Depreciation
In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, and second, the allocation in accounting statements of the original cost of the assets to periods in which the assets are used.
Depreciation is thus the decrease in the value of assets and the method used to reallocate, or "write down" the cost of a tangible asset over its useful life span. Businesses depreciate long-term assets for both accounting and tax purposes. The decrease in value of the asset affects the balance sheet of a business or entity, and the method of depreciating the asset, accounting-wise, affects the net income, and thus the income statement that they report. Generally, the cost is allocated as depreciation expense among the periods in which the asset is expected to be used.
Methods of computing depreciation, and the periods over which assets are depreciated, may vary between asset types within the same business and may vary for tax purposes. These may be specified by law or accounting standards, which may vary by country. There are several standard methods of computing depreciation expense, including fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service. For example, a depreciation expense of 100 per year for five years may be recognized for an asset costing 500.
Depreciation has been defined as the diminution in the utility or value of an asset and is a non-cash expense. It does not result in any cash outflow; it just means that the asset is not worth as much as it used to be. Causes of depreciation are natural wear and tear.
Accounting concept
In determining the net income from an activity, the receipts from the activity must be reduced by appropriate costs. One such cost is the cost of assets used but not immediately consumed in the activity. Such cost allocated in a given period is equal to the reduction in the value placed on the asset, which is initially equal to the amount paid for the asset and subsequently may or may not be related to the amount expected to be received upon its disposal. Depreciation is any method of allocating such net cost to those periods in which the organization is expected to benefit from the use of the asset. Depreciation is a process of deducting the cost of an asset over its useful life. Assets are sorted into different classes and each has its own useful life. The asset is referred to as a depreciable asset. Depreciation is technically a method of allocation, not valuation, even though it determines the value placed on the asset in the balance sheet.Any business or income-producing activity using tangible assets may incur costs related to those assets. If an asset is expected to produce a benefit in future periods, some of these costs must be deferred rather than treated as a current expense. The business then records depreciation expense in its financial reporting as the current period's allocation of such costs. This is usually done in a rational and systematic manner. Generally, this involves four criteria:
- Cost of the asset
- Expected salvage value, also known as the residual value of the assets
- Estimated useful life of the asset
- A method of apportioning the cost over such life
Depreciable basis
Impairment
Accounting rules also require that an impairment charge or expense be recognized if the value of assets declines unexpectedly. Such charges are usually nonrecurring, and may relate to any type of asset.Many companies consider write-offs of some of their long-lived assets because some property, plant, and equipment have suffered partial obsolescence. Accountants reduce the asset's carrying amount by its fair value. For example, if a company continues to incur losses because prices of a particular product or service are higher than the operating costs, companies consider write-offs of the particular asset. These write-offs are referred to as impairments. There are events and changes in circumstances might lead to impairment. Some examples are:
- Large amount of decrease in fair value of an asset
- A change of manner in which the asset is used
- Accumulation of costs that are not originally expected to acquire or construct an asset
- A projection of incurring losses associated with the particular asset
1. Estimate the future cash flow of asset
2. If the sum of the expected cash flow is less than the carrying amount of the asset, the asset is considered impaired
Depletion and amortization
and amortization are similar concepts for natural resources and intangible assets, respectively.Effect on cash
Depreciation expense does not require a current outlay of cash. However, since depreciation is an expense to the P&L account, provided the enterprise is operating in a manner that covers its expenses depreciation is a source of cash in a statement of cash flows, which generally offsets the cash cost of acquiring new assets required to continue operations when existing assets reach the end of their useful lives.Accumulated depreciation
While depreciation expense is recorded on the income statement of a business, its impact is generally recorded in a separate account and disclosed on the balance sheet as accumulated under fixed assets, according to most accounting principles. Accumulated depreciation is known as a contra account, because it separately shows a negative amount that is directly associated with an accumulated depreciation account on the balance sheet. Depreciation expense is usually charged against the relevant asset directly. The values of the fixed assets stated on the balance sheet will decline, even if the business has not invested in or disposed of any assets. Theoretically, the amounts will roughly approximate fair value. Otherwise, depreciation expense is charged against accumulated depreciation. Showing accumulated depreciation separately on the balance sheet has the effect of preserving the historical cost of assets on the balance sheet. If there have been no investments or dispositions in fixed assets for the year, then the values of the assets will be the same on the balance sheet for the current and prior year.Methods for depreciation
There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity of the asset.Straight-line depreciation
Straight-line depreciation is the simplest and most often used method. In this method, the company estimates the residual value of the asset at the end of the period during which it will be used to generate revenues. The company will then charge the same amount to depreciation each year over that period, until the value shown for the asset has reduced from the original cost to the salvage value.Straight-line method:
For example, a vehicle that depreciates over 5 years is purchased at a cost of $17,000, and will have a salvage value of $2000. Then this vehicle will depreciate at $3,000 per year, i.e. /5 = 3.
