Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 9 Fixed Assets and Intangible Assets 405

Another common misunderstanding is that depreciation provides cash needed to

replace fixed assets as they wear out. This misunderstanding probably occurs because

depreciation, unlike most expenses, does not require an outlay of cash in the period in

which it is recorded. The cash account is neither increased nor decreased by the peri-

odic entries that transfer the cost of fixed assets to depreciation expense accounts.

Rather, the cash outflow occurs when the fixed asset is originally purchased.

Factors in Computing Depreciation Expense

Three factors are considered in determining the amount of depreciation expense to be

recognized each period. These three factors are (a) the fixed asset’s initial cost, (b) its

expected useful life, and (c) its estimated value at the end of its useful life. This third

factor is called the residual value,scrap value,salvage value, or trade-in value.

A fixed asset’s residual value at the end of its expected useful life must be esti-

mated at the time the asset is placed in service. If a fixed asset is expected to have lit-

tle or no residual value when it is taken out of service, then its initial cost should be

spread over its expected useful life as depreciation expense. If, however, a fixed asset

is expected to have a significant residual value, the difference between its initial cost

and its residual value, called the asset’s depreciable cost, is the amount that is spread

over the asset’s useful life as depreciation expense. Exhibit 4 shows the relationship

among the factors used to compute periodic depreciation expense.

A fixed asset’s expected useful lifemust also be estimated at the time the asset is

placed in service. Estimates of expected useful lives are available from various trade

associations and other publications. It is not uncommon for different companies to

have different useful lives for similar assets. For example, the primary useful life for

buildings is 50 years for JCPenney, while the useful life for buildings for Tandy

Corporation, which operates Radio Shack, varies from 10 to 40 years. For federal in-

come tax purposes, the Internal Revenue Service (IRS) has established guidelines for

useful lives. For example, the IRS useful life guideline for most vehicles is five years,

while the designated life for most machinery and equipment is seven years. These

Periodic

Depreciation Expense

Depreciable

Cost

Useful

Life

Residual

Value

DEPRECIATION EXPENSE FACTORS

minus equals

Initial

Cost

YEAR

1

YEAR

4

YEAR

5

YEAR

2

YEAR

3

Exhibit 4

Factors that Determine
Depreciation Expense