accumulated depreciation from the asset's cost. In the previous example, the truck will be depreciated by $7,000 in the first year, so its net book value will be $73,000 (80,000 minus 7,000) at the end of the first year. At the end of the second year, another $7,000 will be depreciated, giving an accumulated depreciation of $14,000 for the two years. The truck's net book value at this time is $66,000 (80,000 minus 14,000). Similarly, at the end of ten years, net book value will be $10,000 (80,000 minus 70,000).
Gain or Loss on Sale
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When a company estimates salvage value, it is just that---an estimate. Since it is virtually impossible to sell an asset at its predetermined salvage value at the end of the asset's useful life, it follows that disposing an asset usually results in a gain or loss. Going back to the previous example, if the company sells the truck for $13,000 at the end of 10 years, the company will have recognized a gain on sale of $3,000, since it estimated to dispose of the truck for only $10,000. In other words, a gain or loss on sale is calculated by subtracting salvage value from how much the asset was sold for. If the company had sold the truck for less than its salvage value, it would have incurred a loss on sale.
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References
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