What is Wasting Asset?
A wasting asset is a type of asset whose useful life is limited, and its value decreases over time, examples of which include fixed assets like vehicles, plant, property, and equipment or financial instruments like options.
Types of Wasting Assets with Formula
Now let us look at a different kind of wasting assets and how to calculate their decrease in value over a time period (also known as depreciation in some cases)
#1 – Factory/ Buildings / Office Furniture
These types of 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. are generally depreciated equally over their useful life. The straight-line depreciation methodStraight-line Depreciation 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. is used in this scenario. This is the simplest method of calculating depreciation, and the depreciation expense is the same each year evenly spread over the years. The formula used for calculating depreciation is
Depreciation Expense = (Cost – Salvage Value) / Useful Life
salvage value is the value (can be the selling value) of the asset at the end of its life.
Consider a building with an initial value of $1000 and a useful life of four years. Considering a salvage value of $200 at the end of its life, we can calculate the depreciation expense each year as (1000-200)/4 = $200 and can create a depreciation schedule as given in the following table.
#2 – Vehicles
Vehicles like cars, trucks are generally used very heavily in the initial years and, as such, should be depreciated rapidly in the initial years. We use the double-declining method in that case, which is very similar to the straight-line method apart from the fact that the depreciation rate is twice that of the first method. It assumes that the rate of depreciation of equipment is higher in the initial years as the machine is used more initially. The formula used for calculating depreciation is
Depreciation Expense = Beginning book value x Rate of Depreciation
Rate of depreciation = 100%*2/Useful Life
Consider a car with an initial value of $1000 and a useful life of four years.
In this method, the rate of depreciationRate Of DepreciationThe depreciation rate is the percent rate at which an asset depreciates during its estimated useful life. It can also be defined as the percentage of a company's long-term investment in an asset that the firm claims as a tax-deductible expense throughout the asset's useful life. is 2*100%/4 = 50% each year. So in the first year, the depreciation expense will be 1000*.5 = $500; in 2nd year, it will be $500*.5 = $250 and so on.
Another method of calculating accelerated depreciationAccelerated DepreciationAccelerated 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. is called the sum of the years’ depreciation methodSum Of The Years' Depreciation 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..
In this method
Depreciation Expense = (No of Years Remaining / Sum of Years) x (Cost – Salvage Value)
Consider a car with an initial value of $1000, a salvage value of $100, and a useful life of four years.
So in the first year, the remaining years will be 4, and the sum of the years will be 1+2+3+4 =10, and hence the depreciation will be 4*(1000-100)/10 = $360.
#3 – Machinery
Machines/production equipment and the depreciation is calculated on the basis of the number of units produced and are depreciated by the Units of Production method.
Depreciation Expense = (Number of Units Produced / Life in Number of Units) x (Cost – Salvage Value)
Let us suppose a piece of equipment which produces five, six, four, and ten units respectively in the four years and has a 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. of $100.
The depreciation expense for the first year would be given as 5*(1000-100)/(5+6+4+10)= $180 and so on.
#4 – Options
Enough of depreciation, we have completely ignored the other type of wasting asset called options, which we will describe in brief.
In layman, terms option is a type of instrument which allows the owner of the option to buy or sell a share at a certain price called the strike price. The price of an option depends on a few factors the most important of which are
- Difference between the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. and the current price of the stock: This is because if for an example the buyer has the option to buy a share price $100 for $60 he is making a profit of $40 (the difference between the strike price and exercise price)
- The options have an expiry associated with them, after which the owner can no longer exercise it, and here comes the concept of time decay of options. The closer the options get to the expiry date, the lesser the probability of the owner making a profit, and finally, on the day of expiry, the value of the option becomes zero.
#5 – Natural Resource
Natural resources like petroleum reserves, coal mines, etc. are depleted over time based on the quantity extracted.
Consider a coal mine in which a mining company acquired for $10 million and used another $5 million to develop the site. Consider the mining company that can sell the mine after it has extracted the coal for a certain period for a residual value of $3 million.
Now consider the mining company plans to extract 1000 tons of coal from the mine.
Then the depletion per ton is (10+5-3)*10^6/1000 = $12,000
This is then multiplied by the tons of coal extracted per year to calculate the depletion expenseCalculate The Depletion ExpenseDepletion expense is the cost allocated on natural resources (like oil, natural gas, coal) when they have been extracted. It includes the purchase price or the cost of the resource, cost of rights and anything required for preparing it for suitable extraction of resources. per year.
If you can remember, this method is very similar to the method of units of production used for equipment described above.
Please refer to the above template for the detailed calculation of wasting assets.
Advantages of Wasting Asset
- The primary advantage of owning an asset is its ownership and the fact that owning an asset costs much less than leasingLeasingLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.” in the long run.
- Tax savings can be made by claiming depreciation against the equipmentDepreciation Against The EquipmentDepreciation on Equipment refers to the decremented value of an equipment's cost after deducting salvage value over the life of an equipment. It lowers its resale value. bought.
Disadvantages of Wasting Asset
- Buying an asset may not be possible for a business with low capital if the initial cost of an asset is high.
- The maintenance cost of an asset may be quite high, especially in the latter stages of its life.
Wasting assets are very commonly encountered in everyday life. In fact, most of the assets we can think of, a natural resource like petroleum, or a car, or even a life insurance policy, most of the assets depreciate in value with time and usage. It is up to the analyst to understand the asset and its usage to determine the method to decrease the value of the asset over time.
This has been a guide to what is wasting assets, and it’s a definition. Here we discuss types of wasting assets along with advantages and disadvantages. You can learn more about financing from the following articles –