Depreciation – Formula | Types – Every Company or firm manufacture some goods or provides some services. Companies like Apple, L.G, and Pepsi manufactures goods like Mobile phones, electrical goods, and beverages respectively. Whereas, Companies like Mckinsey, J.P Morgan & etc. provides various financial and other services to their customers. Goods and services are provided by the company with help of Plants & Machinery, Computer, and software and other kinds of assets. All the assets like human have a finite lifespan. Some assets can last for 5 years while others may last for 10 years and so on. Just like human whose health starts deteriorating as he grows old, in the similar way output delivered by the assets starts diminishing with the passage of time. To put simply, this reduction of the value of the asset is known as depreciation.
In this complete guide to depreciation, we look at the following –
- What is Depreciation in Accounting?
- Causes of depreciation
- #1 – Straight line depreciation
- #2 – Double Declining Method of Depreciation
- #3 – Unit of production depreciation method
- #4 – Sum-of-years digits Depreciation Method
- Straight Line vs Accelerated Depreciation – Impact on Financial Statements
- Points to Note – Financial Statements Impact of Depreciation
- US GAAP and Depreciation
- What is Accumulated Depreciation?
- Differences between Amortization and Depreciation
- Disclosure Requirements of Depreciation
- Impact of Inflation on Depreciation
What is Depreciation in Accounting?
In accounting and finance, depreciation refers to the method of allocating the cost of a tangible asset over its useful life. There are various methods for calculating the amount which we will see later in the article, but let us get a brief understanding of how it works with the help of the following illustration.
Company X Inc. starts manufacturing aerated beverages in the year 2016. It has bought bottling machine at a cost of $ 10 MN. Plant supervisor Mr. Trevor has conducted a technical feasibility of bottling machine and believes that it will last for 10 years with no salvage value. What should be the amount of depreciation that should be charged every year in the books of accounts?
For simplicity let us assume that plant will perform evenly throughout its economic life.
- Bottling machine cost: $ 10 MN.
- Estimated life: 10 years
- Depreciation amount for each year = (Cost – salvage value)/ Useful life of asset in years
- = (10,000,000 – 0)/10 = 1,000,000
The company will charge $1,000,000 each year till ten years. At the end of 10 years, the entire cost of the asset would have been charged off. Hence, we can say that depreciation is a systematic allocation of the cost of tangible assets over its useful life.
Causes of depreciation
- Physical deterioration or wear and tear – As the assets are used their performance and quality beings to decline. Physical deterioration is also caused due to the non-judicious use of the assets. When the asset is used, wear and tear also take place from erosion, dust and decay, and etc. Exposure of assets to forces of nature like wind, rain, and sun also form an important factor in causing physical deterioration and wear and tear. No matter how much care or precaution is employed by its user, it is impossible to preserve the original form and quality of the asset.
- Obsolescence – Obsolescence means becoming outdated or obsolete. We live in the age of technology. New technologies emerge within a quick span of time. New and improved technologies make the old products outdated. We can see what the launch of I-Phone 7 has done to its predecessor I-Phone 6. I-Phone 6 has been rendered obsolete by I-Phone 7. An old machinery though in good shape may be rendered obsolete by the introduction of new technologies.
- Inadequacy – Inadequacy refers to the inability to use the same asset due to growth and change in the size of the firm. The company which manufactures 2,000 units of mobile phones will have to employ new and improved machinery if it sales increases to 10,000 units.
- Accidents – To err is human. And when human err it causes an accident. No matter how much precautions and quality checks are employed by the company, some accidents are bound to happen.
All the above-mentioned factors highlight the reason which causes depletion in the value of assets in use. These depletions in value may happen in one year or gradually throughout the economic life of the asset. To record these decline in value company makes provision for depreciation every year. There are various methods for calculating the amount. Let us look at some of the prominent ones.
#1 – Straight line depreciation
It is the simplest and most used method for calculation. Illustration 1 above depicts the straight line method. In Straight line method, a constant depreciation amount is charged every year. Corporations have to estimate the residual value which represents the value which the company expects to recover at the end of useful life of the machine.
Formula for SLM = (Cost of fixed asset – Residual value)/ Useful life in years
Implications of Straight Line method of depreciation
- Pre-dominant accounting method of depreciation in the US and other countries
- Results in increasing rate of return rather than actual rate of return over the life of the asset
- Fixed/ constant cash outflows over the useful life of the asset
- Simple to understand and implement
#2 – Double Declining Method of Depreciation
It is also known as an accelerated method of depreciation. In this method, depreciation is double of that of straight line method. However, it is slightly more complicated than the straight line method. Let’s look at how it works with the help of an illustration.
Company X Inc. has bought the bottling machine at a cost of $ 10 MN. Plant supervisor Mr. Trevor has conducted a technical feasibility of bottling machine and believes that diminishing balance method will be most suited for it for the purpose of depreciation. Expected economic life of an asset is 5 years.
