Depreciation Methods (SL, DDB, SYD)

Instructor Script

Slide 1: Introduction to Depreciation

Alright team, let\'s jump into another classic FAR topic: Depreciation! This is one of those areas that seems simple on the surface, but the different methods and rules can definitely trip you up on exam day if you\'re not careful.

So, what is depreciation? At its core, it\'s simply the process of allocating the cost of a tangible asset, like a building or machine, over its estimated useful life. We\'re matching the expense of using the asset with the revenues it helps generate. Think of it like spreading the cost of a big purchase over time, instead of taking the hit all at once.

To calculate depreciation, we need a few key pieces of information: the asset\'s initial Cost, its estimated Useful Life, and its estimated Salvage Value (sometimes called Residual Value) - what we think it\'ll be worth at the end of its life. The difference between the Cost and Salvage Value gives us the Depreciable Base - the total amount we\'ll depreciate over the asset\'s life.

I remember when I first started studying for the CPA, I kept mixing up these terms. So, I came up with a mnemonic: "SLICE". Salvage Value (subtract it!), Life (useful life), Initial Cost, Calculate Depreciable Base, and Expense Allocation. Keep "SLICE" in mind, and you\'ll have the basics covered!

Slide 2: Straight-Line (SL) Method

Let\'s start with the simplest and most common method: Straight-Line depreciation. As the name suggests, this method allocates an equal amount of depreciation expense in each year of the asset\'s useful life.

The formula is super straightforward: just take the Depreciable Base (Cost minus Salvage Value) and divide it by the Useful Life in years. That gives you your annual depreciation expense.

For example, if we have an asset that cost $50,000, has a salvage value of $5,000, and a useful life of 5 years. The depreciable base is $45,000 ($50k - $5k). Divide that by 5 years, and you get $9,000 of depreciation expense each year. Easy peasy, right?

Why use Straight-Line? It\'s simple, consistent, and easy to understand. That\'s why it\'s so widely used in financial reporting. You\'ll definitely see this on the exam, probably as part of a larger problem or simulation.

Slide 3: Double-Declining Balance (DDB) Method

Now let\'s kick it up a notch with an accelerated method: Double-Declining Balance, or DDB. Accelerated methods recognize more depreciation expense in the early years of an asset\'s life and less in the later years. The idea is that assets are often more productive when they\'re new.

Calculating DDB involves a few steps. First, find the Straight-Line Rate (1 divided by the useful life). Then, double that rate to get the DDB Rate. Finally, multiply the DDB Rate by the asset\'s Book Value at the beginning of the year. Book Value is just the Cost minus Accumulated Depreciation.

Here\'s a crucial point about DDB: you initially ignore the salvage value when calculating the annual depreciation. However, you must stop depreciating once the asset\'s Book Value reaches its Salvage Value. You can never depreciate below the salvage value!

To remember the DDB steps, think "FADE": Find the SL Rate, Accelerate it (double it), Depreciate (Rate times Book Value), and End at Salvage value. Don\'t let DDB "fade" from your memory on exam day!

Slide 4: DDB Example

Let\'s apply DDB to our $50,000 asset with a $5,000 salvage value and 5-year life.

The Straight-Line Rate is 1/5 = 20%. The DDB Rate is 20% × 2 = 40%.

Year 1: Depreciation is 40% of the initial cost ($50,000), which is $20,000. The Book Value drops to $30,000.

Year 2: Depreciation is 40% of the beginning Book Value ($30,000), which is $12,000. Book Value is now $18,000.

Year 3: 40% of $18,000 is $7,200. Book Value becomes $10,800.

Year 4: 40% of $10,800 is $4,320. Book Value is now $6,480.

Year 5: Now, be careful! If we took 40% of $6,480, we\'d get $2,592, bringing the Book Value below the $5,000 salvage value. We can\'t do that! So, in the final year, we only depreciate the amount needed to reach the salvage value: $6,480 - $5,000 = $1,480.

See how the depreciation expense starts high ($20,000) and decreases each year? That\'s the hallmark of an accelerated method. And always remember that final year check to avoid going below salvage value!

Slide 5: Sum-of-the-Years\' Digits (SYD) Method

Next up is another accelerated method: Sum-of-the-Years\' Digits, or SYD. This one also results in higher depreciation in the early years, but it uses a fraction based on the sum of the years in the asset\'s useful life.

First, calculate the Sum of the Years\' Digits. The quick formula is n(n+1)/2, where n is the useful life. For a 5-year life, it\'s 5(5+1)/2 = 15.

Next, create a depreciation fraction for each year. The numerator is the remaining useful life at the beginning of the year, and the denominator is the Sum of the Years\' Digits we just calculated.

Finally, multiply this fraction by the Depreciable Base (Cost minus Salvage Value) to get the annual depreciation expense.

My mnemonic for SYD is "SMART": Sum the Digits, Make the Fraction, Apply to Depreciable Base, Reduce Remaining Life each year, and remember that Total Depreciation must equal the Depreciable Base over the asset\'s life.

