Difficulty: Intermediate | Prerequisites: Chapter 10 (Property, Plant, and Equipment acquisition and valuation)
Depreciation is one of the most tested areas in intermediate accounting. This chapter covers why companies allocate the cost of long-lived assets, how they measure that allocation, and the mechanics of each depreciation method. You need a solid grasp of asset cost determination from Chapter 10 before diving in, because every method here starts from the asset's initial cost.
Companies spread the cost of long-lived assets over the periods that benefit from their use. For plant and equipment, this process is called depreciation; for natural resources, depletion; for intangibles, amortisation. The method you choose (straight-line, accelerated, or activity-based) determines how much expense hits each period, but the total depreciation over the asset's life is always the same: initial cost minus residual value.
Cost allocation
The systematic process of assigning the cost of a long-lived asset to the accounting periods that benefit from its use. Think of it as spreading the purchase price across the asset's working life so no single period bears the full cost.
Depreciation
Cost allocation applied to property, plant, and equipment (PP&E). In simple terms, it is the portion of a tangible asset's cost that is expensed each period.
Depletion
Cost allocation applied to natural resources (oil, timber, minerals). The idea is the same as depreciation, but the asset is literally consumed or extracted rather than worn out.
Amortisation
Cost allocation applied to intangible assets (patents, copyrights, franchises). Same principle, different asset class.
Service life (useful life)
The estimated period over which a company expects to use an asset, expressed in years or in units of activity (e.g. miles driven, units produced). This is shorter than the asset's physical life, because a company may retire the asset before it physically breaks down.
Allocation base (depreciable base)
The total cost to be spread over the asset's useful life. Calculated as initial cost minus residual (salvage) value. In simple terms, it is the chunk of the purchase price that will eventually become expense.
Residual value (salvage value)
The amount a company expects to receive for the asset at the end of its service life, less any disposal costs. Think of it as the trade-in or scrap value. Often estimated at zero when the amount is immaterial.
Straight-line (SL) method
A time-based depreciation method that allocates an equal amount of depreciable base to each year of the asset's service life. The simplest and most common approach.
Sum-of-the-years'-digits (SYD) method
An accelerated depreciation method that applies a declining fraction to the full depreciable base each year. The fraction's numerator is the remaining years of useful life; its denominator is the sum of all the years' digits.
Double-declining-balance (DDB) method
An accelerated method that applies twice the straight-line rate to the asset's declining book value (not the depreciable base). Residual value is not subtracted from the base; instead, depreciation stops once book value equals residual value.
Units-of-production method
An activity-based method that ties depreciation to actual use rather than to time. Depreciation per unit equals the depreciable base divided by estimated total output.
Group depreciation method
Depreciating a collection of similar assets (same service lives, same type) together rather than individually. Reduces record-keeping effort.
Composite depreciation method
Same collective approach as group depreciation, but applied to physically dissimilar assets that are bundled together for convenience.
PP&E and intangible assets are purchased with the expectation that they will deliver benefits over several years. Accounting principles require that the cost of these assets be matched to the periods that benefit from their use, not dumped entirely into the period of purchase.
The label changes depending on the asset class:
Depreciation applies to plant and equipment
Depletion applies to natural resources
Amortisation applies to intangible assets
All three are forms of cost allocation. None of them attempts to measure the asset's current market value; they simply spread the historical cost in a systematic way.
Before depreciation begins, three things must be established:
Service life: how long the company expects to use the asset, measured in years or units of activity
Allocation base: the total amount of cost to be allocated (initial cost minus residual value)
Allocation method: the pattern in which the cost will be recognised as expense (evenly, front-loaded, or tied to usage)
For tangible assets, service life is always shorter than physical life. A delivery truck might run for 15 years mechanically, but the company may plan to replace it after 8 years. The 8-year figure is the service life.
For intangible assets, the legal or contractual life sets the upper bound. A patent granted for 20 years cannot have a service life longer than 20 years, though it may be shorter if the company expects the technology to become obsolete sooner.
Service life can be expressed in time (years) or in activity (miles, units produced). The choice of measure often determines which depreciation method makes sense.
Allocation base = initial cost of the asset - residual (salvage) value
Initial cost includes the purchase price plus any expenditures necessary to get the asset ready for its intended use (installation, shipping, testing).
