Question

Speedy Delivery has a very lazy accountant. When originally setting up the delivery trucks into the accounting system, the accountant did not want to calculate the expected salvage value for each vehicle. He left salvage value at $0 even though this is not the case. Explain what leaving the salvage value at $0 would do for depreciation. Discuss the differences, if any, between straight-line, double-declining, and units-of-production methods.

Answer 1

Salvage value/scrap value/ residual value is the estimated amount of an asset at the end of its useful life, and it is used to calculate the depreciation expense of an asset.

When salvage value is estimated at $0 it would overstate or increase the depreciation expense and decrease the carrying value each year. As we know that salvage value is used to reduce the cost of assets to calculate depreciation for each year. When it is not considered or left at $0, the cost of assets seems to be higher, and depreciation charged on it will also be high.

Differences, between straight-line, double-declining, and units-of-production methods-

1. Straight-line depreciation method- It is used by most of the firms. Under this method, an equal amount of depreciation is allocated throughout the useful life of the asset.

Depreciation expense = (Historical cost of the asset – Estimated residual value) / Estimated useful life.

and Dep. rate= (1/estimated useful life)*100

2. Double Declining Balance (DDB) Depreciation method- It is a more realistic method to calculate depreciation. It speeds up the reorganization at a certain acceleration rate therefore more depreciation expenses are recognized in the early years of useful life. One popular accelerated method is the declining balance method which applies a constant rate to the asset’s book value each year:

With the double-declining-balance method, the depreciation factor is 2x that of the straight-line expense method.

Depreciation formula for the double-declining balance method:

Periodic Depreciation Expense = Beginning book value x Rate of depreciation (twice of straight-line expense method dep. rate )

Please note that the residual value is not in the calculation for this method. Depreciation should end once the estimated salvage value is reached. As a result of different ways of depreciation reporting, net income under the straight-line method will be higher in the early years and then lower in the later years compared to accelerated methods.

3. Units of Production method- It explains the useful life of the asset in terms of the total number of units to be produced by the asset. This is widely used in the production industry when depreciating assets like machines.

Depreciation expense = (Depreciable cost * Production) / Estimated total productive capacity.

Please mention your doubts in the comment box , if any.

Thanks & all the best.....