Depreciation

Depreciation

Depreciation refers to two very different but related concepts: the decrease in the value of assets (fair value depreciation) and the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle). The former affects values of businesses and entities. The latter affects net income.

Generally, the cost is allocated as a depreciation expense among the periods in which the asset is expected to be used. Such expense is recognized by businesses for financial reporting and tax purposes. Methods of computing depreciation may vary by asset for the same business. Several standard methods of computing depreciation expense may be used, such as fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service. Depreciation is generally recognized under historical cost systems of accounting.

Generally, this involves four criteria: cost of the asset, expected salvage value (residual value of the asset), estimated useful life of the asset, and a method of apportioning the cost over such life.

Calculating Depreciation

There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity or use of the asset.

1. Straight-line depreciation is the simplest and most often used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenue (useful life). The company will then expense a portion of original cost in equal increments over that period. The salvage value (residual value or scrap value) is an estimate of the value of the asset at the time it will be sold or disposed of.

\(\text{Annual Depreciation Expense} = \dfrac{\text{Cost of fixed asset - Residual value}}{\text{Useful life of asset (years)}}\)

Depreciation This is the formula used to calculate straight-line depreciation.

2. Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decrease charges in subsequent years are called accelerated depreciation methods. This may be a more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are new. One popular accelerated method is the declining-balance method. Under this method, the book value is multiplied by a fixed rate. The most common rate used is double the straight-line rate:

Annual Depreciation = Depreciation Rate * Book Value at the beginning of the Year.

4. Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than a straight line but less than the declining-balance method. Under this method, annual depreciation is determined by multiplying the depreciable cost by a schedule of fractions.

• Depreciable cost = original cost − salvage value
• Book value = original cost − accumulated depreciation

5. Under the units-of-production method, the useful life of the asset is expressed in terms of the total number of units expected to be produced.

\(\text{Annual Depreciation Expense} = \dfrac{\text{Cost of fixed asset - Residual value}}{\text{Estimated total production}} \times \text{Actual production}\)

Depreciation This is the units-of-production method for calculating depreciation.

Key Points

• Depreciation refers to the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle).
• Generally this involves four criteria: cost of the asset, expected salvage value (residual value of the asset), estimated useful life of the asset, and a method of apportioning the cost over such life.
• There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity of the asset: straight-line depreciation, accelerated depreciation methods, activity depreciation methods, sum-of-years' digits method, and units-of-production method.

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