# Depreciation

In accountancy, depreciation refers to two aspects of the same concept:

1. the decrease in value of assets (fair value depreciation), and
2. the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle).

The former affects the balance sheet of a business or entity, and the latter affects the net income that they report. Generally the cost is allocated, as depreciation expense, among the periods in which the asset is expected to be used. This expense is recognized by businesses for financial reporting and tax purposes. Methods of computing depreciation, and the periods over which assets are depreciated, may vary between asset types within the same business and may vary for tax purposes. These may be specified by law or accounting standards, which may vary by country. There are several standard methods of computing depreciation expense, including fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service. For example, a depreciation expense of 100 per year for 5 years may be recognized for an asset costing 500.wrong

## Accounting concept

In determining the profits (net income) from an activity, the receipts from the activity must be reduced by appropriate costs. One such cost is the cost of assets used but not immediately consumed in the activity.[1] Such cost so allocated in a given period is equal to the reduction in the value placed on the asset, which is initially equal to the amount paid for the asset and subsequently may or may not be related to the amount expected to be received upon its disposal. Depreciation is any method of allocating such net cost to those periods in which the organization is expected to benefit from use of the asset. The asset is referred to as a depreciable asset. Depreciation is technically a method of allocation, not valuation,[2] even though it determines the value placed on the asset in the balance sheet.

Any business or income producing activity[3] using tangible assets may incur costs related to those assets. If an asset is expected to produce a benefit in future periods, some of these costs must be deferred rather than treated as a current expense. The business then records depreciation expense in its financial reporting as the current period's allocation of such costs. This is usually done in a rational and systematic manner. Generally this involves four criteria:

• cost of the asset,
• expected salvage value, also known as residual value of the assets,
• estimated useful life of the asset, and
• a method of apportioning the cost over such life.[4]

### Depreciable basis

Cost generally is the amount paid for the asset, including all costs related to acquisition.[5] In some countries or for some purposes, salvage value may be ignored. The rules of some countries specify lives and methods to be used for particular types of assets. However, in most countries the life is based on business experience, and the method may be chosen from one of several acceptable methods..

### Net basis

When a depreciable asset is sold, the business recognises gain or loss based on net basis of the asset. This net basis is cost less depreciation.

### Impairment

Accounting rules also require that an impairment charge or expense be recognized if the value of assets declines unexpectedly.[6] Such charges are usually nonrecurring, and may relate to any type of asset. Many companies consider write-offs of some of their long-lived assets because some property, plant, and equipment have suffered partial obsolescence. Accountants reduce the asset's carrying amount by its fair value. For example, if a company continues to incur losses because prices of a particular product or service are higher than the operating costs, companies consider write-offs of the particular asset. These write-offs are referred to as impairments. There are events and changes in circumstances might lead to impairment. Some examples are: • Large amount of decrease in fair value of an asset. • A change of manner in which the asset is used. • Accumulation of costs that are not originally expected to acquire or construct an asset. • A projection of incurring losses associated with the particular asset. Events or changes in circumstances indicate that the company may not be able recover the carrying amount of the asset. In which case, companies use the recoverability test to determine whether impairment has occurred. The steps to determine are: 1. Estimate the future cash flow of asset. (from the use of the asset to disposition) 2. If the sum of the expected cash flow is less than the carrying amount of the asset, the asset is considered impaired.

### Depletion and amortization

Depletion and amortization are similar concepts for minerals (including oil) and intangible assets, respectively.

### Effect on cash

Depreciation expense does not require current outlay of cash. However since depreciation is an expense to the P&L account, provided the enterprise is operating in a manner that covers its expenses (e.g. operating at a profit) depreciation is a source of cash in a statement of cash flows, which generally offsets the cash cost of acquiring new assets required to continue operations when existing assets reach the end of their useful lives.

### Accumulated depreciation

While depreciation expense is recorded on the income statement of a business, its impact is generally recorded in a separate account and disclosed on the balance sheet as accumulated depreciation, under fixed assets, according to most accounting principles. Accumulated depreciation is known as a contra account, because it separately shows a negative amount that is directly associated with another account.

Without an accumulated depreciation account on the balance sheet, depreciation expense is usually charged against the relevant asset directly. The values of the fixed assets stated on the balance sheet will decline, even if the business has not invested in or disposed of any assets. The amounts will roughly approximate fair value. Otherwise, depreciation expense is charged against accumulated depreciation. Showing accumulated depreciation separately on the balance sheet has the effect of preserving the historical cost of assets on the balance sheet. If there have been no investments or dispositions in fixed assets for the year, then the values of the assets will be the same on the balance sheet for the current and prior year (P/Y).

## 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 method. In this method, the company estimates the salvage value(scrap value) of the asset at the end of the period during which it will be used to generate revenues (useful life). (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 or even negative. Salvage value is also known as scrap value or residual value.) The company will then charge the same amount to depreciation each year over that period, until the value shown for the asset has reduced from the original cost to the salvage value.

