Depreciation:

Depreciation:
Definition: The monetary value of an asset decreases over time due to use, wear and tear or obsolescence.
This decrease is measured as depreciation.
Depreciation, i.e. a decrease in an asset's value, may be caused by a number of other factors as well such
as unfavorable market conditions, etc. Machinery, equipment, currency are some examples of assets that
are likely to depreciate over a specific period of time. Opposite of depreciation is appreciation which is
increase in the value of an asset over a period of time.
Accounting estimates the decrease in value using the information regarding the useful life of the asset.
This is useful for estimation of property value for taxation purposes like property tax etc. For such assets
like real estate, market and economic conditions are likely to be crucial such as in cases of economic
downturn
What Is Depreciation?
Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful
life or life expectancy. Depreciation represents how much of an asset's value has been used up.
Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each
year the asset is in use. If not taken into account, it can greatly affect profits.
Businesses can depreciate long-term assets for both tax and accounting purposes. For example, companies
can take a tax deduction for the cost of the asset, meaning it reduces taxable income. However, the
Internal Revenue Service (IRS) states that when depreciating assets, companies must spread the cost out
over time. The IRS also has rules for when companies can take a deduction.1
Depreciation methodically accounts for decreases in the value of a company’s assets over time. In the
United States, accountants must adhere to generally accepted accounting principles (GAAP) in
calculating and reporting depreciation on financial statements. GAAP is a set of rules that includes the
details, complexities, and legalities of business and corporate accounting. GAAP guidelines highlight
several separate allowable methods of depreciation that accounting professionals may use.1

Depreciation accounts for decreases in the value of a company’s assets over time.
Accountants must adhere to generally accepted accounting principles (GAAP) for depreciation.
What Are the Different Methods for Calculating Depreciation?How the Different Methods of
Depreciation Work
There are four methods for depreciation: straight line, declining balance, sum-of-the-years' digits, and
units of production.

Straight-Line Depreciation
The straight-line method determines the estimated salvage value (scrap value) of an asset at the end of its
life and then subtracts that value from its original cost. The difference is the value that is lost over time
during the asset's productive use. That difference is also the total amount of depreciation that must be
expensed.

Declining Balance Depreciation

The declining balance method is a type of accelerated depreciation used to write off depreciation costs
more quickly and minimize tax exposure. With the declining balance method, management expenses
depreciate at an accelerated rate rather than evenly over a scheduled number of years. This method is
often used if an asset is expected to have greater utility in its earlier years. This method also helps to
create a larger realized gain when the asset is actually sold. Some companies may also use the double-
declining balance method, which is an even more aggressive depreciation method for early expense
management.

Sum-of-the-Years' Digits Depreciation

The sum-of-the-years' digits method offers a depreciation rate that accelerates more than the straight-line
method but less than the declining balance method. Annual depreciation is separated into fractions using
the number of years of the business asset's useful life. Such assets may include buildings, machinery,
furniture, equipment, vehicles, and electronics.

To cite an example, consider an asset with a useful life of five years, which will have a sum-of-the-years
value of 15 (5 + 4 + 3 + 2 + 1). The first year is assigned a value of 5, the second year value of 4, and so
on. The depreciation rate for the first year is the straight-line value multiplied by the first year's fraction (5
÷ 15, or one-third).

Sometimes called the “SYD” method, this approach is also more appropriate than the straight-line
depreciation model if an asset depreciates more quickly or has greater production capacity during its
earlier years.

Units of Production Depreciation

Units of production assigns an equal expense rate to each unit produced, which makes it most useful for
assembly or production lines. The formula involves using historical costs (the price of an asset based on
its nominal or original cost when acquired by the company) and estimated salvage values. The method
then determines the expense for the accounting period multiplied by the number of units produced.

Special Considerations
Overall, companies have several different options for depreciating the value of an asset over time. Most
companies use a standard depreciation methodology for all of the company’s assets. Thus, depreciation
methodologies are typically industry-specific.

which depreciation method is best among the above:

The straight-line method is the simplest and most commonly used way to calculate depreciation under
generally accepted accounting principles. Subtract the salvage value from the asset's purchase price, then
divide that figure by the projected useful life of the asset

The difference between depreciation expense and accumulated depreciation:

Depreciation expense is the appropriate portion of a company's fixed asset's cost that is being used up
during the accounting period shown in the heading of the company's income statement.

