What is Depreciation?
The method of accounting for the allocation of costs of any physical or tangible asset during its useful life is known as depreciation and it is that value which shows that how much has been utilized of an asset’s value and Depreciating the assets helps the entities to generate revenue from that asset while charging small portion of the cost of asset in use every year.
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 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.
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, etc. Exposure of assets to forces of nature like wind, rain, and sun also forms 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- Obsolescence – Obsolescence means becoming outdated or obsolete.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 New and improved technologies make old products outdated.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. Old machinery though in good shape, maybe 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 its sales increases to 10,000 units.
- Accidents – To err is human. And when human err it causes an accident. No matter how many 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.
Top 4 Types of Depreciation
#1 – Straight-line
It is the simplest and most used method for calculation. Illustration 1 above depicts the straight-line method. 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
Implications of the Straight Line method
- Pre-dominant accounting method 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 it works with the help of an illustration.
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 Declining is 2 x Straight Line = 2 x 20% = 40%.
|Year||Value of asset (1)||Rate of dep (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).
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Accelerated Depreciation and Taxes
- The primary driver of appreciated depreciation adopted by firms tax benefits
- It 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 to increase investments in the economy
#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
Implications of the Unit of Production 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 charges and hence excluded.
- From an analyst’s 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 Method
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 method 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 depreciation (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)
Implications of Sum of Year Digits 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 – Sum of Year Digits Method
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|
Straight Line vs. Accelerated Depreciation
For understanding the impact 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 the Straight-line method with the following 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 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 the accelerated 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 the same for both the companies.
Below are 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 the 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
- Significant impact on both Income Statement and Balance Sheet for capital intensive firms
- Accelerated 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
- 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
- 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 the above four most commonly used methods of depreciation used by companies. The above methods are not exhaustive but are only illustrative. There are various methods 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 requirements, inflation, and etc.
The accounting concept defines 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 reflects the price that was paid for purchasing the asset. Whereas on the other hand, the fair value accounting 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 methods that companies may choose depending nature of the asset and the management decision about capital investment and replacement cost.
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. At the same time, 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 Calculated by various methods, amortization expense has to be based on the estimated useful life of the asset.
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 the method of Straight Line depreciation 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 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
Impact of Inflation
- It is provided based on historical costs to replace the asset at a future date
- Replacement Cost is assumed to be constantly 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 Formula Video
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, etc. cash has to be incurred. There is always an outflow of cash whenever the company incurs any expense. There is no outflow of resources, and 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. The 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 its impact.