Straight-line method:

${\mbox{Annual Depreciation Expense}}={{\mbox{Cost of Fixed Asset}}-{\mbox{Residual Value}} \over {\mbox{Useful Life of Asset}}(years)}$

For example, a vehicle that depreciates over 5 years is purchased at a cost of $17,000, and will have a salvage value of$2000. Then this vehicle will depreciate at $3,000 per year, i.e. (17-2)/5 = 3. This table illustrates the straight-line method of depreciation. Book value at the beginning of the first year of depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated depreciation. book value = original cost − accumulated depreciation Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals scrap value. Depreciation expense Accumulated depreciation at year-end Book value at year-end (original cost)$17,000
$3,000$3,000$14,000 3,0006,00011,000 3,0009,0008,000 3,00012,0005,000 3,00015,000(scrap value) 2,000 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 depreciation recapture. 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 Method Suppose a business has an asset with$1,000 original cost, $100 salvage value, and 5 years of useful life. First, the straight-line depreciation rate would be 1/5, i.e. 20% per year. Under the double-declining-balance method, double that rate, i.e. 40% depreciation rate would be used. The table below illustrates this: Depreciation rate Depreciation expense Accumulated depreciation Book value at end of year original cost$1,000.00
40%400.00400.00600.00
40%240.00640.00360.00
40%144.00784.00216.00
40%86.40870.40129.60
129.60 - 100.0029.60900.00scrap value 100.00

When using the double-declining-balance method, the salvage value is not considered in determining the annual depreciation, but the book value of the asset being depreciated is never brought below its salvage value, regardless of the method used. Depreciation ceases when either the salvage value or the end of the asset's useful life is reached.

Since double-declining-balance depreciation does not 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.

With the declining balance method, one can find the depreciation rate that would allow exactly for full depreciation by the end of the period, using the formula:

${\mbox{depreciation rate}}=1-{\sqrt[ {N}]{{\mbox{residual value}} \over {\mbox{cost of fixed asset}}}}$,

where N is the estimated life of the asset (for example, in years).

Annuity depreciation methods are not based on time, but on a level of Annuity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life is estimated in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. The per-mile depreciation rate is calculated as: ($17,000 cost -$2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the depreciation expense is then calculated by multiplying the number of miles driven by the per-mile depreciation rate. ### Sum-of-years-digits method Sum-of-years-digits is a depreciation method that results in a more accelerated write-off than the straight line method, and typically also more accelerated than the declining balance method. Under this method the 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 Example: If an asset has original cost of$1000, a useful life of 5 years and a salvage value of $100, compute its depreciation schedule. First, determine years' digits. Since the asset has useful life of 5 years, the years' digits are: 5, 4, 3, 2, and 1. Next, calculate the sum of the digits: 5+4+3+2+1=15 The sum of the digits can also be determined by using the formula (n2+n)/2 where n is equal to the useful life of the asset in years. The example would be shown as (52+5)/2=15 Depreciation rates are as follows: 5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th year, and 1/15 for the 5th year. Total depreciable cost Depreciation rate Depreciation expense Accumulated depreciation Book value at end of year$1,000 (original cost)
9005/15300 =(900 x 5/15)300700
9004/15240 =(900 x 4/15)540460
9003/15180 =(900 x 3/15)720280
9002/15120 =(900 x 2/15)840160
9001/1560 =(900 x 1/15)900100 (scrap value)

### Units-of-production depreciation method

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

${\mbox{Annual Depreciation Expense}}={{\mbox{Cost of Fixed Asset}}-{\mbox{Residual value}} \over {\mbox{Estimated Total Production}}}\times {\mbox{Actual Production}}$

Suppose, an asset has original cost $70,000, salvage value$10,000, and is expected to produce 6,000 units.

Depreciation per unit = ($70,000−10,000) / 6,000 =$10

10 × actual production will give the depreciation cost of the current year.

The table below illustrates the units-of-production depreciation schedule of the asset.

Units of
production
Depreciation
cost per unit
Depreciation
expense
Accumulated
depreciation
Book value at
end of year

### Real property

Many tax systems prescribe longer depreciable lives for buildings and land improvements. Such lives may vary by type of use. Many such systems, including the United States and Canada, permit depreciation for real property using only the straight line method, or a small fixed percentage of cost. Generally, no depreciation tax deduction is allowed for bare land. In the United States, residential rental buildings are depreciable over a 27.5 year or 40 year life, other buildings over a 39 or 40 year life, and land improvements over a 15 or 20 year life, all using the straight line method.[10]

### Averaging conventions

Depreciation calculations require a lot of record-keeping if done for each asset a business owns, especially if assets are added to after they are acquired, or partially disposed of. However, many tax systems permit all assets of a similar type acquired in the same year to be combined in a "pool". Depreciation is then computed for all assets in the pool as a single calculation. These calculations must make assumptions about the date of acquisition. The United States system allows a taxpayer to use a half year convention for personal property or mid-month convention for real property.[11] Under such a convention, all property of a particular type is considered to have been acquired at the midpoint of the acquisition period. One half of a full period's depreciation is allowed in the acquisition period (and also in the final depreciation period if the life of the assets is a whole number of years). United States rules require a mid-quarter convention for personal property if more than 40% of the acquisitions for the year are in the final quarter.

## Economics

 ExpenseJohn I. Beggs (1847-1925) — The American businessman responsible for modern depreciation techniquesMACRS tax depreciation rules in the U.S.Revaluation of fixed assetsWriting down allowance

## References

1. ^ Costs of assets consumed in producing goods are treated as cost of goods sold. Other costs of assets consumed in providing services or conducting business are an expense reducing income in the period of consumption under the matching principle.
2. ^
3. ^ Under most systems, a business or income producing activity may be conducted by individuals or companies.
4. ^ Kiesco, et al, p. 521. See also Walther, Larry, Principles of Accounting Chapter 10.
5. ^ An allocation of costs may be required where multiple assets are acquired in a single transaction. Purchase price allocation may be required where assets are acquired as part of a business acquisition or combination.
6. ^ A charge for such impairment is referred to in Germany as depreciation.
7. ^
8. ^ 26 USC 179. Amounts extended by American Taxpayer Relief Act of 2012.
9. ^
10. ^ 26 USC 168(c) and (e).
11. ^