Straight Line Deprecation = 1/5 = 20% each year
Double Declining is 2 x Straight Line = 2 x 20% = 40%.
|Year||Value of asset (1)||Rate of depreciation (2)||Depreciation amount (1) * (2)||Net Book Value|
If you look at the fifth year of depreciation it stands at $1,296,000. Please note that in the last year, the asset gets depreciated fully (salvage value is zero).
Accelerated Depreciation and Taxes
- The primary driver of appreciated depreciation adopted by firms tax benefits
- Depreciation acts as a tax shield in a given period of time
- Cash flows are better off in initial years under the accelerated depreciation method
- Regulators often allow this method of to increase investments in the economy
#3 – Unit of production depreciation method
In the unit of production method, depreciation is charged according to actual usage of the asset. This is similar to the straight-line method except for that life of the asset is estimated based on the activity driving the asset like a number of machine hours, the number of setups, the number of units produced and etc.
Depreciation using Units of Production = (Number of units produced in a given year / Total number of units produced during entire life) x Cost of asset
Implications of Unit of Production Depreciation Method
- Decreases depreciation in periods of low productivity and hence overstates income and asset valuesMisrepresents business reality when competition with higher productivity comes into play
- Misrepresents business reality when competition with higher productivity comes into playResults in restructuring charges when the
- Results in restructuring charges when the overvalued assets are subsequently revalued. From an analysts point of view, these would be non-recurring charges and hence excluded
- From an analysts point of view, these would be non-recurring charges and hence excluded
However, adjustment to earnings estimates should be moderated to suit past over statements
Example of Unit of Production Depreciation Method
Company X Inc. has bought the bottling machine at a cost of $ 10 MN. Plant supervisor Mr. Trevor has conducted a technical feasibility of bottling machine and believes that unit of production method is most suited. Expected economic life of an asset is 5 years during which it will produce 100,000 units, 200,000 units, 300,000 units, 400,000 units and 500,000 units in year 1, year 2, year 3, year 4 & year 5 respectively. Compute the amount of depreciation for each of the five years.
|Time period||Value of asset (1)||Number of units to be produced (2)||Depreciation amount||Value of asset at end|
At the end year 5, we can see that asset accumulated depreciation (1,00,00,000) is equal to its total cost (1,00,00,000). Depreciation depends on upon the number of units produced by the machine. We can see that the maximum depreciation expense is in year 5 when machine produces 500,000 units, and lowest is in year 1 when the machine produced 100,000 units.
#4 – Sum-of-years digits Depreciation Method
The sum of years’ digits method is also an accelerated method of Depreciation. In this method, most of the depreciation is recognized in the first few years of its useful life. Depreciation is calculated based on the sum of years’ digits for each year of its useful life. For e.g. if the asset useful life if 5 years, sum of digits would be = 15 (5 + 4 + 3 +2 +1)
if the asset useful life if 5 years, sum of digits would be = 21 (6+5 + 4 + 3 +2 +1)
Implications of Sum of Year Digits Method
- Benefits from an asset decline over time and hence depreciation is adjusted to match the same
- Inflationary effect on the cost of repairs and maintenance is taken care of by allocating higher
depreciation in the initial years
- Difficulty in estimating efficiency of assets as well as costs of repairs and maintenance
Example – Sum of Year Digits Method
Company X Inc. has bought the bottling machine at a cost of $ 10million. Plant supervisor Mr. Trevor has conducted a technical feasibility of bottling machine and believes that the sum of digits method will be most suited for it for the purpose of depreciation. Expected economic life of an asset is 5 years. Compute the depreciation.
|Years||Useful life remaining (A)||Sum of digits (B)||Depreciation base C= ( A) / (B)||Depreciation rate D=C*100||Annual depreciation|
Total Depreciation = $10million
Straight Line vs Accelerated Depreciation – Impact on Financial Statements
For understanding the impact of depreciation methodology on the Financial Statements, let us take a very basic example.
Let us assume that both Company A and B are exactly the same in terms of everything (except for that of depreciation). We assume that the only change in the depreciation of the two companies
- Company A uses Straight line method of depreciation with the following depreciation profile.
- Year 1 – $100, Year 2 – $100, Year 3 – $100, Year 4 – $100 and Year 5 – $100
- Company B uses accelerated depreciation method with the following depreciation expense
- Year 1 – $150, Year 2 – $120, Year 3 – $100, Year 4 – $75 and Year 5 – $50
- Please note that total depreciation charge is same for both Company A and B. the only
Also, note that accelerated depreciation method charges a higher amount in initial years and a lower amount in the final years.
Below is the Income Statement of Company A and B.
Year 1 – Income Statement
As we note from the above table, that the depreciation policies used are different for both the companies. This results in a higher EBIT, EBT and Net Income for Company A as compared to company B. Please note that all items above depreciation like EBITDA and Gross Margins remain unaffected and are same for both the companies.
Below is the differences in Profitability Margins of Company A and B
Let us now look at how the Profitability margins differ as time progresses.
For Year 5, we assume that all financial parameters are same except for depreciation.
Company A – Year 5 depreciation is $100 (Straight Line) and Company B – year 5 depreciation is $50 (Accelerated Depreciation).
