Factors Determining Depreciation Expense

In order to calculate annual depreciation expense for the purpose of preparing the final (or periodic) accounts of a firm, the depreciation accounting requires the consideration of the following factor: (1) Actual cost of asset; (2) Estimated salvage (residual or scrap) value of the asset; (3) Estimated useful life of the asset. It would be found that the calculation of depreciation expense is based on one actual and two estimated factors which are discussed briefly as:

The cost of the asset (historical cost):

According to cost concept, fixed assets are recorded at their input cost to the business. The input cost normally includes all costs incurred in acquiring the asset (e.g., invoice price, legal charges, freight etc.), installing it and making it ready for use. In the case of plant and machinery, the actual cost means the purchase price, any transportation costs and any installation costs. And where assets are received through gift or inheritance the basis for recording the asset in fair market value i.e., the amount that would be paid in cash or its equivalent if property were being purchased. Historical cost of depreciable assets represents its money outlay or its equivalent in connection with its acquisition, installation, and commissioning as well as for additions to or improvement thereof. The historical cost of depreciable asset may undergo subsequent changes arising as a result of increase or decrease in long-term liability on account of exchange fluctuations, price adjustment, changes in duties or similar factors.

Salvage (Residual or Scrap) value:

The salvage value means the estimated amount which will be recovered when the asset is sold, discarded or exchanged for a new asset at the end of its useful service life. The net depreciable cost (i.e., the amount which is to be depreciated) of the assets to the business enterprise therefore arrived at by deducting the net salvage value of the asset from its actual historical cost or book value where the asset has been revalued. The calculation of net residual value is done by estimating the gross salvage value and reducing there from the cost of its disposal.

Estimated useful life:

It is only in some cases that the established managerial policy may determine the useful service lives of particular fixed assets. More often, however, the useful life is difficult to predict with the result that only a rough estimated is possible. The reasonable correct estimate is important because the portion to be depreciated is to be deducted from the revenue of the current accounting period, thereby affecting the net income of the period. The following points are generally recommended in estimating the useful life of an asset:

(i)    the intensity of use:

The life of an asset, ordinarily depends upon the way in which it is put to use; for example, the high speed and continuous operation of machines may result in shorter useful life than low speed and intermittent operations. Similarly a truck is used on a construction site may have relatively shorter life than a truck used for transportation on National Highways due to good quality of roads.

(ii)    The standard of maintenance:

The careful handling and frequent overhauling usually tend to prolong useful life materially.

(iii)    The replacement policy of the management:

Machinery with an expected physical life of 15 years under normal conditions will have a useful life for depreciation purpose of 10 years if the policy of the firm is to exchange or dispose of such asset after 10 years.

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