Depreciation Method and Loan Application Net Worth
Rosa owns a bakery and is preparing a net-worth statement for a bank loan. In March she bought a refrigerated delivery van for $38,500. The van has an estimated salvage value of $6,500 and a five-year useful life. Her accountant suggests double-declining balance because it matches the van's rapid loss of value, but the bank's loan officer asks for straight-line figures. Rosa also has $12,000 in cash, $8,400 in inventory, $3,200 in accounts receivable, a $9,000 equipment loan balance, and $4,100 in supplier payables. She has owned the van for exactly two years and has recorded no depreciation yet. The bank wants to see book value, not market value, and will not count the van's resale estimate. Rosa wonders whether the depreciation choice changes her loan eligibility or just her tax bill.
1. Compute the annual straight-line depreciation and the van's book value after two years.
Read the worked answer
Annual straight-line depreciation = (cost - salvage) / useful life = ($38,500 - $6,500) / 5 = $32,000 / 5 = $6,400 per year.
After two years, accumulated depreciation = 2 x $6,400 = $12,800.
Book value = cost - accumulated depreciation = $38,500 - $12,800 = $25,700.
Because Rosa has recorded no depreciation, she would need a catch-up entry for two years, not just the current year. The book value is an accounting estimate, not a resale price.
2. Compute double-declining-balance depreciation for years 1 and 2 and the resulting book value.
Read the worked answer
DDB rate = 2 / useful life = 2 / 5 = 40% per year, applied to beginning book value.
Year 1 depreciation = $38,500 x 0.40 = $15,400. Ending book value = $38,500 - $15,400 = $23,100.
Year 2 depreciation = $23,100 x 0.40 = $9,240. Ending book value = $23,100 - $9,240 = $13,860.
The $13,860 is above the $6,500 salvage floor, so no limitation applies yet. In later years Rosa must switch to straight-line or otherwise limit depreciation so book value does not fall below salvage value.
3. Using book values, compute Rosa's net worth under each method. Which method should she present to the bank, and what cautions apply?
Read the worked answer
Net worth = assets - liabilities. Liabilities total $9,000 + $4,100 = $13,100.
Straight-line assets: $12,000 cash + $8,400 inventory + $3,200 receivables + $25,700 van = $49,300. Net worth = $49,300 - $13,100 = $36,200.
DDB assets: $12,000 + $8,400 + $3,200 + $13,860 = $37,460. Net worth = $37,460 - $13,100 = $24,360.
The difference is $36,200 - $24,360 = $11,840, exactly the difference in van book value.
Straight-line produces a higher net worth and may look better for a loan covenant. However, Rosa cannot simply choose the method that improves the application; she must use a consistent, supportable accounting policy. Depreciation is non-cash, so the bank will care more about cash flow and collateral than about the book entry. DDB lowers early reported income and book value but defers taxes. A sensible approach is to present the method actually used in her books and tax returns, then explain the non-cash nature of depreciation to the loan officer.