Depreciation

Depreciation Meaning

Depreciation in accounting refers to an indirect and explicit cost that a company incurs every year while using a fixed asset such as equipment, machinery, or expensive tools. It is the depleting value of a tangible asset.

The value of the assets gets depleted due to constant use for business purposes. Companies depreciate to account for this value throughout the useful life of that asset. It is a fixed cost for the companies, and the amount depreciated can be used to purchase new machinery after the old one turns into a scrap. Also, it is seen as a business expense despite being a non-cash expense.

Key Takeaways
  • Depreciation is a non-cash business expense incurred by a company for employing a tangible asset like machinery, tools, and equipment for business use.
  • It is accounted for throughout the asset’s life expectancy. After that, the asset is discarded at salvage or residual value.
  • Companies depreciate assets using these five methods: straight-line, declining balance, double-declining balance, units of production, and sum-of-years digits.
  • In the balance sheet, the amount shown as a depreciation expense charged goes into the accumulated depreciation account.

Depreciation

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Depreciation in Accounting Explained

Companies depreciate to allocate the cost of a tangible assetTangible AssetAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets. For example, a company's land, as well as any structures erected on it, furniture, machinery, and equipment.read more, over its useful lifeUseful LifeUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets.read more. When the asset is used, wear and tear occur from erosion, dust, and decay. Despite proper maintenance and precaution, it is impossible to preserve the original form and quality of the asset. Therefore, depreciation expense is used to recognize the amount of wear and tear. Firms depreciate because the technology used in the machine may become obsolete, or the asset may become inoperable due to an accident.

In depreciation, there is no cash outflow. Instead, while accounting, this expense is transferred to the accumulated depreciationAccumulated DepreciationThe accumulated depreciation of an asset is the amount of cumulative depreciation charged on the asset from its purchase date until the reporting date. It is a contra-account, the difference between the asset's purchase price and its carrying value on the balance sheet.read more. It is an essential part of accounting that facilitates companies to record the real-time book valueBook ValueThe book value formula determines the net asset value receivable by the common shareholders if the company dissolves. It is calculated by deducting the preferred stocks and total liabilities from the total assets of the company.read more of tangible assets. Also, this sum can be used for purchasing a new asset in the future. Now, let us understand some of the terminologies used in this concept:

  • Fixed Asset Cost: It is the cost at which the organization buys a tangible asset.
  • Salvage Value: The residual cost can be recovered from selling the asset after its useful life.
  • Useful Life of Fixed Asset: It is the estimated number of years for which an asset remains productive and efficient.
  • Depreciation Rate: It is the percentage charged as depreciation on the fixed asset.

Types of Depreciation Methods

All tangible assets depreciate with time. Therefore, firms use the following five methods to charge for it.  

Types of Depreciation

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#1 – Straight-Line Method (SLM)

This is the simplest method of calculating used most of the time. In SLM, a constant depreciation amount is charged every year. First, corporations have to estimate the salvage (residual) value. The salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000.read more represents the cost the company expects to recover at the end of the machine’s useful life. After deducting this residual value from the fixed asset cost, the value acquired is divided by the useful life of the fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more.

Straight-Line Method Formula:

Straight-Line Method Formula

#2 – Declining Balance Method

In this method, the depreciated percentage is charged on the net book value of a fixed asset. This netbook value is the remaining balance of fixed asset cost after deducting the overall depreciation charged for the previous years. Thus, the depreciable value diminishes every year, and so does the depreciated expense.

Declining Balance Method Formula:

Declining Balance Method Formula

#3 – Double Declining Balance Method

This method works similar to the declining balance methodDeclining Balance MethodIn declining balance method of depreciation or reducing balance method, assets are depreciated at a higher rate in the initial years than in the subsequent years. A constant depreciation rate is applied to an asset’s book value each year, heading towards accelerated depreciation.read more; however, it charges double the depreciated rate on the fixed asset’s balance or net book value. Therefore, it is also known as an accelerated methodAccelerated MethodAccelerated depreciation is a way of depreciating assets at a faster rate than the straight-line method, resulting in higher depreciation expenses in the early years of the asset's useful life than in the later years. The assumption that assets are more productive in the early years than in later years is the main motivation for using this method. read more.

Double Declining Balance Method Formula:

Double Declining Balance Method Formula

#4 – Units of Production Method

Under this method, the fraction of the number of fixed asset units (machinery) produced per year and the total number of units generated in a lifetime is multiplied with the fixed asset cost to yield the depreciated expense of each year. Hence, if the production decreases, the depreciated cost also steeps down and vice versa.

Units of Production Method Formula:

Units of Production Method Formula 1
Units of Production Method Formula 1-1

#5 – Sum-of-Years Digits Method

As the name indicates, this method takes the total useful years. Here the digits are arranged in descending order. Then the remaining number of useful years are divided by this sum and multiplied by 100 to get the depreciated rate for the particular year. Finally, the depreciated expense is computed by multiplying this rate with the remaining fixed asset cost after deducting the salvage value.

Sum-of-Years Digits Method Formula:

Depreciation: Sum-of-Years Digits Method Formula

Accounting Depreciation Calculation

Following are examples where the depreciated amount is calculated using different methods.

#1 – Straight-Line Method

XYZ Inc. is a manufacturer of aerated drinks. It bought a bottling machine worth $108000 in 2016. Titus, the plant supervisor, determined the technical feasibility test of the bottling machine. Titus believes it will last for 5 years with a salvage value of $8000. Find out the depreciated expense for each year using the straight-line method.

