Depreciation is a crucial business term. Every business person should learn about depreciation to calculate business expenses and the price of the products accurately. Any machinery or tool starts depreciating as soon as you buy it. For example, you bought a machine, and its value starts to decrease as soon as you installed it in your factory. Therefore, it becomes crucial for a business person to learn about depreciation.
In this article, you will learn about the definition of depreciation, what depreciation is, how to calculate depreciation, and what are the different types of depreciation.
Depreciation can be defined as the decrease in the recorded cost of a fixed asset of an organization calculated systematically until the value of the fixed asset becomes zero or negligible.
What is depreciation?
“Depreciation” is a business term used for the reducing value of machinery, devices, furniture, buildings, computer, equipment, parking space, car, trucks, office lighting, etc. The assets that I mentioned here are the assets that will last more than a year but are not going to last forever. The value of these assets is used up at the end of each accounting period. The accounting period can be a quarter, month, half-yearly, or yearly.
However, the land is a fixed asset of an organization, which is an exception for depreciation as its value doesn’t depreciate with time, but it appreciates with each passing year. But there can be land improvement depreciation, as well as the cost of a building built on the land is considered as a fixed asset whose value depreciates with the passing time.
The portion of a fixed asset that is used at the end of every financial period is termed as depreciation. The decreased value of fixed assets is reported as depreciation expense in the income statement. A portion of fixed asset’s cost is moved from balance sheet to income statement by the end of each financial period of the fixed asset.
Let us understand depreciation with the help of an example. Let us consider a company that buys a machine worth $200,000. The machine is expected to work well for ten years.
Depreciation can be calculated and reported. Therefore, the company will depreciate the asset under depreciation expense as $20,000 every financial year for ten years.
Two principles can be considered while calculating the depreciation value of a fixed asset
1. Cost Principle
According to the cost principle, the depreciation expense of a fixed asset reported on the annual balance sheet and income statement of an organization must be based on the original value of the asset.
The value should not be found on the current value of the asset in the market as well as it should not be based on the amount that will be spent to replace the asset.
2. Matching Principle
The matching principle states that the value of the fixed asset should be assigned to depreciation expense in the income statement throughout its life. According to this principle, the total cost of the fixed asset is divided so that some of the cost of the fixed asset is mentioned on the income statement of the organization.
In this way, the company tries to recover the cost of the asset for each period in which the asset was used. In simple words, it can be said that the value of the fixed asset is recovered from the total revenue generated by the organization throughout the life period of the fixed asset.
How to calculate the depreciation value?
Different methods are used to calculate the depreciation value of a fixed asset. However, to estimate the depreciation value of a fixed asset, it is necessary to include the original cost of the asset.
The initial price must also include the cost of acquiring the asset, transporting the asset, and the total cost of installing or setting up the asset. Then the scrap value or salvage value of the asset is subtracted from the original amount. Then the number obtained is divided over the total life cycle of the asset.
The life of an asset is determined by the Internal Revenue Services set up for different types of properties. Companies can mention a specific amount of depreciation value of an asset on their income tax return for each financial year of the life of the asset.
This is done by many businesses to get tax advantages. For example, if a company has bought a vehicle of value $300,000 and the expected life of the vehicle is ten years, then the company can deduct $3000 in the form of depreciation of the vehicle from the tax return for ten years.
Types of Depreciation
Depreciation can be calculated by three methods that are given by the Internal Revenue Services. The three purposes of calculating the depreciation value are straight-line depreciation, double-line depreciation, and the sum of the year digit.
You can get different benefits by using different methods. Therefore, you should consult with your tax professional before adopting any of the depreciation methods.
Now let us learn about all of the depreciation methods one by one.
The following are the three main inputs that you need to consider while applying any of the depreciation methods.
1. Salvage value
The salvage value is the value of the asset at which it is sold once its useful life is over. The salvage value is considered because companies usually sell out the assets at reduced prices once the useful life of the products is over.
The salvage value can be a value at which the product is sold to another company, or it can be the scrap value of the product if it is of no use at all after its useful life is over.
2. Useful life
The useful life is the life of the assets for which it is considered productive. Once the useful life of the asset is over, the asset becomes least cost-effective for the company. For example, if the useful life of a machine is ten years, then the owner of the device will try to recover the depreciation cost within those ten years.
3. The original cost of the asset
The original cost of the asset is the cost at which the asset is bought along with expenses like transportation cost, shipping cost, taxes, and packaging cost, etc.
- Straight-line depreciation method:
The straight-line depreciation method is the simplest method of calculating depreciation. In this method, the rate of depreciation is evenly divided over the years of the useful life of the asset.
The following is the formula for calculating the depreciation value of an asset.
Annual depreciation rate = ( Asset cost – Residual value or salvage value ) / Useful life of the asset.
Consider your company buys a machine worth $200,000, and the salvage value or residual value of the machine is $10,000. The useful life of the machine is 20 years.
The annual depreciation rate can be calculated by putting these values in the above formula.
Annual depreciation rate = ( 200,000 – 10,000 ) / 20 = 9500
The annual depreciation expense you need to add to your income statement will be 9500.
Unit of production method
The unit of production method is a little complex compared to the straight-line depreciation method, as this method involves two steps instead of one step. In the unit of production method, the equal expense rate is equally distributed among each unit produced.
This method is beneficial in the assembly of the production line. Therefore, in this method, the depreciation calculation depends on the production capacity of the company rather than the total number of years of the useful life of the asset.
The followings are the steps involved in the unit of production method:
Step 1. Calculate the per-unit depreciation:
Per Unit Depreciation: ( Asset Cost – Residual or Salvage cost ) / Useful life in units of production
Step 2. Calculation of the total depreciation of total units produced:
Total Depreciation Expense: Per Unit Depreciation * Units Produced
Let us understand the example
Consider your company buys a machine for $100,000, which has a useful life of 200,000 units and a residual value of $5000. Using this machine, the company produces 5000 products.
The rate of depreciation can be calculated by following the steps of the unit of production method.
Step 1. ( $100,000 – $5000 ) / $200,000 = $0.475
Step 2. $0.475 * 5000 = $2375
The total depreciation expense calculated using unit of production is $2375. This output can be applied to future output operations.
Double declining method
The double-declining method is the second conventional method used by companies to calculate the depreciation value after the straight-line depreciation method. It is also known as an accelerated depreciation method. The double-declining depreciation method calculates the expense twice the book value of the asset every year.
The formula to calculate the double-declining method is as follows:
Depreciation = 2 * Straight-line depreciation percent * The book value at the beginning of the accounting year.
Book value = Cost of the asset – accumulated depreciation.