Depreciation

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In accounting, depreciation is a process whereby the value of an asset is allocated over a period of time. The concept comes from the fact that, over time, all assets decline due to normal wear and tear, obsolescence, or actual destruction. All assets of a business are depreciated, except for real estate (which appreciates over time in most cases) and some unusual items such as artwork or vintage automobiles.

Basics

In order to determine depreciation the company needs to determine four things about the asset:

  • First, it needs to determine its historical cost. The cost is not just that of the asset, but may also include sales/use taxes, freight/shipping, and costs to install and test the asset for its intended use.
  • Second, it needs to determine its useful life. This can be in terms of years or some unit of use or production.
  • Third, it needs to determine its residual value (also called salvage value or scrap value, though it does not mean the asset is nothing but scrap or salvage at the end of its useful life). Although there are cases where an asset may have a negative residual value at the end of its useful life, for accounting purposes a residual value below zero is not used.
  • Finally, it needs to determine a method of depreciation. Common methods of depreciation include straight-line (this is the most common and easiest to understand), units, declining balance, and sum-of-the-years-digits.

It should be noted that once an asset is fully depreciated, the company is still allowed to use the asset for business purposes. Also, a company will have a depreciation policy which states how various broad categories of assets will be depreciated, and may use different methods for different assets.

Example

A company buys machinery for $50,000, expects it to last five years, and at that time have a residual value of $5,000. It is also expected to produce 1,000,000 units during its useful life.

Straight-Line Depreciation

Under the straight-line method, the yearly depreciation is $9,000/year [($50,000 - $5,000) / 5 years]. This amount is recorded each year until, in Year 5, the residual value is reached.

Year Value at Year Beginning Depreciation Value at Year End
1 $50,000 $9,000 $41,000
2 $41,000 $9,000 $32,000
3 $32,000 $9,000 $23,000
4 $23,000 $9,000 $14,000
5 $14,000 $9,000 $5,000

Units Depreciation

Under the units method, the yearly depreciation is calculated as a rate per unit. In the example above, the rate is $0.045/unit [($50,000 - $5,000) / 1,000,000 units].

This method requires additional recordkeeping to determine the number of units, in addition to normal records relating to depreciation. Also, if the production rate changes dramatically, adjustments may need to be made to how depreciation is calculated. For example, a machine may have been forecast to produce 1,000,000 units, but now due to economic circumstances will only produce 800,000 units before it becomes technologically obsolete.

The units can either be units of consumption (such as miles on an automobile) or units of production.

Declining Balance Depreciation

Under the declining balance method, the straight-line amount per year is expressed as a percentage of the total amount to be depreciated, then the percentage is increased by a certain amount. The most common is double-declining-balance (sometimes called "200% declining balance"), where the depreciation in the first year is double what it normally would be. However, "150% declining balance" is also used in some cases.

Under this method, the same percentage is applied each year to the undepreciated historical cost without taking residual value into account. However, in the final year, the depreciation amount does take residual value into account, so the depreciation charge for that year is much smaller.

In the example above, the depreciation of $9,000/year is 20% of the total; using double-declining-balance, the percentage to be taken is 40% of the historical cost until, in Year 5, the residual value is reached.

Year Value at Year Beginning Depreciation Value at Year End
1 $50,000 $20,000[1] $30,000
2 $30,000 $12,000[2] $18,000
3 $18,000 $7,200[3] $10,800
4 $10,800 $4,320[4] $6,480
5 $6,480 $1,480[5] $5,000

Sum-Of-The-Years-Digits Depreciation

Under the sum-of-the-years-digits method, the calculation is determined based on the number of years. An easy formula to use in determining the denominator is (n2+n)/2 where n is equal to the useful life of the asset in years. The numerator is the number of remaining years (including that year). The fraction is applied to the original historical cost less residual value.

In the example above, a five year life would result in the denominator being 15 [(52+5)/2 = 15]. In the first year the fraction is 5/15, then 4/15, 3/15, 2/15, and finally 1/15. The table below shows the calculation (amounts are rounded to the nearest whole dollar).

Year Value at Year Beginning Depreciation Value at Year End
1 $50,000 $15,000[6] $35,000
2 $35,000 $12,000[7] $23,000
3 $23,000 $9,000[8] $14,000
4 $14,000 $6,000[9] $8,000
5 $8,000 $3,000[10] $5,000

Depreciation for tax purposes

The United States Tax Code has undergone major, significant revisions of method and treatment of depreciation since it first began about 1919, and almost certainly will continue to be revised in the future.

As a means of "economic stimulus", depreciation rules have been created in the Code which allow for means of "accelerated depreciation", as a means of getting companies to purchase items sooner than they would otherwise. The rules have included:

  • useful lives which are shorter than economic lives (a notable one is for residential housing, which can be depreciated over 27.5 years, while houses generally last far longer)
  • depreciation methods (in addition to those above)
  • Section 179 expensing rules, which allow some assets below a certain amount that would normally be subject to depreciation, to be expensed fully for tax purposes in the year of purchase

However, these methods are generally not allowed for financial reporting purposes at publicly-traded companies; therefore, the company has to maintain two separate sets of depreciation records.

Notes

  1. $50,000 x 40% = $20,000
  2. $30,000 x 40% = $12,000
  3. $18,000 x 40% = $7,200
  4. $10,800 x 40% = $4,320
  5. $6,480 - $5,000 residual value = $1,480
  6. $45,000 x 5/15 = $15,000
  7. $45,000 x 4/15 = $12,000
  8. $45,000 x 3/15 = $9,000
  9. $45,000 x 2/15 = $6,000
  10. $45,000 x 1/15 = $3,000