Depreciation

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Depreciation Meaning

Depreciation in accounting refers to an indirect and explicit cost that a company incurs every year while using a fixed asset such as equipment, machinery, or expensive tools. It is the depleting value of a tangible asset.

The value of the assets gets depleted due to constant use for business purposes. Companies depreciate to account for this value throughout the useful life of that asset. It is a fixed cost for the companies, and the amount depreciated can be used to purchase new machinery after the old one turns into a scrap. Also, it is seen as a business expense despite being a non-cash expense.

Depreciation Meaning

Depreciation is a non-cash business expense incurred by a company for employing a tangible asset like machinery, tools, and equipment for business use.
It is accounted for throughout the asset's life expectancy. After that, the asset is discarded at salvage or residual value.
Companies depreciate assets using these five methods: straight-line, declining balance, double-declining balance, units of production, and sum-of-years digits.
In the balance sheet, the amount shown as a depreciation expense charged goes into the accumulated depreciation account.

Depreciation in Accounting Explained

Companies depreciate to allocate the cost of a tangible asset, over its useful life. When the asset is used, wear and tear occur from erosion, dust, and decay. Despite proper maintenance and precaution, 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. Firms depreciate because the technology used in the machine may become obsolete, or the asset may become inoperable due to an accident.

In depreciation, there is no cash outflow. Instead, while accounting, this expense is transferred to the accumulated depreciation. It is an essential part of accounting that facilitates companies to record the real-time book value of tangible assets. Also, this sum can be used for purchasing a new asset in the future. Now, let us understand some of the terminologies used in this concept:

Fixed Asset Cost: It is the cost at which the organization buys a tangible asset.
Salvage Value: The residual cost can be recovered from selling the asset after its useful life.
Useful Life of Fixed Asset: It is the estimated number of years for which an asset remains productive and efficient.
Depreciation Rate: It is the percentage charged as depreciation on the fixed asset.

Depreciation - Explained in Video

Types of Depreciation Methods

All tangible assets depreciate with time. Therefore, firms use the following five methods to charge for it.

#1 - Straight-Line Method (SLM)

This is the simplest method of calculating used most of the time. In SLM, a constant depreciation amount is charged every year. First, corporations have to estimate the salvage (residual) value. The salvage value represents the cost the company expects to recover at the end of the machine's useful life. After deducting this residual value from the fixed asset cost, the value acquired is divided by the useful life of the fixed assets.

Straight-Line Method Formula:

#2 - Declining Balance Method

In this method, the depreciated percentage is charged on the net book value of a fixed asset. This netbook value is the remaining balance of fixed asset cost after deducting the overall depreciation charged for the previous years. Thus, the depreciable value diminishes every year, and so does the depreciated expense.

Declining Balance Method Formula:

#3 - Double Declining Balance Method

This method works similar to the declining balance method; however, it charges double the depreciated rate on the fixed asset's balance or net book value. Therefore, it is also known as an accelerated method.

Double Declining Balance Method Formula:

#4 - Units of Production Method

Under this method, the fraction of the number of fixed asset units (machinery) produced per year and the total number of units generated in a lifetime is multiplied with the fixed asset cost to yield the depreciated expense of each year. Hence, if the production decreases, the depreciated cost also steeps down and vice versa.

Units of Production Method Formula:

#5 - Sum-of-Years Digits Method

As the name indicates, this method takes the total useful years. Here the digits are arranged in descending order. Then the remaining number of useful years are divided by this sum and multiplied by 100 to get the depreciated rate for the particular year. Finally, the depreciated expense is computed by multiplying this rate with the remaining fixed asset cost after deducting the salvage value.

Sum-of-Years Digits Method Formula:

Accounting Depreciation Calculation

Following are examples where the depreciated amount is calculated using different methods.

#1 - Straight-Line Method

XYZ Inc. is a manufacturer of aerated drinks. It bought a bottling machine worth $108000 in 2016. Titus, the plant supervisor, determined the technical feasibility test of the bottling machine. Titus believes it will last for 5 years with a salvage value of $8000. Find out the depreciated expense for each year using the straight-line method.

Given:

Cost of Bottling Machine = $108,000
Salvage Value = $8,000
Useful Life of Bottling Machine = 5 years

Solution:

Depreciation = (Cost of Bottling Machine - Salvage Value)/ Useful Life of Bottling Machine.

Depreciation = (108,000 – 8,000)/ 5
Depreciation = $20,000

#2 - Declining Balance Method

For the same example, what will be the depreciating expense if the company charges 20% per annum? Use the declining balance method.

Given:

Depreciating Rate = 20% p.a.
Solution:

Depreciation = (Net Book Value - Salvage Value) × Rate of Depreciation

Year	Depreciable Asset Value ($)	Depreciation Rate	Depreciation Amount ($)	Net Book Value ($)
2017	108,000-8,000 = 100,000	20%	20,000	80,000
2018	80,000	20%	16,000	64,000
2019	64,000	20%	12,800	51,200
2020	51,200	20%	10,240	40,960
2021	40,960	20%	40,960	-

Note: The machinery will depreciate with the whole amount in 2025, i.e., in the last year of its useful life.