Residual value is the amount the company expects to receive when it disposes of the asset at the end of its service life, net of any disposal costs. When residual value is immaterial or too uncertain to estimate reliably, it is assumed to be zero.
The simplest method. Allocates an equal amount of the depreciable base to each year of the asset's life.
Annual depreciation = (initial cost - residual value) / useful life
Example: a machine costs $50,000, has a residual value of $5,000, and a useful life of 5 years.
Depreciable base: $50,000 - $5,000 = $45,000
Annual depreciation: $45,000 / 5 = $9,000 per year
Every year gets the same $9,000 charge. Straightforward, widely used, and the default choice when there is no strong reason to front-load or tie expense to output.
Accelerated methods recognise more depreciation in the early years of an asset's life and less in the later years. The rationale is that many assets deliver more benefit (or lose more value) early on.
Regardless of which accelerated method you use, the total accumulated depreciation over the asset's full life is the same as under straight-line: initial cost minus residual value. The methods differ only in timing.
Applies a declining fraction to the full depreciable base each year.
Numerator: remaining useful life at the start of the year
Denominator: sum of the digits from 1 to n, calculated as n(n + 1) / 2
Example (5-year life):
Denominator: 5(5 + 1) / 2 = 15
Year 1 fraction: 5/15
Year 2 fraction: 4/15
Year 3 fraction: 3/15
Year 4 fraction: 2/15
Year 5 fraction: 1/15
Each year's depreciation = fraction x depreciable base. The base stays constant; only the fraction changes.
Applies twice the straight-line rate to the asset's book value (not the depreciable base).
Depreciation rate = (1 / useful life) x 2
Each year's depreciation = rate x book value at the start of the year
Key differences from SYD:
The base declines each year. Year 1's base is the full cost. Year 2's base is cost minus Year 1 depreciation. And so on.
Residual value is not subtracted up front. Instead, depreciation stops once book value reaches the residual value. In the final year, you depreciate only the amount needed to bring book value down to residual value, even if the formula would give a larger number.
Example (5-year life, $50,000 cost, $5,000 residual):
Rate: (1/5) x 2 = 40%
Year 1: 40% x $50,000 = $20,000 (book value drops to $30,000)
Year 2: 40% x $30,000 = $12,000 (book value drops to $18,000)
Year 3: 40% x $18,000 = $7,200 (book value drops to $10,800)
Year 4: 40% x $10,800 = $4,320 (book value drops to $6,480)
Year 5: only $1,480 (not $2,592), because book value cannot fall below the $5,000 residual
Ties depreciation to actual use rather than the calendar. Useful for assets whose wear depends on output (machines, vehicles, equipment with a measurable activity count).
Depreciation rate per unit = (cost - residual value) / estimated total units of output
Periodic depreciation = depreciation rate per unit x units produced (or miles driven, hours run, etc.) in the period
In the final year, be careful: you cannot depreciate past the depreciable base. If the remaining book value above residual is less than the formula amount, you depreciate only enough to bring accumulated depreciation to the full depreciable base.
Both methods depreciate a collection of assets together rather than tracking each one individually.
Group method: the assets in the pool share similar service lives and attributes. Think of a fleet of identical delivery vans.
Composite method: the assets are physically dissimilar but are bundled together for convenience. Think of all the equipment in a factory, each with different lives, pooled into one depreciation calculation.
The main advantage is reduced record-keeping. The trade-off is less precision at the individual asset level.
This distinction comes up regularly on exams.
US GAAP: PP&E is reported on the balance sheet at cost less accumulated depreciation (book value). Revaluation upward is prohibited.
IFRS: companies may choose to report PP&E at book value (cost model) or at fair value (revaluation model). If a company chooses revaluation, it must revalue all assets within the same class on a regular basis, not selectively.
Method | Formula | Notes |
|---|---|---|
Straight-line | (Cost - Residual value) / Useful life | Same amount each year |
SYD rate per year | Remaining years / [n(n+1)/2] | Apply rate to full depreciable base |
DDB rate | (1 / Useful life) x 2 | Apply rate to declining book value, not depreciable base |
Units-of-production rate | (Cost - Residual value) / Estimated total units | Multiply rate by actual units in the period |
Depreciable base | Cost - Residual value | Same total for all methods |
Depletion per unit | (Cost - Residual value) / Estimated extractable units | Multiply by units extracted |
"Depreciation measures the drop in an asset's market value." It does not. Depreciation is a cost allocation process, not a valuation exercise. The book value of an asset after depreciation rarely equals its market value.
