Depreciation

Image:DecliningBalanceDepreciation.png
Declining-balance depreciation of a $50,000 asset with$6,500 salvage value over 20 years.

Depreciation is a term used in accounting, economics and finance with reference to the fact that assets with finite lives lose value over time. (There is also a separate use in international finance to refer to a reduction in the exchange rate of a currency - see devaluation).

In accounting, depreciation is a term used to describe any method of attributing the cost of an asset across the useful life of the asset. Depreciation 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 "wear and tear", obsolescence, or impairment on an asset, but these issues, where seen as significant enough to account for, are handled through an asset revaluation reserve. The use of depreciation affects the financial statements and in some countries the taxes of companies and individuals. 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 affect the cash flow of a company, as both are accounting representations of expenses attributable to a given period. In accounting statements, depreciation may either not figure in the cash flow statement, or may be "added back" to net income (along with other items) to derive the operating cash flow.

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. First, to match its expenses with the income generated by means of those expenses. Second, 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 average 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), but there is no expectation that each individual item declines in value by the same amount.

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 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. Companies have no obligation to dispose of depreciated assets, of course, and many depreciated assets continue to generate income.

Recording a depreciation expense will involve a credit to an accumulated depreciation account. The corresponding debit will involve either an expense account or an asset account which represents a future expense, such as work in process. 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. An example of this would be a removal of goodwill from 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 after the length of time over which it is depreciated, and assumes the drop in the asset's value is in equal, constant yearly increments over that amount of time. 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. 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 − (5 x $3000)) =$2000 In other words it is the cost of the assets divided by number of year of its useful life. If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess depreciation would be considered as income by the tax office (capital gains). If the sales price is less than the book value, the resulting capital loss is tax deductible.

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.

Sinking fund method

A method of depreciation under which the depreciation expense is an amount of an Annuity so that the amount of the annuity at the end of the useful life would equal the Acquisition Cost of the asset. Theoretically, the depreciation charge should include interest on accumulated depreciation at the beginning of the period. This method is rarely used in practice. The sinking fund method allocates more depreciation to the later years.

The depreciation for the first year equals the annual deposit needed for a sinking fund to accumulate at the given rate to an amount that equals the depreciation base.

Then for each consecutive year, the annual depreciation equals the annual sinking fund deposit plus the interest earned on the fund up to that year.

Declining-balance depreciation

As declining-balance method is a type of accelerated depreciation, because it recognizes a higher depreciation cost earlier in an asset's lifetime. This may be a more realistic reflection of an asset's actual resale value, as well as the expected benefit from the use of the asset: many assets are most useful when they are new. In the U.S., a form of double declining-balance depreciation, MACRS, is used for tax purposes and is based on time.

In declining-balance depreciation, each period's depreciation is based on the previous year's net book value, the estimated useful life, and a factor. The factor is commonly two; this is known as double declining-balance. Each period we calculate depreciation:

$\mbox{Depreciation expense} = \mbox{Previous period NBV} \times {\mbox{factor} \over N}$

For the double-declining balance method, using the vehicle example from above, we compute the depreciation after the first year:

$\mbox{Previous period NBV} \times {\mbox{factor} \over N} = \17000 \times {2 \over 5} = \6800$

 Sum of years digits depreciation

Sum of Years Digits is a historical depreciation method that results in a more accelerated write off than straight line, but less than declining balance or later methods. Salvage value is counted in the method. There are no property classes of later methods.

• Given;
• N = Depreciable life of asset
• B = Cost basis
• S = Salvage value
• D(t) = Depreciation charge for year t
• $\mathrm{Sum}={N (N+1) \over 2}$
• $D(t)=(N-t+1) \times {(B-S) \over Sum}$

Example: If an asset costs $1000, has a depreciable life of 5 years and a salvage value of$90, compute its depreciation schedule.

 Year D(t) Sum of D(t) Remaining Book Value 1 $303$303 $697 2$242 $546$454 3 $182$728 $272 4$121 $849$151 5 $61$910 \$90

The equation for year 1 would look like this:

$D(t)=(5-1+1) \times {(1000-90) \over {5 (5+1) \over 2}} = 303.33$

Note: Most depreciation schedules round to the nearest dollar.

 Units of Production depreciation

Units of Production depreciation is used in the U.S. in cases where MACRS is inappropriate, and the value to depreciate is based in the asset, such as a mine or natural resources. The method calculates the depreciation based on the units of the asset place in service as compared to the total units of the asset.

 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.

Taxes

When a company spends money for a service or anything else that isn't a tangible asset, this expenditure is usually immediately tax deductible, and the company enjoys an immediate tax benefit.

However, when a company buys some physical 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; the number of years depends on an estimate of how long it typically takes that type of asset to become effectively useless, and require a replacement. A computer may depreciate completely over five years; a factory building, over 30 years. The maximum allowable useful life estimate under U.S. income tax regulations is 40 years. Other countries have other systems, many of which remove the choice of depreciation rate and method from the company 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.

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 declining. 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.