# Depreciation

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In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wear, and second, the allocation in accounting statements of the original cost of the assets to periods in which the assets are used (depreciation with the matching principle). [1]

## Contents

Depreciation is thus the decrease in the value of assets and the method used to reallocate, or "write down" the cost of a tangible asset (such as equipment) over its useful life span. Businesses depreciate long-term assets for both accounting and tax purposes. The decrease in value of the asset affects the balance sheet of a business or entity, and the method of depreciating the asset, accounting-wise, affects the net income, and thus the income statement that they report. Generally, the cost is allocated as depreciation expense among the periods in which the asset is expected to be used.

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 five years may be recognized for an asset costing 500. Depreciation has been defined as the diminution in the utility or value of an asset and is a non-cash expense. It does not result in any cash outflow; it just means that the asset is not worth as much as it used to be. Causes of depreciation are natural wear and tear[ citation needed ].

## Accounting concept

In determining the net income (profits) 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. [2] Such cost 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 the use of the asset. Depreciation is a process of deducting the cost of an asset over its useful life. [3] Assets are sorted into different classes and each has its own useful life. The asset is referred to as a depreciable asset. Depreciation is technically a method of allocation, not valuation, [4] even though it determines the value placed on the asset in the balance sheet.

Any business or income-producing activity [5] 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 the residual value of the assets
• Estimated useful life of the asset
• A method of apportioning the cost over such life [6]

### Depreciable basis

Cost generally is the amount paid for the asset, including all costs related to acquiring and bringing the asset into use. [7] 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.

### Impairment

Accounting rules also require that an impairment charge or expense be recognized if the value of assets declines unexpectedly. [8] 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 natural resources (including oil) and intangible assets, respectively.

### Effect on cash

Depreciation expense does not require a 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 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 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. Theoretically, 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 for 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. The straight-line depreciation is calculated by dividing the difference between assets cost and its expected salvage value by the number of years for its expected useful life. (The salvage value may be zero, or even negative due to costs required to retire it; however, for depreciation purposes salvage value is not generally calculated at below zero.) 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:

${\displaystyle {\mbox{annual depreciation expense}}={{\mbox{cost of fixed asset}}-{\mbox{residual value}} \over {\mbox{useful life of asset}}(years)}}$

DE=(Cost-SL)/UL

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. ### Diminishing balance method Depreciation rate Depreciation expense Accumulated depreciation Book value at year-end 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

The double-declining-balance method is usedto calculate an assets accelerated rate of depreciation against its non depreciated balance during earlier years of assets useful life. 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. The double-declining-balance method is also a better representation of how vehicles depreciate and can more accurately match cost with benefit from asset use. The company in the future may want to allocate as little depreciation expenses as possible to help with additional expenses.

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:

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

where N is the estimated life of the asset (for example, in years). DE= 2 x SLDP x BV

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 shent 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. Sum of the years' digits method of depreciation is one of the accelerated depreciation techniques which are based on the assumption that assets are generally more productive when they are new and their productivity decreases as they become old. The formula to calculate depreciation under SYD method is: SYD depreciation = depreciable base x (remaining useful life/sum of the years' digits) depreciable base = cost − salvage value 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 the years' digits. Since the asset has a 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. Depreciable base 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

Units-of-production depreciation method calculates greater deductions for depreciation in years when the asset is heavily used

${\displaystyle {\mbox{annual depreciation expense}}={{\mbox{cost of fixed asset}}-{\mbox{residual value}} \over {\mbox{estimated total production}}}\times {\mbox{actual production}}}$

DE= ((OV-SV)/EPC) x Units per year

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
year-end

### 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 the 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. [12]

### 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. [13] 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 per property if more than 40% of the acquisitions for the year are in the final quarter.

## Related Research Articles

In accounting, fixed capital is any kind of real, physical asset that is used repeatedly in the production of a product. In economics, fixed capital is a type of capital good that as a real, physical asset is used as a means of production which is durable or isn't fully consumed in a single time period. It contrasts with circulating capital such as raw materials, operating expenses etc.

In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be "tangible book value".

Expenditure is an outflow of money, or any form of fortune in general, to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often referred to as an expense. An expense is a cost that is "paid" or "remitted", usually in exchange for something of value. Something that seems to cost a great deal is "expensive". Something that seems to cost little is "inexpensive". "Expenses of the table" are expenses of dining, refreshments, a feast, etc.

