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.
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 assetsTangible AssetsAny 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 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.. It is reported in both the income statementThe Income 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 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..
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. and replacement cost.
Top 4 Types of Depreciation Methods
#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 valueResidual ValueResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed., 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
- Pre-dominant accounting methodAccounting MethodAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods. in the US and other countries
- Results in an increasing rate of return rather than the 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
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 2 is 2 x Straight Line = 2 x 20% = 40%.
|Year||Value 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".|
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. (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 methodStraight-line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. 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
- Decreases depreciation in periods of low productivity and hence overstates income and asset values Misrepresent business reality when competition with higher productivity comes into play.
- Misrepresents business reality when competition with higher productivity comes into play results in restructuring charges when the
- Results in restructuring charges when the overvalued assets are subsequently revalued; From an analyst’s point of view, these would be non-recurring chargesNon-recurring ChargesNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off. and hence excluded.
- From an analyst’s point of view, these would be non-recurring charges and hence excluded.
However, adjustment to earnings estimatesEarnings EstimatesEarnings Estimate is the projection of earning of an entity for a given period. Future projects, cash flows, market conditions, and several other factors are considered in calculating this estimate. should be moderated to suit past over statements.
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. 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 period||Value of asset (1)||Number of units to be produced (2)||Depreciation amount||Value of asset at the end|
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. (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 methodSum Of Years' Digits MethodThe sum of years digits method is an accelerated depreciation method whereby the method declines the asset's value at an accelerated rate. Therefore, greater deductions are allowed in the starting life of the assets than in subsequent years. 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
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.
|Years||Useful life remaining (A)||Sum of digits (B)||base C= ( A) / (B)||Dep rate D=C*100||Annual depreciation|
How Depreciation Affects Ratio Analysis?
- Depreciation significantly impacts both Income Statement and Balance Sheet for 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 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 methods
- 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 methods are used, hence more conservative
- The impact, however, reverses in the later years with lower depreciation expense
- A firm with high capital outlays may take a conservative approach of adopting the Accelerated approach as lower depreciation on aging assets is compensated by higher on new assets
- Conservative Depreciation methods also increase 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.. It may be advisable to calculate Fixed Assets Turnover Ratios using Gross Fixed Asset Investment as a denominator.
As the choice of depreciation method can impact the pattern of reported income
- Disclosures are made as foot-notes in the section listing accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.
- Most American firms use the method of Straight Line depreciationStraight Line DepreciationStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. while the Accelerated method is popular in other countries
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 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. 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 –