Given:

  • Cost of Bottling Machine = $108,000
  • Salvage Value = $8,000
  • Useful Life of Bottling Machine = 5 years

Solution:

Depreciation = (Cost of Bottling Machine – Salvage Value)/ Useful Life of Bottling Machine.

  • Depreciation = (108,000 – 8,000)/ 5
  • Depreciation = $20,000

#2 – Declining Balance Method

For the same example, what will be the depreciating expense if the company charges 20% per annum? Use the declining balance method.

Given:

  • Depreciating Rate = 20% p.a.
  • Solution:

Depreciation = (Net Book Value – Salvage Value) × Rate of Depreciation

Year Depreciable Asset Value ($) Depreciation Rate Depreciation Amount ($) Net Book Value ($)
2017108,000-8,000 = 100,00020%20,00080,000
201880,00020%16,00064,000
201964,00020%12,80051,200
202051,20020%10,24040,960
202140,96020%40,960

Note: The machinery will depreciate with the whole amount in 2025, i.e., in the last year of its useful life.

#3 – Double Declining Balance Method

Again, for the same example, assume that the company charges using the double-declining balance method. Determine the amount charged on the depreciating asset each year.

Depreciation = (Net Book Value – Salvage Value) × 2 × Depreciating Rate

New Depreciating Rate = 2×20% p.a. = 40% p.a.

Solution:

Year Depreciable Bottling Machine Value ($) Depreciation Rate Depreciation Amount ($) Net Book Value ($)
2017108,000-8,000 = 100,00040%40,00060,000
201860,00040%24,00036,000
201936,00040%14,40021,600
202021,60040%8,64012,960
202112,96040%12,960

Note: Here also, the machinery will depreciate with the whole amount in 2025, i.e., in the last year of its useful life.

#4 – Units of Production Method

In the above example, now assume that the bottling machine filled the following units of bottles for the respective years:

  • 14,600,000 bottles in 2020,
  • 15,700,000 bottles in 2021,
  • 12,400,000 bottles in 2022,
  • 14,900,000 bottles in 2023,
  • 13,500,000 bottles in 2024.

Here, the estimated lifetime bottling capacity of the machine is 100,000,000 bottles. Now, find out the depreciating amount using the units of production methodUnits Of Production MethodUnit of production depreciation is an activity method to ascertain asset value through its usage. It is evaluated as the multiplication of depreciation rate per unit and units produced per year, where depreciation per unit is the asset's cost minus salvage value divided by a particular year's production units.read more.

Given:

Total number of bottles filled during the useful life of bottling machine = 100,000,000

Solution:

Depreciating Rate Per Unit = (Cost of Bottling Machine – Salvage Value)/ Total number of bottles filled during the useful life of bottling machine

  • Depreciating Rate Per Unit = (108,000 – 8,000)/ 100,000,000
  • Depreciating Rate Per Unit = $0.001
  • Depreciation = number of bottles filled in a given year × depreciation
Year Number of bottles filled in a given year ($) Depreciable Rate Per Unit ($) Depreciation Amount ($)
202014,600,0000.00114600
202115,700,0000.00115,700
202212,400,0000.00112,400
202314,900,0000.00114,900
202413,500,0000.00113,500
202516,500,0000.00116,500
202612,400,0000.00112,400
Total100,000,000100,000

Note: We can see that the machine depreciates entirely in 2027 when its lifetime capacity of bottling is attained.

#5 – Sum-of-Years Digits Method

Now, assume XYZ Inc. depreciates the bottling machine through the sum-of-years digits method; what will be the depreciating amount?

Solution:

Depreciation = [(Useful Life Remaining / Sum of Years Digits) × 100] × Depreciable Bottling Machine Value

  • Sum of Years Digits = 5+4+3+2+1
  • Sum of Years Digits = 15
  • Depreciable Bottling Machine Value = Bottling Machine Cost – Salvage Value
  • Depreciable Bottling Machine Value = 108,000 – 8,000
  • Depreciable Bottling Machine Value = $100,000
Year Useful Life Remaining (in years) Sum of Digits Depreciation Rate = [Useful Life Remaining / Sum of Years Digits] × 100 Depreciation = Depreciation Rate × Depreciable Bottling Machine Value
201751533%33,000
201841527%27,000
201931520%20,000
202021513%13,000
20211157%7,000
Total100%100,000

How Depreciation Affects Accounting Ratios?

Depreciating assets impacts various financial ratios and accounting books in the following manner:

Frequently Asked Questions (FAQs)

How is depreciation calculated?

The most common way of calculating depreciating expense is the straight-line method. The difference between the fixed asset cost and its salvage value is divided by the useful life of that asset in years to get the depreciating value for each year.

Is depreciation a fixed cost?

The business entities depreciate fixed assets every year irrespective of production or sales. Fixes assets include machinery, tools, equipment, and vehicles. In accounting, therefore, depreciating of asserts comes under fixed cost. However, when computed using the units of production method, it is taken as a variable cost.  This is because the rise or fall in production causes the asset to depreciate more or less.

Why is depreciation important?

It is the depletion in the value of something. In accounting, fixed assets’ value declines every year due to wear and tear caused by constant usage. This happens throughout the useful life of an asset.

Companies depreciate to account for the cost of fixed assets. After all, every asset has a specific lifespan and turns into scrap after this period. Therefore, recording the appropriate book value of an asset helps accumulate funds for its future replacement.

Depreciation Video

This has been a guide to depreciation and its meaning. Here we discuss the 5 methods used by companies to depreciate assets along with formulas, calculations, and examples. You may learn more about accounting from the following articles –

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