Depreciation

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For a separate use in international finance to refer to a reduction in the exchange rate of a currency, see Depreciation (currency).

Depreciation is a term used in accounting, economics and finance with reference to the fact that assets with finite lives lose value over time.

In accounting, depreciation is a term used to describe any method of attributing the historical or purchase cost of an asset, across its useful life, roughly corresponding to normal wear and tear.Beginner\'s Guide to Financial Statements by the US Securities and Exchange Commission It is of most use when dealing with assets of a short, fixed service life, and which is an example of applying the matching principle as per generally accepted accounting principles. Depreciation in accounting is often mistakenly seen as a basis for recognizing impairment of an asset, but unexpected changes in value, where seen as significant enough to account for, are handled through write-downs or similar techniques which adjust the book value of the asset to reflect its current value. Therefore, it is important to recognize that depreciation, when used as a technical accounting term, is the allocation of the historical cost of an asset across time periods when the asset is employed to generate revenues. This process of cost allocation has little or no direct relationship to the market value or current selling price of the asset, it is simply the recognition that a portion of the asset\'s cost--the portion that will never be recuperated through re-sale or disposal of the asset--was "used up" in the generation of revenues for that time period.

The use of depreciation affects the financial statements and in some countries the taxes of companies and individuals. The recording of depreciation will cause an expense to be recognized, thereby lowering stated profits on the income statement, while the net value of the asset (the portion of the historical cost of the asset that remains to provide future value to the company) will decline on the balance sheet. Depreciation reported for accounting and tax purposes may differ substantially.

Depreciation and its related concept, amortization (generally, the depreciation of intangible assets), are non-cash expenses. Neither depreciation nor amortization will directly affect the cash flow of a company, as both are accounting representations of expenses attributable to a given period. In accounting statements, depreciation may neither figure in the cash flow statement, or may be "added back" to net income (along with other items) to derive the operating cash flow.ISAB standards on the treatment of goodwill and other intangible assets Depreciation recognized for tax purposes will, however, affect the cash flow of the company, as tax depreciation will reduce taxable profits; there is generally no requirement that treatment of depreciation for tax and accounting purposes be identical. Where depreciation is shown on accounting statements, the figure usually does not relate to depreciation for tax purposes.

In economics depreciation is the decrease in the economic value of the capital stock of a firm, nation or other entity, either through physical depreciation, obsolescence or changes in the demand for the services of the capital in question. If capital stock is $C\_0$ at the beginning of a period, investment is $I$ and depreciation $D$, the capital stock at the end of the period, $C\_1$, is $C\_0\; +\; I\; -\; D$.

Contents 1 Accounting 2 Recording depreciation 3 Methods of depreciation 3.1 Straight-line depreciation 3.2 Declining-balance/Reducing balance depreciation 3.3 Activity depreciation 3.4 Sum of years digits depreciation 3.5 Units of Production depreciation 3.6 Units of time depreciation 4 Taxes 5 Economics 5.1 National accounts 6 Further reading 7 See also 8 External links

Accounting

A company needs to report depreciation accurately in its financial statements in order to achieve two main objectives. First, to match its expenses with the income generated by means of those expenses. Second, to ensure that the asset values in the balance sheet are not overstated. An asset acquired in Year 1 is unlikely to be worth the same amount in Year 5.

Depreciation is an estimated or expected view of the decline in value of an asset. For example, an entity may depreciate its equipment by 15% per year. This rate should be reasonable in aggregate (such as when a manufacturing company is looking at all of its machinery), and consistently employed. However, there is no expectation that each individual item declines in value by the same amount, primarily because the recognition of depreciation is based upon the allocation of historical costs and not current market prices.

Accounting standards bodies have detailed rules on which methods of depreciation are acceptable, and auditors will express a view if they believe the assumptions underlying the estimates do not give a true and fair view.