Depreciation expense is the periodic depreciation charge that a business takes against its assets in each
reporting period. Accumulated depreciation is the cumulative amount of this depreciation that has piled
up since the initiation of depreciation for each asset. The following differences apply to the two concepts:
Depreciation expense appears on the income statement, while accumulated depreciation appears on the
balance sheet.
The balance in the depreciation expense account is a debit, while the balance in the accumulated
depreciation account is a credit.
Depreciation expense is a separate and independent line within the income statement, while accumulated
depreciation is paired with and offsets the fixed assets line item on the balance sheet.
The depreciation expense for an asset is halted when the asset is sold, while accumulated depreciation is
reversed when the asset is sold.

Example of Depreciation Expense and Accumulated Depreciation

Quest Adventure Gear buys an automated industrial sewing machine for $60,000, which it expects to
operate for the next five years. Quest uses straight-line depreciation. Based on the 60-month useful life of
the machine, Quest will charge $12,000 of this cost to depreciation expense in each of the next five years.
At the end of the first year, the related amount of accumulated depreciation will be $12,000, followed by
$24,000 at the end of the second year, $36,000 at the end of the third year, $48,000 at the end of the
fourth year, and $60,000 at the end of the fifth year.

What Is Accumulated Depreciation?

The accumulated depreciation account is a contra asset account on a company's balance sheet, meaning it
has a credit balance. It appears on the balance sheet as a reduction from the gross amount of fixed assets
reported.

The amount of accumulated depreciation for an asset or group of assets will increase over time as
depreciation expenses continue to be credited against the assets. When an asset is eventually sold or put
out of use, the accumulated depreciation associated with that asset will be reversed, eliminating all record
of the asset from the company's balance sheet.

What Are Depreciation Expenses?

Depreciation expenses, on the other hand, are the allocated portion of the cost of a company's fixed assets
that are appropriate for the period. Depreciation expense is recognized on the income statement as a non-
cash expense that reduces the company's net income. For accounting purposes, the depreciation expense
is debited, and the accumulated depreciation is credited.

What is Depreciation Expense?

Depreciation expense is the type of expense that is the amount of an asset’s cost that has been allocated and
reported as an expense for the period in the income statement. It is a non-cash expense that reduces the
company’s net income.
For financial statement purposes, the depreciation amount should be applied against the business’s income for
the year on the income statement.
The calculation of depreciation expense follows the matching principle of accounting, which requires that
revenues earned in an accounting period must always be matched with related expenses.
Four factors play a significant role in determining depreciation expense. They are:
1. Asset cost
2. Salvage Value
3. The useful life of the asset

4. Obsolescence

What is Accumulated Depreciation?

Accumulated depreciation is an aggregate of depreciation expenses of an asset until its lifetime. It gives an
idea about the relative age of assets.
The amount of accumulated depreciation of an asset or group of assets will increase over time as depreciation
expenses continue to be credited against the assets of the business.
Let us look at the most important points of difference between depreciation expense and accumulated
depreciation in the following table.

Parameters Depreciation Expense Accumulated Depreciation

Definition Depreciation expense is the amount of cost of Accumulated depreciation is the
an asset that is allocated and reported at the end total depreciation that is incurred for
of the financial year an asset
Debit or Credit Depreciation expense is placed as a debit Accumulated depreciation is
represented as a credit
Representation in the Reported in the balance sheet Reported in the Income statement
book of accounts
Sale of Asset Depreciation expense halted when the asset is Accumulated depreciation gets
sold reversed when the asset is sold

why a business might choose an accelerated depreciation method?

Many companies employ accelerated depreciation methods when they have assets that they expect to be
more productive in their early years. Accelerated depreciation helps companies shield income from taxes
-- after all, the higher the depreciation expense, the lower the net income.
Accelerated depreciation is any method of depreciation used for accounting or income tax purposes that
allows greater deprecation expenses in the early years of the life of an asset. ... This is unlike the straight-
line depreciation method, which spreads the cost evenly over the life of an asset.
The main advantage of an accelerated depreciation system is it lets you take a higher deduction
immediately. By receiving a higher depreciation deduction today, a business will reduce its current tax
bill. This deduction is especially helpful for new businesses who may be having short-term cash-flow
problems.

