Answer
The factors that are relevant in determining the annual depreciation charge include:
i. The initial recorded amount (cost)
ii. Estimated salvage value
iii. Estimated useful life
iv. Depreciation method.
Work Step by Step
- Normally, assets are recognized at their acquisition cost, which is in most cases objectively determinable. However, cost assignments in other cases and the selection of an implicit interest rate in asset acquisition under deferred-payment plans may be quite subjective, involving considerable judgment.
- The salvage value is an estimate of an amount potentially realizable when the asset is retired from service. The estimate is based on judgment and is affected by the length of the useful life of the asset.
- The useful life is also based on judgment. It involves selecting the unit of measure of service life and estimating the number of such units embodied in the asset. Such units may be measured in terms of time periods or in terms of activity. When selecting the life, one should select the shorter of the physical life or the economic life. Physical life involves wear and tear and casualties; economic life involves such things as technological obsolescence and inadequacy.
- Choosing the depreciation method is also generally a judgment decision, but a method may be inherent in the definition adopted for the units of service life, as discussed earlier. For example, if such units are machine hours, the method is a function of the number of machine hours used during each period. A method should be selected that will best measure the portion of services expiring each period. Once a method is selected, it may be objectively applied by using a predetermined, objectively derived formula.