Recording depreciation

For historical cost purposes, assets are recorded on the balance sheet at their original cost; this is called the historical cost. Historical cost minus all depreciation expenses recognized on the asset since purchase is called the book value. Depreciation is not taken out of these assets directly. It is instead recorded in a contra asset account: an asset account with a normal credit balance, typically called "accumulated depreciation". Balancing an asset account with its corresponding accumulated depreciation account will result in the net book value. The net book value will never fall below the salvage value, meaning that once an asset is fully depreciated, no further expenses will be taken during its life. Salvage value is the estimated value of the asset at the end of its useful life. In this way, total depreciation for an asset will never exceed the estimated total cash outlay (depreciable basis) for the asset. The exception to this is in many price-regulated industries (public utilities) where salvage is estimated net of the cost of physically removing the asset from service. If the expected cost of removal exceeds the expected raw (or gross) salvage, then the net of the two (called Net Salvage) may be negative. In this case, the depreciation recorded on the regulated books may exceed the depreciable basis. Companies have no obligation to dispose of depreciated assets, of course, and many fully depreciated assets continue to generate income.

Recording a depreciation expense will involve a credit to an accumulated depreciation account. The corresponding debit will involve either an expense account or an asset account which represents a future expense, such as work in process. Depreciation is recorded as an adjusting journal entry.

A write-down is a form of depreciation that involves a partial write off. Part of the value of the asset is removed from the balance sheet. The reason may be that the book value (accounted value) of the fixed asset has diverged from the market value and causes the company a loss. An example of this would be a revaluation of goodwill on an acquisition that went bad.

Methods of 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.

Straight-line depreciation

Straight-line depreciation is the simplest and most often used technique, in which the company estimates the "salvage value" of the asset after the length of time over which it will be used to generate revenues (useful life), and will recognize a portion of that original cost in equal increments over that amount of time. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero. For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a "salvage value" of US$2000, will depreciate at US$3,000 per year: ($17,000 - $2,000)/ 5 years = $3,000 annual straight-line depreciation expense. In other words, it is the cost of the asset (that can never be recuperated through re-sale) divided by number of years of its useful life.

Straight-Line Method:

$\backslash mbox\{Depreciation\; expense\}\; =\; \{\backslash mbox\{Cost\; of\; fixed\; asset\}\; -\; \backslash mbox\{Scrap\; value\}\; \backslash over\; \backslash mbox\{Life\; span\}\; (years)\}$

If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess would be considered a gain and subject to the depreciation recapture rule. In addition, this gain above the depreciated value would be recognized as ordinary income by the tax office. If the sales price is ever less than the book value, the resulting capital loss is tax deductible. If the sale price were ever more than the original book value, then the gain above the original book value is recognized as a capital gain.

If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department\'s and company\'s view of the profit.

Declining-balance/Reducing balance depreciation

A declining-balance method, also known as the reducing balance method, is a type of accelerated depreciation because it recognizes a higher depreciation cost earlier in an asset\'s lifetime. 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. In the U.S., a form of declining-balance depreciation known as the Modified Accelerated Cost Recovery System (MACRS) is used.

In declining-balance depreciation, each period\'s depreciation is based on the previous year\'s net book value, the estimated useful life, and a factor. The factor is commonly two; this is known as double declining-balance. Each period we calculate depreciation:

$\backslash mbox\{Depreciation\; expense\}\; =\; \backslash mbox\{Previous\; period\; NBV\}\; \backslash times\; \{\backslash mbox\{factor\}\; \backslash over\; N\}$

For the double-declining balance method, using the vehicle example from above, we compute the depreciation after the first year:

$\backslash mbox\{Previous\; period\; NBV\}\; \backslash times\; \{\backslash mbox\{factor\}\; \backslash over\; N\}\; =\; \backslash \$17000\; \backslash times\; \{2\; \backslash over\; 5\}\; =\; \backslash \$6800$