#3 - Double Declining Balance Method

Again, for the same example, assume that the company charges using the double-declining balance method. Determine the amount charged on the depreciating asset each year.

Depreciation = (Net Book Value - Salvage Value) × 2 × Depreciating Rate

New Depreciating Rate = 2×20% p.a. = 40% p.a.

Solution:

Year	Depreciable Bottling Machine Value ($)	Depreciation Rate	Depreciation Amount ($)	Net Book Value ($)
2017	108,000-8,000 = 100,000	40%	40,000	60,000
2018	60,000	40%	24,000	36,000
2019	36,000	40%	14,400	21,600
2020	21,600	40%	8,640	12,960
2021	12,960	40%	12,960	-

Note: Here also, the machinery will depreciate with the whole amount in 2025, i.e., in the last year of its useful life.

#4 - Units of Production Method

In the above example, now assume that the bottling machine filled the following units of bottles for the respective years:

14,600,000 bottles in 2020,
15,700,000 bottles in 2021,
12,400,000 bottles in 2022,
14,900,000 bottles in 2023,
13,500,000 bottles in 2024.

Here, the estimated lifetime bottling capacity of the machine is 100,000,000 bottles. Now, find out the depreciating amount using the units of production method.

Given:

Total number of bottles filled during the useful life of bottling machine = 100,000,000

Solution:

Depreciating Rate Per Unit = (Cost of Bottling Machine – Salvage Value)/ Total number of bottles filled during the useful life of bottling machine

Depreciating Rate Per Unit = (108,000 – 8,000)/ 100,000,000
Depreciating Rate Per Unit = $0.001
Depreciation = number of bottles filled in a given year × depreciation

Year	Number of bottles filled in a given year ($)	Depreciable Rate Per Unit ($)	Depreciation Amount ($)
2020	14,600,000	0.001	14600
2021	15,700,000	0.001	15,700
2022	12,400,000	0.001	12,400
2023	14,900,000	0.001	14,900
2024	13,500,000	0.001	13,500
2025	16,500,000	0.001	16,500
2026	12,400,000	0.001	12,400
Total	100,000,000	-	100,000

Note: We can see that the machine depreciates entirely in 2027 when its lifetime capacity of bottling is attained.

#5 - Sum-of-Years Digits Method

Now, assume XYZ Inc. depreciates the bottling machine through the sum-of-years digits method; what will be the depreciating amount?

Solution:

Depreciation = × Depreciable Bottling Machine Value

Sum of Years Digits = 5+4+3+2+1
Sum of Years Digits = 15
Depreciable Bottling Machine Value = Bottling Machine Cost – Salvage Value
Depreciable Bottling Machine Value = 108,000 – 8,000
Depreciable Bottling Machine Value = $100,000

Year	Useful Life Remaining (in years)	Sum of Digits	Depreciation Rate = × 100	Depreciation = Depreciation Rate × Depreciable Bottling Machine Value
2017	5	15	33%	33,000
2018	4	15	27%	27,000
2019	3	15	20%	20,000
2020	2	15	13%	13,000
2021	1	15	7%	7,000
Total	-	-	100%	100,000

How Depreciation Affects Accounting Ratios?

Depreciating assets impacts various financial ratios and accounting books in the following manner:

Depreciating assets significantly impacts the Income Statement and Balance Sheet of capital-intensive firms.
Choice of useful life and salvage value also impacts depreciating expense and the stated asset values. Assets depreciate more when they have a shorter useful life and lower salvage values.
Higher depreciation expense subdues the return ratios. An analyst should take care of this while comparing firms with different methods. Compared to SLM, the accelerated depreciating method tends to depress both net income and shareholder's equity during the initial years.
Also, return ratios are lower when Accelerated methods are used, hence more conservative. The impact, however, reverses in the later years with a lower depreciating expense.
A firm with high capital may take a conservative approach of adopting the Accelerated approach as depreciating less with aging assets is compensated by depreciating more on new assets.
Depreciating with conservative methods also increases the Asset Turnover Ratio.

Frequently Asked Questions (FAQs)

How is depreciation calculated?

The most common way of calculating depreciating expense is the straight-line method. The difference between the fixed asset cost and its salvage value is divided by the useful life of that asset in years to get the depreciating value for each year.

Is depreciation a fixed cost?

The business entities depreciate fixed assets every year irrespective of production or sales. Fixes assets include machinery, tools, equipment, and vehicles. In accounting, therefore, depreciating of asserts comes under fixed cost. However, when computed using the units of production method, it is taken as a variable cost. This is because the rise or fall in production causes the asset to depreciate more or less.

Why is depreciation important?

It is the depletion in the value of something. In accounting, fixed assets' value declines every year due to wear and tear caused by constant usage. This happens throughout the useful life of an asset.

Companies depreciate to account for the cost of fixed assets. After all, every asset has a specific lifespan and turns into scrap after this period. Therefore, recording the appropriate book value of an asset helps accumulate funds for its future replacement.