Slide 6: SYD Example

Let\'s use our same $50,000 asset, $5,000 salvage, 5-year life.

Depreciable Base is $45,000. Sum of Years\' Digits is 15.

Year 1: Remaining life is 5 years. Fraction is 5/15. Depreciation = (5/15) × $45,000 = $15,000.

Year 2: Remaining life is 4 years. Fraction is 4/15. Depreciation = (4/15) × $45,000 = $12,000.

Year 3: Remaining life is 3 years. Fraction is 3/15. Depreciation = (3/15) × $45,000 = $9,000.

Year 4: Remaining life is 2 years. Fraction is 2/15. Depreciation = (2/15) × $45,000 = $6,000.

Year 5: Remaining life is 1 year. Fraction is 1/15. Depreciation = (1/15) × $45,000 = $3,000.

If you add up the depreciation ($15k + $12k + $9k + $6k + $3k), it equals $45,000, which is our depreciable base. Perfect! Like DDB, SYD is accelerated, but the decline is more gradual.

Slide 7: Units-of-Production Method

Okay, let\'s switch gears from time-based methods to a usage-based method: Units-of-Production. This method is great when an asset\'s wear and tear is more related to how much it\'s used rather than just the passage of time. Think of a delivery truck (miles driven) or a manufacturing machine (units produced).

First, calculate a depreciation rate per unit of activity. Take the Depreciable Base (Cost - Salvage) and divide it by the Total Estimated Units the asset can produce or use over its entire life.

Then, for each year, multiply this rate per unit by the Actual Units Produced or Used during that specific year. That\'s your depreciation expense for the year.

For example, a machine costs $50,000, salvage $5,000, and is expected to produce 100,000 units total. The rate is ($45,000 / 100,000 units) = $0.45 per unit. If it produces 15,000 units in Year 1, the depreciation is $0.45 × 15,000 = $6,750. If it produces 20,000 units in Year 2, depreciation is $0.45 × 20,000 = $9,000. The expense varies with usage.

Slide 8: Partial Year Depreciation

What happens if you buy or sell an asset partway through the year? You need to calculate partial year depreciation. The exam loves to test this!

The most precise way is to calculate depreciation for the actual number of days or months the asset was owned during the year. However, companies often use conventions for simplicity.

A common one, especially for tax, is the Half-Year Convention, where you take half a year\'s depreciation in both the year you buy the asset and the year you sell it, regardless of the actual date.

There\'s also the Mid-Month Convention (treat assets as bought/sold in the middle of the month) and the Mid-Quarter Convention (used for tax if you buy a lot of assets late in the year).

The key takeaway for the exam is to read the question carefully! Note the acquisition and disposal dates, and see if any specific convention is mentioned. If not, assume you calculate based on the actual time owned.

Slide 9: Changes in Estimates

Life happens, and sometimes our initial estimates for useful life or salvage value turn out to be wrong. How do we handle these changes in accounting estimates?

The rule is simple: handle changes in estimates prospectively. That means you don\'t go back and restate prior years. Instead, the change affects the current year and future years only.

Here\'s how: First, calculate the asset\'s Book Value right before the change. Then, determine the revised remaining useful life and revised salvage value. Finally, calculate the new annual depreciation by taking the current Book Value minus the revised Salvage Value, and dividing by the revised Remaining Useful Life.

For example, our asset had a Book Value of $32,000 after 2 years (using SL). If we now estimate the remaining life is 4 years (instead of 3) and the salvage value is $2,000 (instead of $5,000), the new annual depreciation is ($32,000 - $2,000) / 4 years = $7,500 per year going forward.

Remember: Prospective application only! No retroactive adjustments for changes in estimates.

Slide 10: Impairment of Assets

Sometimes, an asset\'s value drops significantly due to damage, obsolescence, or other factors. When events suggest the asset\'s carrying amount (Book Value) might not be recoverable, we need to test for impairment.

For assets held for use, it\'s a two-step test. Step 1 is the Recoverability Test: Compare the asset\'s Carrying Amount to the Sum of its Undiscounted Future Cash Flows. If the Carrying Amount is higher, the asset might be impaired, and you proceed to Step 2.

Step 2 is calculating the Impairment Loss. The loss is the difference between the Carrying Amount and the asset\'s Fair Value (what it could be sold for). You write the asset down to its Fair Value.

An impairment loss reduces the asset\'s book value, and any subsequent depreciation is calculated based on this new, lower book value over its remaining useful life.

My mnemonic for impairment is "ACTS": Assess Recoverability (Undiscounted Cash Flows), Calculate Loss (Carrying Amount - Fair Value), Test Triggered? (Events indicating impairment), and Subsequent Depreciation (based on new value). Impairment is a big topic, but this covers the basics related to depreciable assets.

That covers the main depreciation methods and related issues you\'ll likely encounter. Let\'s solidify this with some practice!