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.
- 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 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., 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.. 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.. 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. 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.
#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. 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..
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:
#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.; 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. .
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:
#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:
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.
- Cost of Bottling Machine = $108,000
- Salvage Value = $8,000
- Useful Life of Bottling Machine = 5 years
Depreciation = (Cost of Bottling Machine – Salvage Value)/ Useful Life of Bottling Machine.
- Depreciation = (108,000 – 8,000)/ 5
- Depreciation = $20,000
#2 – Declining Balance Method
For the same example, what will be the depreciating expense if the company charges 20% per annum? Use the declining balance method.
- Depreciating Rate = 20% p.a.
Depreciation = (Net Book Value – Salvage Value) × Rate of Depreciation
|Year||Depreciable Asset Value ($)||Depreciation Rate||Depreciation Amount ($)||Net Book Value ($)|
|2017||108,000-8,000 = 100,000||20%||20,000||80,000|
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.
|Year||Depreciable Bottling Machine Value ($)||Depreciation Rate||Depreciation Amount ($)||Net Book Value ($)|
|2017||108,000-8,000 = 100,000||40%||40,000||60,000|
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..
Total number of bottles filled during the useful life of bottling machine = 100,000,000
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 ($)||Depreciation Amount ($)|
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?
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|
How Depreciation Affects Accounting Ratios?
Depreciating assets impacts various financial ratios and accounting books in the following manner:
- Depreciating assets significantly impacts the Income StatementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. and Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. of capital-intensive firmsCapital-intensive FirmsCapital intensive refers to those industries or companies that require significant upfront capital investments in machinery, plant & equipment to produce goods or services in high volumes and maintain higher levels of profit margins and return on investments. Examples include oil & gas, automobiles, real estate, metals & mining..
- Choice of useful life and salvage value also impacts depreciating expense and the stated asset values. Assets depreciate more when they have a shorter useful life and lower salvage values.
- Higher depreciation expense subdues the return ratios. An analyst should take care of this while comparing firms with different methods. Compared to SLM, the accelerated depreciating method tends to depress both net income and shareholder’s equity during the initial years.
- Also, return ratios are lower when Accelerated methods are used, hence more conservative. The impact, however, reverses in the later years with a lower depreciating expense.
- A firm with high capital may take a conservative approach of adopting the Accelerated approach as depreciating less with aging assets is compensated by depreciating more on new assets.
- Depreciating with conservative methods also increases the Asset Turnover RatioAsset Turnover RatioThe asset turnover ratio is the ratio of a company's net sales to total average assets, and it helps determine whether the company generates enough revenue to justify holding a large amount of assets under the company’s balance sheet..
Frequently Asked Questions (FAQs)
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.
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.
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.
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 –