# 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 over its useful life.

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 and replacement cost.

For eg:
Source: Depreciation (wallstreetmojo.com)

### Top 4 Types of Depreciation Methods

For eg:
Source: Depreciation (wallstreetmojo.com)

#### #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 , 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 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

If you look at the fifth year of depreciation, it stands at \$1,296,000. Please note that in the last year, the (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 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 and hence excluded.
• From an analyst’s point of view, these would be non-recurring charges and hence excluded.
However, adjustment to should be moderated to suit past over statements.

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 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.

At the end of year 5, we can see that asset (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 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.

### How Depreciation Affects Ratio Analysis?

• Depreciation significantly impacts both Income Statement and Balance Sheet for
• 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 . It may be advisable to calculate Fixed Assets Turnover Ratios using Gross Fixed Asset Investment as a denominator.

### Disclosure Requirements

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

• Disclosures are made as foot-notes in the section listing
• Most American firms use the method of 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 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 –