Definitions

Physical depreciation

Depreciation

[dih-pree-shee-ey-shuhn]

Depreciation is a term used in accounting, economics and finance to spread the cost of an asset over the span of several years.

In simple words we can say that depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or obsolescence, depletion or other such factors. In accounting, depreciation is a term used to describe any method of attributing the historical or purchase cost of an asset across its useful life, roughly corresponding to normal wear and tear. It is of most use when dealing with assets of a short, fixed service life, and which is an example of applying the matching principle as per generally accepted accounting principles. Depreciation in accounting is often mistakenly seen as a basis for recognizing impairment of an asset, but unexpected changes in value, where seen as significant enough to account for, are handled through write-downs or similar techniques which adjust the book value of the asset to reflect its current value. Therefore, it is important to recognize that depreciation, when used as a technical accounting term, is the allocation of the historical cost of an asset across time periods when the asset is employed to generate revenues. This process of cost allocation has little or no direct relationship to the market value or current selling price of the asset, it is simply the recognition that a portion of the asset's cost--the portion that will never be recuperated through re-sale or disposal of the asset--was "used up" in the generation of revenues for that time period.

The use of depreciation affects the financial statements and in some countries the taxes of companies and individuals. The recording of depreciation will cause an expense to be recognized, thereby lowering stated profits on the income statement, while the net value of the asset (the portion of the historical cost of the asset that remains to provide future value to the company) will decline on the balance sheet. Depreciation reported for accounting and tax purposes may differ substantially.

Depreciation and its related concept, amortization (generally, the depreciation of intangible assets), are non-cash expenses. Neither depreciation nor amortization will directly affect the cash flow of a company, as both are accounting representations of expenses attributable to a given period. In accounting statements, depreciation may neither figure in the cash flow statement, nor be "added back" to net income (along with other items) to derive the operating cash flow. Depreciation recognized for tax purposes will, however, affect the cash flow of the company, as tax depreciation will reduce taxable profits; there is generally no requirement that treatment of depreciation for tax and accounting purposes be identical. Where depreciation is shown on accounting statements, the figure usually does not relate to depreciation for tax purposes.

Salvage value is the estimated value of an asset at the end of its useful life. In accounting, the salvage value of an asset is its remaining value after depreciation. This is also known as residual value or scrap value. It is the net cash inflow that occurs when the asset is liquefied at the end of its life. Salvage value can be negative if the residual asset requires special treatment to terminate—for example, used nuclear materials.

In economics, depreciation is the decrease in the economic value of the capital stock of a firm, nation or other entity, either through physical depreciation, obsolescence or changes in the demand for the services of the capital in question. If capital stock is C_0 at the beginning of a period, investment is I and depreciation D, the capital stock at the end of the period, C_1, is C_0 + I - D.

Accounting

A company needs to report depreciation accurately in its financial statements in order to achieve two main objectives: 1) to match its expenses with the income generated by means of those expenses, and 2) to ensure that the asset values in the balance sheet are not overstated. An asset acquired in Year 1 is unlikely to be worth the same amount in Year 5.

Depreciation is an estimated or expected view of the decline in value of an asset. For example, an entity may depreciate its equipment by 15% per year. This rate should be reasonable in aggregate (such as when a manufacturing company is looking at all of its machinery), and consistently employed. However, there is no expectation that each individual item declines in value by the same amount, primarily because the recognition of depreciation is based upon the allocation of historical costs and not current market prices.

Accounting standards bodies have detailed rules on which methods of depreciation are acceptable, and auditors will express a view if they believe the assumptions underlying the estimates do not give a true and fair view.

Recording depreciation

For historical cost purposes, assets are recorded on the balance sheet at their original cost; this is called the historical cost. Historical cost minus all depreciation expenses recognized on the asset since purchase is called the book value. Depreciation is not taken out of these assets directly. It is instead recorded in a contra asset account: an asset account with a normal credit balance, typically called "accumulated depreciation". Balancing an asset account with its corresponding accumulated depreciation account will result in the net book value. The net book value will never fall below the salvage value, meaning that once an asset is fully depreciated, no further expenses will be taken during its life. Salvage value is the estimated value of the asset at the end of its useful life. In this way, total depreciation for an asset will never exceed the estimated total cash outlay (depreciable basis) for the asset. The exception to this is in many price-regulated industries (public utilities) where salvage is estimated net of the cost of physically removing the asset from service. If the expected cost of removal exceeds the expected raw (or gross) salvage, then the net of the two (called net salvage) may be negative. In this case, the depreciation recorded on the regulated books may exceed the depreciable basis. Companies have no obligation to dispose of depreciated assets, of course, and many fully depreciated assets continue to generate income.

Recording a depreciation expense will involve a credit to an accumulated depreciation account.So the corresponding debit will involve either an expense account or an asset account which represents a future expense, such as work in progress. Depreciation is recorded as an adjusting journal entry.