Year 5 Income Statement and Margins
As we can see from above that in Year 5, the EBIT Margins, EBT Margin and Profit Margin as higher for Company B as compared to Company A.
Points to Note – Financial Statements Impact of Depreciation
- Significant impact on both Income Statement and Balance Sheet for capital intensive firms
- Accelerated Depreciation methods tend to depress both net income and shareholder’s equity in the initial years as compared to the Straight Line method
- Also, return ratios are lower when Accelerated Depreciation methods are used, hence more conservative
- The impact, however, reverses in the later years with lower depreciation expense
- A firm with high capital expenditures may take a conservative approach of adopting the Accelerated Depreciation approach as lower depreciation on aging assets is compensated by higher depreciation on new assets
- Choice of useful life and salvage value also impact the depreciation expense as well as the stated asset values
- Shorter useful lives and lower salvage values would result in higher depreciation
- Higher depreciation expense subdues the return ratios, an analyst should take care of this while comparing firms with different depreciation methods
- Conservative Depreciation methods also increase the Asset Turnover Ratio. It may be advisable to calculate Fixed Assets Turnover Ratios using Gross Fixed Asset Investment as a denominator.
US GAAP and Depreciation
We have seen above four most commonly used method of depreciation used by Companies. Above methods are not exhaustive but are only illustrative. There are various methods of depreciation apart from the above like units of time , Group method, composite method and etc. The selection of the method is not only dependent on the nature of assets but also on a number of other factors like accounting policies, regulatory requirement, inflation, and etc.
Accounting concept defines the depreciation as a systematic allocation of the cost of an asset over its estimated useful life. Assets are recognized in the books of account on the basis of historical cost. Historical cost is significantly different from the fair value as the historical cost reflect the price that was paid for purchasing the asset. Whereas on the other hand, fair value reflects the market or current price of an asset. Though there is a concept of revaluation of assets in US GAAP which if used will reflect the fair value of assets but revaluation concept is hardly used due to its complexities and time-consuming approach.
In order to calculate depreciation, companies first determine the depreciable base of an asset (Difference between an asset’s cost and its salvage value). U.S GAAP allows a number of depreciation methods that companies may choose depending nature of the asset and the management decision about capital investment and replacement cost.
Depreciation charge is recorded in each accounting period. It is reported in both the income statement and the balance sheet. It is also to be reported in the cash flow statement.
What is Accumulated Depreciation?
Accumulated depreciation is the cumulative amount from the year of its purchase till the current year. In the Balance sheet, the cost of an asset has to be deducted from the amount of accumulated depreciation. An asset’s carrying value on the balance sheet is the difference between its purchase price and accumulated depreciation.
Assets are can be grouped into two types of assets – One that is expenses during the year of its purchase (Inventory and other operating assets) and those that are long-lived (Computer, machinery and etc.) Accumulated depreciation will be realized only in case of the long-lived asset.
Differences between Amortization and Depreciation
The concept of amortization and depreciation are exactly similar except for one minor and vital difference. Amortization refers to the process of allocating the cost of an intangible asset over a period of time. Whereas depreciation refers to the process of allocating the cost of a depreciable asset over a period of time. Intangible assets are assets that are not physical in nature. Software, Copyrights, patents and Goodwill are some of the most commonly found intangible assets in the balance sheet of any Company. Unlike depreciation which can be computed by various methods, amortization expense has to be based on the estimated useful life of the asset.
Disclosure Requirements of Depreciation
As the choice of depreciation method can impact the pattern of reported income
- Disclosures are made as foot-notes in the section listing accounting policies
- Most American firms use Straight Line method while Accelerated method is popular in other countries
source: Ford SEC Filings
- Disclosures are required in order to have comparability of a firm over a period of time OR with the peer group
- Management disclosures on Useful Life and Salvage Value are usually vague
- Useful life is ill-defined and an excessively long life estimation can overstate profitability
- Salvage Value estimates can vary widely and a high Salvage Value would understate depreciation
Analysts should be able to arrive at an approximate value based on provided information
Impact of Inflation on Depreciation
- Depreciation is provided based on historical costs in order to replace the asset at a future date
- Replacement cost of the assets are assumed to be constant resulting in insufficient funds to
replace the asset in case of cost appreciation
- Accelerated depreciation methods are better off as cost recovery is higher in the initial years thereby shortening the overall recovery period
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Depreciation is the charge on the use of the asset. But it is quite different from other operating expenses. For operating expenses like rent, salaries, and etc. cash has to be incurred. There is always an outflow of cash whenever company incurs any expense. But in depreciation, there is no outflow of resources. It is a non-cash expenditure. Hence, wherever important financial decisions are taken, an important consideration has to be taken on the inclusion or exclusion of depreciation. Most commonly used benchmark for judging the profitability of the company is EBITDA (Earnings before interest, tax, depreciation and amortization) which excludes the impact of depreciation. Despite being a non-cash expenditure, it cannot be overlooked because true profits have to consider an impact of depreciation.