Tax deduction is a reduction of income that is able to be taxed and is commonly a result of expenses, particularly those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and credits. The difference between deductions, exemptions and credits is that deductions and exemptions both reduce taxable income, while credits reduce tax.

An income statement or profit and loss account is one of the financial statements of a company and shows the company's revenues and expenses during a particular period.

A company's earnings before interest, taxes, depreciation, and amortization is an accounting measure calculated using a company's earnings, before interest expenses, taxes, depreciation, and amortization are subtracted, as a proxy for a company's current operating profitability.

In business and accounting, net income is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, and taxes for an accounting period.

Fixed assets, also known as long-lived assets, tangible assets or property, plant and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash. Fixed assets are different than current assets, such as cash or bank accounts, because the latter are liquid assets. In most cases, only tangible assets are referred to as fixed.

Capital expenditure or capital expense is the money an organization or corporate entity spends to buy, maintain, or improve its fixed assets, such as buildings, vehicles, equipment, or land. It is considered a capital expenditure when the asset is newly purchased or when money is used towards extending the useful life of an existing asset, such as repairing the roof.

Consumption of fixed capital (CFC) is a term used in business accounts, tax assessments and national accounts for depreciation of fixed assets. CFC is used in preference to "depreciation" to emphasize that fixed capital is used up in the process of generating new output, and because unlike depreciation it is not valued at historic cost but at current market value ; CFC may also include other expenses incurred in using or installing fixed assets beyond actual depreciation charges. Normally the term applies only to producing enterprises, but sometimes it applies also to real estate assets.

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Capital Cost Allowance (CCA) is the means by which Canadian businesses may claim depreciation expense for calculating taxable income under the Income Tax Act (Canada). Similar allowances are in effect for calculating taxable income for provincial purposes.

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The situation of additional taxes or tax savings resulting from selling the last item of its class in an inventory due to difference between its undepreciated capital cost (UCC) and its salvage value (SV).

Accounting for leases in the United States is regulated by the Financial Accounting Standards Board (FASB) by the Financial Accounting Standards Number 13, now known as Accounting Standards Codification Topic 840. These standards were effective as of January 1, 1977. The FASB completed in February 2016 a revision of the lease accounting standard, referred to as ASC 842.

Deferred tax is a notional asset or liability to reflect corporate income taxation on a basis that is the same or more similar to recognition of profits than the taxation treatment. Deferred tax liabilities can arise as a result of corporate taxation treatment of capital expenditure being more rapid than the accounting depreciation treatment. Deferred tax assets can arise due to net loss carry-overs, which are only recorded as asset if it is deemed more likely than not that the asset will be used in future fiscal periods. Different countries may also allow or require discounting of the assets or particularly liabilities. There are often disclosure requirements for potential liabilities and assets that are not actually recognised as an asset or liability.

Accelerated depreciation refers to any one of several methods by which a company, for 'financial accounting' or tax purposes, depreciates a fixed asset in such a way that the amount of depreciation taken each year is higher during the earlier years of an asset's life. For financial accounting purposes, accelerated depreciation is expected to be much more productive during its early years, so that depreciation expense will more accurately represent how much of an asset's usefulness is being used up each year. For tax purposes, accelerated depreciation provides a way of deferring corporate income taxes by reducing taxable income in current years, in exchange for increased taxable income in future years. This is a valuable tax incentive that encourages businesses to purchase new assets.

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A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

International Accounting Standard 16 Property, Plant and Equipment or IAS 16 is an international financial reporting standard adopted by the International Accounting Standards Board (IASB). It concerns accounting for property, plant and equipment, including recognition, determination of their carrying amounts, and the depreciation charges and impairment losses to be recognised in relation to them.

## References

1. Raymond H. Peterson, Accounting for Fixed Assets, John Wiley and Sons, Inc., 2002
2. 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.
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 Archived 2010-07-29 at the Wayback Machine .
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. 26 USC 179. Amounts extended by American Taxpayer Relief Act of 2012.
8. 26 USC 168(c) and (e).
• Kieso, Donald E; Weygandt, Jerry J.; and Warfield, Terry D.: Intermediate Accounting, Chapter 11. ISBN   978-0-471-44896-9.
• Financial Accounting Standards Board (U.S.) Accounting Standards Codification 360-10-35. Available for free browsing access with registration.
• International Financial Reporting Standards IAS 16
• Depreciation Journal Entries

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