What is Depreciation?

Depreciation refers to two very different but related concepts:

the decline in value of assets (fair value depreciation), and

the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle).

The former affects values of businesses and entities. The latter affects net income. Generally the cost is allocated, as depreciation expense, among the periods in which the asset is expected to be used. Such expense is recognized by businesses for financial reporting and tax purposes. Methods of computing depreciation may vary by asset for the same business. Methods and lives may be specified in accounting and/or tax rules in a country. Several standard methods of computing depreciation expense may be used, including fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service. Example: a depreciation expense of 100 per year for 5 years may be recognized for an asset costing 500.

In economics, depreciation is the gradual and permanent 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 C₀ at the beginning of a period, investment is I and depreciation D, the capital stock at the end of the period, C₁, is C₀ + I – D.

Accounting concept

In determining the profits (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 currently consumed in the activity. Such costs must be allocated to the period of use. The cost of an asset so allocated is the difference between the amount paid for the asset and the amount expected to be received upon its disposition. Depreciation is any method of allocating such net cost to those periods expected to benefit from use of the asset. The asset is referred to as a depreciable asset. Depreciation is a method of allocation, not valuation.

Any business or income producing activity using tangible assets may incur costs related to those assets. Where the assets produce benefit in future periods, the costs must be deferred rather than treated as a current expense. The business then records depreciation expense as an allocation of such costs for financial reporting. The costs are allocated in a rational and systematic manner as depreciation expense to each period in which the asset is used, beginning when the asset is placed in service. Generally this involves four criteria:

• cost of the asset,
• expected salvage value, also known as residual value of the asset,
• estimated useful life of the asset, and
• a method of apportioning the cost over such life.

 

Depreciable basis

Cost generally is the amount paid for the asset, including all costs related to acquisition. In some countries or for some purposes, salvage value may be ignored. The rules of some countries specify lives and methods to be used for particular types of assets. However, in most countries the life is based on business experience, and the method may be chosen from one of several acceptable methods.

Net basis

When a depreciable asset is sold, the business recognizes gain or loss based on net basis of the asset. This net basis is cost less depreciation.

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.

Depletion and amortization

Depletion and amortization are similar concepts for mineral assets (including oil) and intangible assets, respectively.

Effect on cash

Depreciation expense does not require current outlay of cash. However, the cost of acquiring depreciable assets may require such outlay. Thus, depreciation does not affect a statement of cash flows, but cost of acquiring assets does.

Historical cost

Depreciation is generally recognized under historical cost systems of accounting. Some proposals for fair value accounting have no provision for systematic depreciation expense.

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 depreciation, 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 another account.

Without 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. 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 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 or even negative. Salvage value is also known as scrap value or residual value.

Straight-line method:

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.

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 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 (at a point in time) between the taxation department’s and company’s view of the profit.

Declining-balance method (or Reducing 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.

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. 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 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.

It is possible to find a rate that would allow for full depreciation by its end of life with the formula:

,

where N is the estimated life of the asset (for example, in years).

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 of $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

The sum of the digits can also be determined by using the formula (n²+n)/2 where n is equal to the useful life of the asset. The example would be shown as (5²+5)/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.

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 = ($70,000−10,000) / 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.

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.