A write-down is a form of depreciation that involves a partial write off. Part of the value of the asset is removed from the balance sheet. The reason may be that the book value (accounted value) of the fixed asset has diverged from the market value and causes the company a loss. An example of this would be a revaluation of goodwill on an acquisition that went bad.

Methods of depreciation

There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.

Straight-line depreciation

Straight-line depreciation is the simplest and most often used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life), and will expense a portion of original cost in equal increments over that period. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero. Salvage value is scrap value, by another name. Straight-Line Method:
mbox{Annual Depreciation Expense} = {mbox{Cost of fixed asset} - mbox{Scrap Value} over mbox{Life span} (years)}
For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a salvage value of US$2000, will depreciate at US$3,000 per year: ($17,000 - $2,000)/ 5 years = $3,000 annual straight-line depreciation expense. In other words, it is the depreciable cost of the asset divided by the number of years of its useful life.

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.

Book Value -
Beginning of Year
Depreciation
Expense
Accumulated
Depreciation
Book Value -
End of Year
$17,000 (Original Cost) $3,000 $3,000 $14,000
$14,000 $3,000 $6,000 $11,000
$11,000 $3,000 $9,000 $8,000
$8,000 $3,000 $12,000 $5,000
$5,000 $3,000 $15,000 $2,000 (Scrap Value)

If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess would be considered a gain and subject to the depreciation recapture rule. 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 (at a point in time) between the taxation department's and company's view of the profit.

Declining-Balance Method

Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decreasing charges in subsequent years are called accelerated depreciation methods. This may be a more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are new. One popular accelerated method is the declining-balance method. Under this method the Book Value is multiplied by a fixed rate.

Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year

The most common rate used is double the straight-line rate. For this reason, this technique is referred to as the double-declining-balance method. To illustrate, suppose a business has an asset with $1,000 Original Cost, $100 Salvage Value, and 5 years useful life. First, calculate straight-line depreciation rate. Since the asset has 5 years useful life, the straight-line depreciation rate equals (100% / 5) 20% per year. With double-declining-balance method, as the name suggests, double that rate, or 40% depreciation rate is used.

The table below illustrates the double-declining-balance 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 Salvage Value, or Scrap Value.

Book Value -
Beginning of Year
Depreciation
Rate
Depreciation
Expense
Accumulated
Depreciation
Book Value -
End of Year
$1,000 (Original Cost) 40% $400 $400 $600
$600 40% $240 $640 $360
$360 40% $144 $784 $216
$216 40% $86.40 $870.40 $129.60
$129.60 $129.60 - $100 $29.60 $900 $100 (Scrap Value)

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. The process continues until the Salvage Value, or the end of the asset's useful life, is reached. In the last year of depreciation a subtraction might be needed in order to prevent Book Value from falling below estimated Scrap Value.

Since declining-balance depreciation doesn't 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.

Activity depreciation

Activity depreciation methods are not based on time, but on a level of activity. 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: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the depreciation expense is then calculated by multiplying the rate by the actual activity level.

Sum-of-Years' Digits Method

Sum-of-Years' Digits is a depreciation method that results in a more accelerated write-off than straight line, but less than declining-balance method. Under this method annual depreciation is determined by multiplying the Depreciable Cost by a schedule of fractions.

Depreciable Cost = Original Cost - Salvage Value

Book Value = Original Cost - Accumulated Depreciation

Example: If an asset has Original Cost $1000, a useful life of 5 years and a Salvage Value of $100, compute its depreciation schedule.

First, determine Years' digits. Since the asset has 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

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.

Book Value -
Beginning of Year
Total
Depreciable
Cost
Depreciation
Rate
Depreciation
Expense
Accumulated
Depreciation
Book Value -
End of Year
$1,000 (Original Cost) $900 5/15 $300 ($900 * 5/15) $300 $700
$700 $900 4/15 $240 ($900 * 4/15) $540 $460
$460 $900 3/15 $180 ($900 * 3/15) $720 $280
$280 $900 2/15 $120 ($900 * 2/15) $840 $160
$160 $900 1/15 $60 ($900 * 1/15) $900 $100 (Scrap Value)

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. Annual depreciation is computed in three steps.

First, a Depreciable Cost is computed.

Depreciable Cost = Original Cost - Salvage Value.

Second, Depreciation per Unit is computed. Depreciation charge per unit is computed by dividing Depreciable Cost by Total Units, expected to be produced during the useful life of the asset.

Depreciation per Unit = Depreciable Cost / Total Units of production

Third, annual depreciation, or Depreciation Expense, by another name, is computed. Depreciation Expense equals Depreciation per Unit multiplied by the number of units produced during the year. Depreciation Expense = Depreciation per Unit * Units produced during the Year.

Book Value, as always, is calculated by subtracting Accumulated Depreciation from the Original Cost.

Book Value = Original Cost - Accumulated Depreciation

Suppose, an asset has Original Cost $70,000, Salvage Value $10,000, and is expected to produce 6,000 units.

