## 2. Salvage value and straight-line depreciation method

Assume that a company purchased in a new piece of equipment and the following information is available about the equipment:

 Original cost \$120,000 Useful life 5 years Salvage value \$20,000

Under the straight-line method of depreciation the annual depreciation expense will be \$20,000:

 Depreciation Expense = Historical Cost - Salvage Value Useful Life
 Depreciation Expense = \$120,000 - \$20,000 = \$20,000 5 years

The reason for including the salvage value in calculating depreciation expense is to have the net book value equal to the salvage value at the end of the asset useful life. Refer to the table below to see how the net book value changes over time:

 Year Beginning Net Book Value Depreciation Expense Accumulated Depreciation Ending Net Book Value 1 \$120,000 \$20,000 \$20,000 \$100,000 2 \$100,000 \$20,000 \$40,000 \$80,000 3 \$80,000 \$20,000 \$60,000 \$60,000 4 \$60,000 \$20,000 \$80,000 \$40,000 5 \$40,000 \$20,000 \$100,000 \$20,000

Note how the ending net book value reduces to \$20,000 – the salvage value amount – at the end of the asset useful life. Had we not subtracted the salvage value from the original cost in calculating the annual depreciation, the result would have been different:

 Depreciation Expense = Historical Cost Useful Life
 Depreciation Expense = \$120,000 = \$24,000 5 years
 Year Beginning Net Book Value Depreciation Expense Accumulated Depreciation Ending Net Book Value 1 \$120,000 \$24,000 \$24,000 \$96,000 2 \$96,000 \$24,000 \$48,000 \$72,000 3 \$72,000 \$24,000 \$72,000 \$48,000 4 \$48,000 \$24,000 \$96,000 \$24,000 5 \$24,000 \$24,000 \$120,000 \$0

As you can see, not subtracting the salvage value from the original cost in calculating the straight-line depreciation results in depreciating the asset to zero and thus in overstating depreciation expense and understating assets.

Not a member?