We subtract $6800 from our previous year\'s net book value to obtain our new net book value: $\backslash mathrm\{NBV\}\_1\; =\; \backslash \$17000\; -\; \backslash \$6800\; =\; \backslash \$10200$. For the second year, we use this new value to calculate depreciation. Notice that it is significantly lower than the first year:

$\backslash \$10200\; \backslash times\; \{2\; \backslash over\; 5\}\; =\; \backslash \$4080$

This process continues until we reach the salvage value or the end of the asset\'s useful life. Since declining-balance depreciation doesn\'t always depreciate an asset fully by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This has the effect of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the asset\'s life. It should also be noted that the book value of the asset being depreciated is never brought below its salvage value, regardless of the method used.

Taxable Year (Remaining Years)	Net Book Value (NBV)	Double Declining Method (40% of NBV)	Straight Line Method (NBV / remaining years)	Depreciation Deduction (Greater of DD or SL)
1(5)	$17,000	$6,800	$3,400	$6,800
2(4)	$10,200	$4,080	$2,550	$4,080
3(3)	$6,120	$2,448	$2,040	$2,448
4(2)	$3,672	$1,469	$1,836	$1,672 ($1,836-$164 to equal salvage value)
5(1)	$2,000 (salvage value)	$203

Activity depreciation

Activity depreciation methods are not based on time, but on a level of activity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, we estimate its life in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. We calculate a per-mile depreciation rate: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, we then calculate the depreciation expense by multiplying the rate by the actual activity level.

Sum of years digits depreciation

Sum of Years Digits is a historical depreciation method that results in a more accelerated write off than straight line, but less than declining balance or later methods. Salvage value is counted in the method. There are no property classes of later methods.

• Given;
  • N = Depreciable life of asset
  • B = Cost basis
  • S = Salvage value
  • D(t) = Depreciation charge for year t
  • $\backslash mathrm\{Sum\}=\{N\; (N+1)\; \backslash over\; 2\}\backslash ;\backslash ;\backslash mathrm\{\backslash displaystyle\backslash scriptstyle\; Comment:\backslash ,\; This\backslash ,\; is\backslash ,\; the\backslash ,\; sum\backslash ,\; of\backslash ,\; the\backslash ,\; factors\backslash ,\; (N-t+1)\backslash ,\; for\backslash ,\; all\backslash ,\; t\}$
  • $D(t)=(N-t+1)\; \backslash times\; \backslash frac\{(B-S)\}\{Sum\}\; =\; (N-t+1)\; \backslash times\; \backslash frac\{2\; (B-S)\}\{N(N+1)\}$

Example: If an asset costs $1000, has a depreciable life of 5 years and a salvage value of $90, compute its depreciation schedule.

Year	D(t)	Sum of D(t)	Remaining Book Value
1	$303	$303	$697
2	$243	$546	$454
3	$182	$728	$272
4	$121	$849	$151
5	$61	$910	$90

The equation for year 1 would look like this:

$D(t)=(5-1+1)\; \backslash times\; \{(1000-90)\; \backslash over\; \{5\; (5+1)\; \backslash over\; 2\}\}\; =\; 303.33$

Note: Most depreciation schedules round to the nearest dollar.

Units of Production depreciation

Units of Production depreciation is used in the U.S. in cases where MACRS is inappropriate, and the value to depreciate is based in the asset, such as a mine or natural resources. The method calculates the depreciation based on the units of the asset place in service as compared to the total units of the asset.

Units of time depreciation

Units of Time Depreciation is similar to units of production, and is used for depreciation equipment used in mine or natural resource exploration, or cases where the amount the asset is used is not linear year to year.

A simple example can be given for construction co, where some equipments are used only for some specific usage. Depending on the number of projects the equipment will be used & depreciation charged accordingly.