How Does Accelerated Depreciation Work?

Let's assume Company XYZ purchases a piece of machinery for $1,000,000, and that piece of machinery
is expected to last for 10 years. If Company XYZ were using the straight-line method of depreciation (not
accelerated), each year it would simply record on its income statement depreciation expense equal to one-
tenth of the asset's cost ($1,000,000/10 = $100,000). This method would spread the cost of the asset out
evenly over the life of the asset.

However, if Company XYZ uses an accelerated depreciation method, it might expense far more of the
asset's cost in the first few years and expense less cost in the later years.
The most popular accelerated depreciation methods are the Sum of the Years Digits method and the
Double Declining Balance (DDB) method. Let's look at the DDB method first.
The formula for Double Declining Balance Depreciation is:
((cost of asset - salvage value) / years of useful life) x

A secondary reason for using accelerated depreciation is that it may actually reflect the usage pattern of
the underlying assets, where they experience heavier usage early in their useful lives.

Depreciation Methods:
There are several calculations available for accelerated depreciation, such as the double declining balance
method and the sum of the years' digits method. If a company elects not to use accelerated depreciation, it
can instead use the straight-line method, where it depreciates an asset at the same standard rate throughout
its useful life. All of the depreciation methods end up recognizing the same amount of depreciation,
which is the cost of the fixed asset, less any expected salvage value. The only difference between the
various methods is the speed with which depreciation is recognized.

When Accelerated Depreciation is Not Used

Accelerated depreciation requires additional depreciation calculations and record keeping, so some
companies avoid it for that reason (though fixed asset software can readily overcome this issue).
Companies may also ignore it if they are not consistently earning taxable income, which takes away the
primary reason for using it. Companies may also ignore accelerated depreciation if they have a relatively
small amount of fixed assets, since the tax effect of using accelerated depreciation is minimal. Finally, if a
company is publicly held, management may be more interested in reporting the highest possible amount
of net income in order to buoy its stock price for the benefit of investors - these companies will likely not
be interested in accelerated depreciation, which reduces the reported amount of net income.
Financial Analysis Effects
From a financial analysis perspective, accelerated depreciation tends to skew the reported results of a
business to reveal profits that are lower than would normally be the case. This is not the situation over the
long-term, as long as a business continues to acquire and dispose of assets at a steady rate. To properly
review a business that uses accelerated depreciation, it is better to review its cash flows, as revealed on it
statement of cash flows.

Types of Accelerated Depreciation Methods

Double-Declining Balance Method
The double-declining balance (DDB) method is an accelerated depreciation method. After taking the
reciprocal of the useful life of the asset and doubling it, this rate is applied to the depreciable base—also
known as the book value, for the remainder of the asset’s expected life.

For example, an asset with a useful life of five years would have a reciprocal value of 1/5 or 20%. Double
the rate, or 40%, is applied to the asset's current book value for depreciation. Although the rate remains
constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable
base each period.

Sum of the Years’ Digits (SYD)

The sum-of-the-years’-digits (SYD) method also allows for accelerated depreciation. To start, combine
all the digits of the expected life of the asset. For example, an asset with a five-year life would have a
base of the sum-of-the-digits one through five, or 1+ 2 + 3 + 4 + 5 = 15.

In the first depreciation year, 5/15 of the depreciable base would be depreciated. In the second year, only
4/15 of the depreciable base would be depreciated. This continues until year five depreciates the
remaining 1/15 of the base.
what are the factors to be considered in computing for depreciation expense?

There are four main factors that affect the calculation of depreciation expense: asset cost, salvage value,
useful life, and obsolescence
Factors are the percentages that are used to depreciate assets. ... In progressive depreciation, the amount
of depreciation increases each depreciation period. In digressive depreciation, the amount of depreciation
per period decreases over time. In straight line depreciation, the depreciation is the same in each period.
What are the factors for accurate depreciation?

