11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
What is Depreciation?
Depreciation is the process of allocating the cost of a tangible asset over its useful life.
Purpose:
- Match cost with periods that benefit
- Reflect asset's declining value
- Provide for asset replacement
Important: Depreciation is an allocation process, not a valuation process.
Depreciation Factors
Three Factors Needed:
- Cost: Original cost of asset
- Useful Life: Expected period of use
- Salvage Value: Estimated value at end of useful life
Depreciable Cost: Depreciable Cost = Cost - Salvage Value
Depreciation Methods
Common Methods:
- Straight-Line Method
- Declining Balance Method
- Units-of-Production Method
Straight-Line Method
Formula: Annual Depreciation = (Cost - Salvage Value) ÷ Useful Life
Characteristics:
- Same amount each year
- Simple to calculate
- Most common method
- Used in Luxembourg
Example:
- Equipment: €10,000
- Useful Life: 5 years
- Salvage Value: €1,000
- Depreciable Cost: €10,000 - €1,000 = €9,000
- Annual Depreciation: €9,000 ÷ 5 = €1,800 per year
Journal Entry (Annual):
640000 Depreciation Expense €1,800
241000 Accumulated Depreciation €1,800
To record annual depreciation
PCN Accounts:
- 640000: Depreciation Expense (Class 6)
- 241000: Accumulated Depreciation (Class 2 - Contra-Asset)
Declining Balance Method
Formula: Annual Depreciation = Book Value × Depreciation Rate
Depreciation Rate:
- Often 2× straight-line rate (double-declining balance)
- Or 1.5× straight-line rate (150% declining balance)
Characteristics:
- More depreciation in early years
- Less depreciation in later years
- Accelerated method
- May need to switch to straight-line
Example:
- Equipment: €10,000
- Useful Life: 5 years
- Straight-line rate: 20%
- Double-declining rate: 40%
Year 1:
- Depreciation: €10,000 × 40% = €4,000
- Book Value: €10,000 - €4,000 = €6,000
Year 2:
- Depreciation: €6,000 × 40% = €2,400
- Book Value: €6,000 - €2,400 = €3,600
Year 3:
- Depreciation: €3,600 × 40% = €1,440
- Book Value: €3,600 - €1,440 = €2,160
And so on...
Units-of-Production Method
Formula: Depreciation per Unit = (Cost - Salvage Value) ÷ Total Units Expected
Annual Depreciation = Depreciation per Unit × Units Produced
Characteristics:
- Based on usage, not time
- More accurate for assets with variable usage
- Used for vehicles, machinery
Example:
- Vehicle: €30,000
- Salvage Value: €3,000
- Expected Miles: 100,000
- Depreciation per Mile: (€30,000 - €3,000) ÷ 100,000 = €0.27 per mile
Year 1 (15,000 miles):
- Depreciation: 15,000 × €0.27 = €4,050
Year 2 (20,000 miles):
- Depreciation: 20,000 × €0.27 = €5,400
Comparison of Methods
Same Asset:
- Cost: €10,000
- Useful Life: 5 years
- Salvage Value: €1,000
Straight-Line: €1,800 per year (constant)
Double-Declining Balance:
- Year 1: €4,000
- Year 2: €2,400
- Year 3: €1,440
- Year 4: €864
- Year 5: €296 (adjusted to reach salvage value)
Units-of-Production: Varies with usage
Partial Year Depreciation
When Asset is Purchased Mid-Year:
Option 1: Full Year in Year of Purchase
- Depreciate full year regardless of purchase date
Option 2: Partial Year (Pro-Rata)
- Depreciate based on months owned
- Example: Purchased July 1, depreciate 6/12 of annual amount
Luxembourg Practice: Usually pro-rata for first year
Luxembourg Depreciation Rules
Tax Depreciation:
- Different rates for different asset types
- May differ from book depreciation
- Must follow tax rules for tax purposes
- Can use different method for books vs. tax
Common Rates:
- Buildings: 2-4% per year
- Equipment: 10-20% per year
- Vehicles: 20-25% per year
- Computer equipment: 33% per year
Luxembourg Compliance Note:
Depreciation in Luxembourg:
- Must use consistent method
- Must follow tax rules for tax purposes
- Can differ between book and tax
- Must be disclosed in financial statements
- Must comply with PCN requirements
- Must maintain proper documentation
Think It Through
Why might a business choose declining balance depreciation over straight-line? What are the advantages and disadvantages?