An Allocation Pattern
Question: If a company pays $600,000 on January 1, Year One to rent a building to serve as a store for five
years, a prepaid rent account (an asset) is established for that amount. Because the rented facility will be used to
generate revenues throughout this period, a portion of the cost is reclassified annually as an expense to comply
with the matching principle. At the end of Year One, $120,000 (or one-fifth) of the cost is moved from the asset
balance into rent expense by means of an adjusting entry. As a result, the prepaid rent on the balance sheet drops
to $480,000, the amount paid for the four remaining years.
If, instead, the company buys a building with an expected five-year life1
for $600,000, the accounting is quite similar. The initial cost is capitalized to reflect the future economic benefit.
Once again, an expense is then recorded at the end of Year One for a portion of this cost to satisfy the matching
principle. This expense is referred to as depreciation. Should the Year One depreciation recognized in connection
with this acquired building also be $120,000?
How is the annual amount of depreciation expense determined for reporting purposes?
Answer: The specific amount of depreciation expense recorded each year for buildings, machinery, furniture, and
the like is based on four variables:
1. The historical cost of the asset
2. Its expected useful life
3. Any anticipated residual (or salvage) value
4. An allocation pattern
After total cost is computed, officials estimate the useful life based on company experience with similar assets in
the past or other sources of information such as guidelines provided by the manufacturer2. In a similar fashion,
officials arrive at an expected residual value—an estimate of the likely worth of the asset at the end of its useful
life to the company. Because both life expectancy and residual value are no more than guesses, depreciation is
simply a mechanically derived pattern that allocates the asset’s cost to expense over its expected years of use.
To illustrate, assume a building is purchased by a company on January 1, Year One, for cash of $600,000. Based
on experience with similar assets, officials believe that this structure will be worth only $30,000 at the end of
an expected five-year life. U.S. GAAP does not require any specific computational method for determining the
annual allocation of the asset’s cost to expense. Over fifty years ago, the Committee on Accounting Procedure
(the authoritative body at the time) issued Accounting Research Bulletin 43 which stated that any method could
be used to determine annual depreciation if done in a “systematic and rational manner.” This guidance remains in
effect today.
Consequently, a vast majority of reporting companies (including Wal-Mart) have chosen to adopt the straight-line
method to assign the cost of property and equipment to expense over their useful lives. The estimated residual
value is subtracted from cost to arrive at the asset’s depreciable base. This figure is then expensed evenly over the
expected life. It is systematic and rational: Straight-line depreciation allocates an equal expense to each period in
which the asset is used to generate revenue.
Straight-line method:
(cost – estimated residual value) = depreciable base
depreciable base/expected useful life = annual depreciation
($600,000 – $30,000) = $570,000/5 years = depreciation expense of $114,000 per year