Depreciation

Depreciation Meaning

Depreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year.

Understanding Depreciation

In accounting and finance, depreciation refers to the method of allocating the cost of a tangible asset over its useful life. When the asset is used, wear and tear also take place from erosion, dust, and decay, etc. 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. Therefore, depreciation expense is used to recognize the amount of wear and tear. Additionally, firms charge depreciation since the technology used in the machine may become obsolete or the asset may become inoperable due to an accident.

Let us take an example of depreciation

Company X Inc. starts manufacturing aerated beverages in the year 2016. It has bought a bottling machine at the cost of $ 10 MN. Plant supervisor Mr. Trevor has conducted technical feasibility of the bottling machine and believes that it will last for 10 years with no salvage value. What should be the amount that should be changed 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 an asset in years

= (10,000,000 – 0)/10 =   1,000,000

The company will charge $1,000,000 each year to 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.

The depreciation charge is recorded in each accounting periodEach Accounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more. It is reported in both the income statement and the balance sheet. It is also to be reported in the cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities.read more.

Assets are recognized in the books of account on the basis of historical cost. In order to calculate depreciation expense, companies first determine the depreciable base of an asset (Difference between an asset’s cost and its salvage value). There are various methods of depreciation that you may choose depending nature of the asset and the management decision about capital investmentAbout Capital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more and replacement cost.

Depreciation

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Top 4 Types of Depreciation Methods

Types-of-Depreciation

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#1 – Straight-line 

It is the simplest and most used depreciation method for calculation. In the 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 the useful life of the machine.

The formula for SLM = (Cost of a fixed asset – Residual value)/ Useful life in years

Features of Straight Line Depreciation Method

#2 – Double Declining Method

It is also known as an accelerated method. In this method, depreciation is double that of the straight-line method. However, it is slightly more complicated than the straight-line method. Let’s look at how this type of depreciation method works with the help of an example.

Company X Inc. has bought the bottling machine at the cost of $ 10 MN. Plant supervisor Mr. Trevor has conducted technical feasibility of the bottling machine and believes that the diminishing balance method will be most suited for it for the purpose of depreciation. The expected economic life of an asset is 5 years.

Straight Line = 1/5 = 20% each year

Double DecliningDouble DecliningThe Double Declining Balance Method is one of the accelerated methods used for calculating the depreciation amount to be charged in the company's income statement. It is determined by multiplying the book value of the asset by the straight-line method's rate of depreciation and 2read more is 2 x Straight Line = 2 x 20% = 40%.

YearValue of asset (1)Rate of dep (2)Depreciation amount (1) * (2)Net Book ValueNet Book ValueNet book value refers to the carrying value of the corporate assets acquired after accounting for depreciation, as reported in the company's balance sheet. An asset's net book value is calculated as "Net Book Value = Original Purchase Cost – Accumulated Depreciation".read more
Year 110,000,00040%4,000,0006,000,000
Year 26,000,00040%2,400,0003,600,000
Year 33,600,00040%1,440,0002,160,000
Year 42,160,00040%864,0001,296,000
Year 51,296,00040%1,296,000

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 fullyAsset Gets Depreciated FullyFully depreciated assets are the assets that can no longer be depreciated for accounting or tax purposes. It implies that the entire depreciation has been provided in the accumulated depreciation account. These assets continue to be a part of the balance sheet unless they are sold or destroyed.read more (salvage value is zero).

#3 – Unit of production depreciation method

In the unit of production method, depreciation is charged according to the 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           

Features of Unit of Production Depreciation Method

Example

Company X Inc. has bought the bottling machine at the cost of $ 10 MN. Plant supervisor Mr. Trevor has conducted technical feasibility of the bottling machine and believes that the unit of production methodThe Unit 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 is most suited. The 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. Calculate the amount of depreciation for each of the five years.       

Time periodValue of asset (1)Number of units to be produced (2)Depreciation amountValue of asset at the end
Year 11,00,00,0001,00,0006,66,667         93,33,333
Year 293,33,3332,00,00013,33,333         80,00,000
Year 380,00,0003,00,00020,00,000         60,00,000
Year 460,00,0004,00,000 26,66,667         33,33,333
Year 533,33,3335,00,000 33,33,333                         –
Total 15,00,000 1,00,00,000

At the end of year 5, we can see that asset 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 (1,00,00,000) is equal to its total cost (1,00,00,000). It depends on the number of units produced by the machine. We can see that the maximum expense is in year 5 when the machine produces 500,000 units, and the lowest is in year 1 when the machine produced 100,000 units.

#4 – Sum-of-years digits 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. It 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)

Features of Sum of Year Digits Depreciation Method

  • Benefits from an asset decline over time and hence it 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 the efficiency of assets as well as costs of repairs and maintenance

Example

Company X Inc. has bought the bottling machine at the cost of $ 10million. Plant supervisor Mr. Trevor has conducted technical feasibility of the bottling machine and believes that the sum of the digits method will be most suited. The expected economic life of an asset is 5 years. Calculate the depreciation.

YearsUseful life remaining (A)Sum of digits (B)base C= ( A) / (B)Dep rate  D=C*100Annual depreciation
15155/1533%33,33,333
24154/1527%26,66,667
33153/1520%20,00,000
42152/1513%13,33,333
51151/157%6,66,667

How Depreciation Affects Ratio Analysis?

Disclosure Requirements 

As the choice of depreciation method can impact the pattern of reported income

ford-straight-line

source: Ford SEC Filings

  • Disclosures are required in order to have comparability of a firm over some 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 the provided information

Depreciation Formula Video

This has been a guide to what is Depreciation and its meaning. Here we discuss the top 4 types of depreciation methods along with examples. You may learn more about accounting from the following articles –

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