This table illustrates the straight-line method of depreciation. Book value at the beginning of the first year of depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated depreciation.
book value = original cost − accumulated depreciation
Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals scrap value.
| Depreciation expense | Accumulated depreciation at year-end | Book value at year-end |
| $17,000 | ||
| $3,000 | $3,000 | $14,000 |
| 3,000 | 6,000 | 11,000 |
| 3,000 | 9,000 | 8,000 |
| 3,000 | 12,000 | 5,000 |
| 3,000 | 15,000 | 2,000 |
If the vehicle were to be sold and the sales price exceeded the depreciated value then the excess would be considered a gain and subject to depreciation recapture. In addition, this gain above the depreciated value would be recognized as ordinary income by the tax office. If the sales price is ever less than the book value, the resulting capital loss is tax-deductible. If the sale price were ever more than the original book value, then the gain above the original book value is recognized as a capital gain.
If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference between the taxation department's and company's view of the profit.
Diminishing balance method
| Depreciation rate | Depreciation expense | Accumulated depreciation | Book value at year-end |
| original cost $1,000.00 | |||
| 40% | 400.00 | 400.00 | 600.00 |
| 40% | 240.00 | 640.00 | 360.00 |
| 40% | 144.00 | 784.00 | 216.00 |
| 40% | 86.40 | 870.40 | 129.60 |
| 129.60 - 100.00 | 29.60 | 900.00 | scrap value 100.00 |
When using the double-declining-balance method, the salvage value is not considered in determining the annual depreciation, but the book value of the asset being depreciated is never brought below its salvage value, regardless of the method used. Depreciation ceases when either the salvage value or the end of the asset's useful life is reached.
Since double-declining-balance depreciation does not always depreciate an asset fully by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This has the effect of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the asset's life.
With the declining balance method, one can find the depreciation rate that would allow exactly for full depreciation by the end of the period, using the formula:
where N is the estimated life of the asset.
Annuity depreciation
Annuity depreciation methods are not based on time, but on a level of Annuity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life is estimated in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. The per-mile depreciation rate is calculated as: / 50,000 miles = $0.30 per mile. Each year, the depreciation expense is then calculated by multiplying the number of miles driven by the per-mile depreciation rate..Sum-of-years-digits method
Sum-of-years-digits is a shent depreciation method that results in a more accelerated write-off than the straight-line method, and typically also more accelerated than the declining balance method. Under this method, the annual depreciation is determined by multiplying the depreciable cost by a schedule of fractions.Sum of the years' digits method of depreciation is one of the accelerated depreciation techniques which are based on the assumption that assets are generally more productive when they are new and their productivity decreases as they become old. The formula to calculate depreciation under SYD method is:
SYD depreciation = depreciable base x
depreciable base = cost − salvage value
Example: If an asset has original cost of $1000, a useful life of 5 years and a salvage value of $100, compute its depreciation schedule.
First, determine the years' digits. Since the asset has a useful life of 5 years, the years' digits are: 5, 4, 3, 2, and 1.
Next, calculate the sum of the digits: 5+4+3+2+1=15
The sum of the digits can also be determined by using the formula /2 where n is equal to the useful life of the asset in years. The example would be shown as /2=15
Depreciation rates are as follows:
5/15 for the 1st year,
4/15 for the 2nd year,
3/15 for the 3rd year,
2/15 for the 4th year, and
1/15 for the 5th year.
| Depreciable base | Depreciation rate | Depreciation expense | Accumulated depreciation | Book value at end of year |
| $1,000 | ||||
| 900 | 5/15 | 300 = | 300 | 700 |
| 900 | 4/15 | 240 = | 540 | 460 |
| 900 | 3/15 | 180 = | 720 | 280 |
| 900 | 2/15 | 120 = | 840 | 160 |
| 900 | 1/15 | 60 = | 900 | 100 |
Units-of-production depreciation method
Under the units-of-production method, useful life of the asset is expressed in terms of the total number of units expected to be produced:Suppose, an asset has original cost $70,000, salvage value $10,000, and is expected to produce 6,000 units.
