SL Depreciation rate queries

CFA Level I FRA
#1

Dear all,

Consider the below hypothetical example:

  • A machine with initial cost of $100K
  • Useful life: 5 years
  • Salvage value: $10K
  • SL depreciation

Depreciation expense per year will be : (100K-10K)/5 = 18K

Question: If we are to calculate the depreciation rate, we will ignore the salvage value and proceed with 100K/5= 20%?

Thanks!

Cheers,

Ernest

#2

Hi Ernest,

If you’re amortizing straight line (5 years) then residual and/or salvage values are deducted from the numerator. If you use the declining balance method (20%), then they are not considered, and amortization is higher for the first year than via SL.

Hope this helps,

Seth

#3

Hey Seth,

Totally agreed with what you said.

However, I happen to see some discussion on similar topic in this forum and there is this machine with salvage value; the depreciation rate calculated is ’ cost of the machine’/ ’ _ useful lives _ ’ ; instead of ’ cost of the machine - salvage value’/ ’ _ useful lives _ ’

Am I right to say for SL depreciation/amortization, calculating depreciation expeneses can be done using either:

  1. depreciation rate x cost of the machine = depreciation expenses for each period OR;
  2. [Cost - Salvage Value] / [Useful lives] = depreciation expenses
#4

Hi Ernest,

Which discussion are you referring to that someone is suggesting residual value should not be deducted? This is incorrect. See IAS guidance below:

Per IAS 32.50: “The depreciable amount of an asset shall be allocated on a systematic basis over its useful life”

This is followed by IAS32.53: “The depreciable amount of an asset is determined after deducting its residual value.”

It isn’t the cost of the machine that is depreciated, it is the depreciable amount. The depreciabl amount under the declining balance method happens to be capital cost, but via straight line it is net of residual/salvage

#5

Impressive, you actually can remember in such depth in accounting standards! Okay back to the question:

My apology for confusing you. My understanding for SL depreciation is really limited to ‘Cost - Salvage’/ ‘useful lives’ to obtain the depreciation expense. I have been seeing depreciation rate (from various sources e.g. accounting websites, schwesers notes). I’m wondering how is depreciation rate calculated in that manner.

#6

I just pulled open the handbook and looked up the guidance, certainly didn’t remember it verbatim haha. I also have an accounting background so this stuff is pretty second nature for me.

I’m not sure that I fully understand your question - but I will say that an assets useful life, or the depreciation rate assigned to an asset, is completley based on management’s assessment of the likely productive capacity and/or use of the asset over time. So for example, if they think that a piece of manufacturing equipment will be able to produce at 100% capacity in Y1 and slowly decrease each year thereafter, it would be more appropriate to use declining balance or units produced as a systematic basis for depreciation, so that the depreciation expenses better match the cash flows generated by the asset.

If we’re talking about a buillding, much less likely to degrade more/less slowly over time so straight line is extremely standard in practice

#7

Totally agreed on what you said!

Okay, I will phrase my question directly:

  • Using the above example, what will be the depreciation rate?

Thanks Seth.

#8

$18k/yr for 5 years = $90k depreciation

Salvage asset for $10k

NBV = $0 after salvage

#9

Agreed with thanks! What if the question ask for SL- depreciate rate (%)? It will be depreciation expense/ (cost - salvage)

#10

yep! It will not be a percentage though. The question would be “what is the asset’s useful life”

#11

This is incorrect; the depreciable amount is price less salvage irrespective of the depreciation method. This is the reason that, when using a declining-balance method we always compare the book value to the residual (salvage) value to ensure that we don’t depreciate below the residual.

#12

S2000 - you understood what I meant. Clearly we do not amortize below the residual value, I was tyring to illustrate the different between the two methods respective to how the annual depreciation is calculated.

#13

I did, indeed, understand what you meant.

However, because others on this forum may not have understood (and, therefore, may have thought that under a declining balance method the depreciation could go, essentially, to zero), I thought that a clarification was appropriate.