"DDB subtracts residual value from the base, just like SYD." Wrong. Under DDB, you apply the rate to the full book value. Residual value acts as a floor: you stop depreciating once book value reaches it, but you never subtract it from the starting base.
"Accelerated methods produce more total depreciation than straight-line." They do not. Total depreciation over the asset's life equals the depreciable base under every method. Accelerated methods only shift more expense to the early years.
"Units-of-production always gives different expense each year." Only if actual output varies. If a machine produces the same number of units every year, units-of-production gives the same result as straight-line.
⚠️ You will almost certainly be asked to calculate depreciation under at least two different methods for the same asset and compare the results.
⚠️ DDB final-year adjustments are a common exam trap. Remember: book value cannot drop below residual value, so the last year's depreciation is often a plug figure.
⚠️ Know the IFRS vs GAAP distinction on revaluation cold. A typical exam question gives you a scenario and asks whether revaluation is permitted.
⚠️ Group vs composite depreciation: the difference is whether the pooled assets are similar (group) or dissimilar (composite). Exams test the definition, not the calculation.
True or false: Depreciation is a process that tracks the decline in an asset's fair market value.
False. Depreciation is cost allocation, not valuation.
Fill in the blank: Allocation base equals ______ minus ______.
Initial cost minus residual (salvage) value.
True or false: Under DDB, you subtract residual value before applying the depreciation rate.
False. You apply the rate to book value. Residual value is a floor, not a deduction from the base.
Fill in the blank: The SYD denominator for an asset with a 6-year life is ______.
21 (calculated as 6 x 7 / 2).
True or false: Total accumulated depreciation over an asset's full life differs depending on which method is used.
False. Total depreciation equals the depreciable base regardless of method.
Q: A company purchases equipment for $120,000. The equipment has an estimated useful life of 8 years and a residual value of $8,000. What is the straight-line annual depreciation?
A: ($120,000 - $8,000) / 8 = $14,000 per year.
Q: Using the same facts above, what is the SYD depreciation for Year 1?
A: Depreciable base = $112,000. SYD denominator = 8(9)/2 = 36. Year 1 fraction = 8/36. Depreciation = $112,000 x 8/36 = $24,889 (rounded).
Q: A machine costs $80,000 with a $5,000 residual value and a 4-year life. Under DDB, what is Year 2 depreciation?
A: DDB rate = (1/4) x 2 = 50%. Year 1: 50% x $80,000 = $40,000 (BV = $40,000). Year 2: 50% x $40,000 = $20,000.
Q: Under US GAAP, can a company revalue its PP&E upward to fair value?
A: No. US GAAP prohibits upward revaluation. PP&E is reported at cost less accumulated depreciation. IFRS permits the revaluation model as an alternative.
Q: A delivery truck costs $60,000, has a $6,000 residual value, and is expected to be driven 180,000 miles over its life. In Year 1 the truck is driven 35,000 miles. What is Year 1 depreciation under units-of-production?
A: Rate = ($60,000 - $6,000) / 180,000 = $0.30 per mile. Year 1 depreciation = 35,000 x $0.30 = $10,500.
This material connects directly to Chapter 10 (acquisition of PP&E), because the initial cost figure you calculated there is the starting point for every depreciation method here. It also feeds into Chapter 11's later sections on impairment testing, where the remaining book value after depreciation is compared to fair value. If you go on to study income taxes, you will see that tax depreciation (MACRS) differs from book depreciation, creating temporary differences that drive deferred tax calculations.
Related Terms / Search Tags
depreciation, depletion, amortisation, amortization, cost allocation, useful life, service life, residual value, salvage value, scrap value, depreciable base, allocation base, straight-line depreciation, SL method, accelerated depreciation, sum-of-the-years-digits, SYD, double-declining-balance, DDB, 200% declining balance, units-of-production, activity-based depreciation, group depreciation, composite depreciation, IFRS revaluation, US GAAP PP&E, book value, fair value, ACCTG 471, intermediate financial accounting, Chapter 11