Depreciation per unit = / 6,000 = $10
10 × actual production will give the depreciation cost of the current year.
The table below illustrates the units-of-production depreciation schedule of the asset.
| Units of production | Depreciation cost per unit | Depreciation expense | Accumulated depreciation | Book value at year-end |
| $70,000 | ||||
| 1,000 | 10 | 10,000 | 10,000 | 60,000 |
| 1,100 | 10 | 11,000 | 21,000 | 49,000 |
| 1,200 | 10 | 12,000 | 33,000 | 37,000 |
| 1,300 | 10 | 13,000 | 46,000 | 24,000 |
| 1,400 | 10 | 14,000 | 60,000 | 10,000 |
Depreciation stops when book value is equal to the scrap value of the asset. In the end, the sum of accumulated depreciation and scrap value equals the original cost.
Group depreciation method
The group depreciation method is used for depreciating multiple-asset accounts using a similar depreciation method. The assets must be similar in nature and have approximately the same useful lives.Composite depreciation method
The composite method is applied to a collection of assets that are not similar, and have different service lives. For example, computers and printers are not similar, but both are part of the office equipment. Depreciation on all assets is determined by using the straight-line-depreciation method.| Asset | Historical cost | Salvage value | Depreciable cost | Life | Depreciation per year |
| Computers | $5,500 | $500 | $5,000 | 5 | $1,000 |
| Printers | $1,000 | $100 | $900 | 3 | $300 |
| Total | $6,500 | $600 | $5,900 | 4.5 | $1,300 |
Composite life equals the total depreciable cost divided by the total depreciation per year.
$5,900 / $1,300 = 4.5 years.
Composite depreciation rate equals depreciation per year divided by total historical cost.
$1,300 / $6,500 = 0.20 = 20%
Depreciation expense equals the composite depreciation rate times the balance in the asset account. $1,300.
Debit depreciation expense and credit accumulated depreciation.
When an asset is sold, debit cash for the amount received and credit the asset account for its original cost. Debit the difference between the two to accumulated depreciation. Under the composite method, no gain or loss is recognized on the sale of an asset. Theoretically, this makes sense because the gains and losses from assets sold before and after the composite life will average themselves out.
To calculate composite depreciation rate, divide depreciation per year by total historical cost.
To calculate depreciation expense, multiply the result by the same total historical cost. The result, not surprisingly, will equal the total depreciation per year again.
Common sense requires depreciation expense to be equal to total depreciation per year, without first dividing and then multiplying total depreciation per year by the same number.
Tax Depreciation
Most income tax systems allow a tax deduction for recovery of the cost of assets used in a business or for the production of income. Such deductions are allowed for individuals and companies. Where the assets are consumed currently, the cost may be deducted currently as an expense or treated as part of cost of goods sold. The cost of assets not currently consumed generally must be deferred and recovered over time, such as through depreciation. Some systems permit the full deduction of the cost, at least in part, in the year the assets are acquired. Other systems allow depreciation expense over some life using some depreciation method or percentage. Rules vary highly by country, and may vary within a country based on the type of asset or type of taxpayer. Many systems that specify depreciation lives and methods for financial reporting require the same lives and methods be used for tax purposes. Most tax systems provide different rules for real property and personal property.Capital allowances
A common system is to allow a fixed percentage of the cost of depreciable assets to be deducted each year. This is often referred to as a capital allowance, as it is called in the United Kingdom. Deductions are permitted to individuals and businesses based on assets placed in service during or before the assessment year. Canada's Capital Cost Allowance are fixed percentages of assets within a class or type of asset. Fixed percentage rates are specified by the type of asset. The fixed percentage is multiplied by the tax basis of assets in service to determine the capital allowance deduction. The tax law or regulations of the country specifies these percentages. Capital allowance calculations may be based on the total set of assets, on sets or pools by year or pools by classes of assets...Depreciation has got three methods only.