Depreciable Cost = ($70,000-$10,000) $60,000

Depreciation per Unit = ($60,000 / 6,000) = $10

The table below illustrates the Units-of-Production depreciation schedule of the asset.

Book Value -
Beginning of Year
Units of
Production
Depreciation
Cost per Unit
Depreciation
Expense
Accumulated
Depreciation
Book Value -
End of Year
$70,000 (Original Cost) 1,000 $10 $10,000 $10,000 $60,000
$60,000 1,100 $10 $11,000 $21,000 $49,000
$49,000 1,200 $10 $12,000 $33,000 $37,000
$37,000 1,300 $10 $13,000 $46,000 $24,000
$24,000 1,400 $10 $14,000 $60,000 $10,000 (Scrap Value)

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 to the Original Cost.

Units of time depreciation

Units of Time Depreciation is similar to units of production, and is used for depreciation equipment used in mine or natural resource exploration, or cases where the amount the asset is used is not linear year to year.

A simple example can be given for construction co, where some equipments are used only for some specific usage. Depending on the number of projects the equipment will be used and depreciation charged accordingly.

Group Depreciation Method

Group Depreciation method is used for depreciating multiple-asset accounts using straight-line-depreciation method. Assets must be similar in nature and have approximately the same useful lives.
Asset Historical
Cost
Salvage
Value
Depreciable
Cost
Life Depreciation
Per Year
Computers $5,500 $500 $5,000 5 $1,000

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. (0.20 * $6,500) $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.

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 to 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. Creators of accounting rules sometimes are very creative, as was noted on the discussion forum of Accounting Coach at

Taxes

When a company spends money for a service or anything else that is short-lived, this expenditure is usually immediately tax deductible in some countries, and the company enjoys an immediate tax benefit.

To be eligible for depreciation, an asset must have two features: (1) it has a useful life beyond the taxable year (essentially why it was capitalized in the first place), and (2) it wears out, decays, declines in value due to natural causes, or is subject to exhaustion or obsolescence.

Therefore, when a company buys an asset that will last longer than one year, like a computer, car, or building, the company cannot immediately deduct the cost and enjoy an immediate tax benefit. Instead, the company must depreciate the cost over the useful life of the asset, taking a tax deduction for a part of the cost each year. Eventually the company does get to deduct the full cost of the asset, but this happens over several years. In the US, the IRS's depreciation schedule for any given class of asset is fixed, and is related to typical durability. A computer may depreciate completely over five years; a nonresidential building, usually 39 years. The maximum allowable useful life under US income tax regulations is 40 years. Though the IRS does allow a small choice of permutations for depreciation life and acceleration, it does not allow a taxpayer to invent any arbitrary asset life. Other countries have other systems, many simply eliminate all choice altogether. In these jurisdictions accounting depreciation and tax depreciation are almost always significantly different numbers, as in many instances a form of "accelerated depreciation" can be used for tax purposes to lower (taxable) net income in a given period (or, in some instances, a fixed asset may be allowed to be expensed for tax purposes; Section 179 of the Internal Revenue Code allows for this treatment in some circumstances). Technically, these are not considered "tax reductions" but tax deferrals: lowering taxable income now by increasing expenses should increase future taxable income (and taxes) at a later date.

Importantly, no depreciation deduction is allowed for inventories or other property held for sale to customers in the ordinary course of business (Treas. Reg. § 1.167(a)-2 and Thor Power Tool Company v. Commissioner). Land is also not depreciable (Treas. Reg. § 1.167(a)-2). However, improvements to land are usually depreciable, including landscaping.

In the US, there are generally five variables that a taxpayer must take into account when computing the correct depreciation deduction. These variables include: (1) the depreciation base (the asset’s cost basis), (2) the asset’s class life (estimated life expectancy of the asset), (3) the applicable recovery period (the number of years the taxpayer can claim depreciation deductions), (4) the applicable depreciation method (see double declining balance method or straight-line method), and (5) the applicable convention (§ 168(d)(4) of the code—generally the half-year convention).

Economics

In economics, the value of a capital asset is equal to the present value of the flow of services the asset will generate in future, appropriately adjusted for uncertainty. Economic depreciation over a given period is the reduction in the remaining value of future services.

Under certain circumstances, such as an unanticipated increase in the price of the services generated by an asset, its value may increase rather than decline. Depreciation is then negative.

National accounts

In national accounts, depreciation represents the decline in the aggregate capital stock arising from the use of capital in production, also referred to as consumption of fixed capital. Hence, depreciation is equal to the difference between aggregate (gross) investment and net investment or between Gross National Product and Net National Product. Unlike depreciation in business accounting, depreciation in national accounts is, in principle, not a method of allocating the costs of past expenditures on fixed assets over subsequent accounting periods. Rather, fixed assets at a given moment in time are valued according to the remaining benefits derived from their use.

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