Depreciation is apportioning the cost of a fixed asset over a period of time instead of deducting the total
cost as an expense upon purchase. Five factors are required in order to produce an accurate depreciation
figure.
The 5 factors needed for depreciation:
1. Date placed in service - If a new asset is placed in service immediately upon acquisition, its date placed
in service is simple to establish. If an asset is added to a register that was already placed in service but
originally excluded from the fixed asset register, determining the date placed in service will be more of a
challenge, but important for your calculations.
2. Acquisition value - This is referring to an asset's value at the end of its useful life.
3. Salvage value - Fixed assets are typically recorded at historical cost. If an asset, such as a building, is
of significant value, a more formal appraisal may be required to determine its value. For assets that have
been excluded from the fixed asset register, you may first want to try researching the item's historical
cost. If that information is unavailable, it is permissible to estimate the amount based on a similar asset's
value.
4. Estimated useful life - The estimated useful life of an asset refers to the number of years that an asset
can be used for its original intent.
5. Depreciation method - Using the straight-line method to calculate depreciation of fixed assets would
consist of the following: Depreciation = Acquisition Value - Salvage Value/Estimated Useful Life. The
asset is written off evenly over the course of its useful life, resulting in equal depreciation from year to
year.
For help with accurate depreciation calculations, fixed asset software can efficiently manage depreciation
budgeting and forecasting and offer tracking functionalit

Causes of Depreciation:
1. Normal Physical Wear and Tear:
Due to normal use of the assets, the assets deteriorate physically, which results in reduction in their value.

2. Efflux of Time:
Certain intangible assets have fixed life span such as Trade Marks, Patents or Copyrights etc. The value
of such assets decreases anyway with the passage of time irrespective of the fact business enterprise is
using them or not.

3. Obsolescence:
Research & Development leads to innovations, in the form of better and technically advanced machines
that scrap old machines even though they may be capable of being run physically.

In that case there may be a permanent decrease in the market prices of certain assets like Computers,
Motor Cars etc. This results in decline in the value of old machines. Obsolescence is a loss arising from
outdating and replacing the existing asset with the new and improved model of that asset.

4. Accidents:
Destruction or damage caused by an accident may result in reducing the value of assets.

Factors Affecting Depreciation:

As already stated, depreciation is not an attempt to record the changes in the market value of the asset but
a systematic allocation of the total cost of depreciable asset (capital expenditure) to expenses (revenue
expenditure) over the useful life of the asset because market value of some assets may increase in short
run but even then the depreciation process continues. Based on the matching principle a reasonable
portion of capital expenditure (i.e. the cost of the asset) should be charged to revenue during the useful
life of an asset.

Depreciation

The calculation of amount of depreciation expense for an accounting period is affected by the:

(i) Actual cost of the asset

(ii) Estimated useful life of the asset

(iii) Estimated residual value of the asset.

It is worth mentioning here that out of three factors, two factors are based on just estimation and only one
factor is based on actual. Thus, calculation of depreciation expense is just an estimated loss in value of
assets and not the real and exact decrease in value of an asset.
Now we shall move on to discuss each of the above factors in detail:
1. Actual Cost of the Asset:
Actual cost or historical cost means the acquisition cost of the asset and includes all incidental expenses
which are necessary to bring the asset to its present condition and location. Examples of such expenses
are installation charges, freight inwards or expenses incurred for improvements of such assets and which
are of capital nature.
2. Estimated Useful Life of the Asset:
Estimated useful life of the asset is either:
(i) The period over which a depreciable asset is expected to be used by the enterprise or
(ii) The number of production or similar units expected to be obtained from the use of the asset by the
enterprise.
3. Estimated Residual or Scrap Value of the Asset:
Residual or scrap value is the expected value which may be realized when the asset is sold or exchanged
at the end of its estimated useful life. When residual value is significant, it should be taken into
consideration for computing depreciation. However, an insignificant residual value can be ignored for
computation of depreciation.

Depreciation is a continuous process, but we don’t record depreciation daily. Actually, the total amount of
depreciation to be charged on any asset is an advance expenditure which has been paid by the enterprise
at the time of acquisition of such asset.

In other words, this expenditure should be treated like deferred expenditure and only adjusting entries, for
charging reasonable and appropriate amount of depreciation to revenue in the income statement, are
required to be passed every year