Taxes

Main article: MACRS

When a company spends money for a service or anything else that is short-lived, this expenditure is usually immediately tax deductible in some countries, and the company enjoys an immediate tax benefit.IRS small business tax guide

To be eligible for depreciation, an asset must have two features: (1) it has a useful life beyond the taxable year (essentially why it was capitalized in the first place), and (2) it wears out, decays, declines in value due to natural causes, or is subject to exhaustion or obsolescence.

Therefore, when a company buys an asset that will last longer than one year, like a computer, car, or building, the company cannot immediately deduct the cost and enjoy an immediate tax benefit. Instead, the company must depreciate the cost over the useful life of the asset, taking a tax deduction for a part of the cost each year. Eventually the company does get to deduct the full cost of the asset, but this happens over several years. In the US, the IRS\'s depreciation schedule for any given class of asset is fixed, and is related to typical durability. A computer may depreciate completely over five years; a nonresidential building, usually 39 years. The maximum allowable useful life under US income tax regulations is 40 years. Though the IRS does allow a small choice of permutations for depreciation life and acceleration, it does not allow a taxpayer to invent any random asset life. Other countries have other systems, many simply eliminate all choice altogether. In these jurisdictions accounting depreciation and tax depreciation are almost always significantly different numbers, as in many instances a form of "accelerated depreciation" can be used for tax purposes to lower (taxable) net income in a given period (or, in some instances, a fixed asset may be allowed to be expensed for tax purposes; Section 179 of the Internal Revenue Code allows for this treatment in some circumstances). Technically, these are not considered "tax reductions" but tax deferrals: lowering taxable income now by increasing expenses should increase future taxable income (and taxes) at a later date.

Importantly, no depreciation deduction is allowed for inventories or other property held for sale to customers in the ordinary course of business (Treas. Reg. § 1.167(a)-2 and Thor Power Tool Company v. Commissioner). Land is also not depreciable (Treas. Reg. § 1.167(a)-2). However, improvements to land are usually depreciable, including landscaping.

In the US, there are generally five variables that a taxpayer must take into account when computing the correct depreciation deduction. These variables include: (1) the depreciation base (the asset’s cost basis), (2) the asset’s class life (estimated life expectancy of the asset), (3) the applicable recovery period (the number of years the taxpayer can claim depreciation deductions), (4) the applicable depreciation method (see double declining balance method or straight-line method), and (5) the applicable convention (§ 168(d)(4) of the code—generally the half-year convention).

Economics

In economics, the value of a capital asset is equal to the present value of the flow of services the asset will generate in future, appropriately adjusted for uncertainty. Economic depreciation over a given period is the reduction in the remaining value of future services.

Under certain circumstances, such as an unanticipated increase in the price of the services generated by an asset, its value may increase rather than decline. Depreciation is then negative.

National accounts

In national accounts, depreciation represents the decline in the aggregate capital stock arising from the use of capital in production, also referred to as consumption of fixed capital. Hence, depreciation is equal to the difference between aggregate (gross) investment and net investment or between Gross National Product and Net National Product. Unlike depreciation in business accounting, depreciation in national accounts is, in principle, not a method of allocating the costs of past expenditures on fixed assets over subsequent accounting periods. Rather, fixed assets at a given moment in time are valued according to the remaining benefits derived from their use.

Further reading

See also

• John I. Beggs (1847-1925) - The American businessman responsible for modern depreciation techniques
• Expense
• Consumption of fixed capital
• Tax depletion
• Cost segregation study
• Deferred tax

External links

• Depreciation Accelerated depreciation, book vs. tax depreciation, use of estimates, journal entries...
• Fixed Asset Info Automatic depreciation calculator, tax and other accounting links, depreciation classes, and more...
• Asset Management Software Asset register, depreciation calendar, Tax and Sarbanes-Oxley compliance.
• depreciation schedule of computer equipment
• Asset Depreciation Tracking Software SQL based software, Easy Asset Maintenence, automated depreciation calculation and Sarbanes-Oxley compliance.

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