Depreciation

Depreciation is a term used in accounting, economics and finance to spread the cost of an
asset over the span of several years.

In common speech, depreciation is the reduction in the cost of an asset used for business
purposes during certain amount of time due to usage, passage of time, wear and tear,
technological outdating or obsolescence, depletion, inadequacy, rot, rust, decay or other such
factors.

In accounting, however, 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.[1] 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 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.

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, nor be "added back" to net income (along with other items) to derive the operating
cash flow.[2] 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 match the
depreciation for tax purposes.

Because of its non-standardized derivation, depreciation is a key component of EBITDA, a

metric used to gauge the worth of a company independent of tax-jurisdiction effects and
capitalization structure.

Salvage value is the estimated value of an asset at the end of its useful life. In accounting, the
salvage value of an asset is its remaining value after depreciation. This is also known as
residual value or scrap value. It is the net cash inflow that occurs when the asset is liquefied
at the end of its life. Salvage value can be negative if the residual asset requires special
treatment to terminate—for example, used nuclear materials or CRT's containing lead.
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 C0 at the beginning of
a period, investment is I and depreciation D, the capital stock at the end of the period, C1, is
C0 + I - D.

Contents
 1 Accounting
 2 Recording depreciation
 3 Methods of depreciation
o 3.1 Straight-line depreciation

o 3.2 Declining-balance method

o 3.3 Activity depreciation

o 3.4 Sum-of-years' digits method

o 3.5 Units-of-production depreciation method

o 3.6 Units of time depreciation

o 3.7 Group depreciation method

o 3.8 Composite depreciation method

 4 Taxes
 5 Economics
o 5.1 Models

o 5.2 National accounts

 6 See also
 7 References

 8 External links
Accounting
A company needs to report depreciation accurately in its financial statements in order to
achieve two main objectives:
1. matching its expenses with the income generated by means of those expenses, and
2. ensuring 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 attempt to write-off the cost of Non Current Asset over its useful life. The
word write-off means to turn it into an expense. 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 should 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. (Decommissioning a nuclear power
plant is a nontrivial expense.) 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
that represents a future expense, such as work in progress. 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 at the end of the period during which it will
be used to generate revenues (useful life) and will expense a portion of original cost in equal
increments over that period. 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.

Straight-line method:

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
depreciable cost of the asset divided by the number of years of its useful life.

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.

Book value at Depreciation Accumulated Book value at

beginning of year expense depreciation end of year
$17,000 (original cost) $3,000 $3,000 $14,000
$14,000 $3,000 $6,000 $11,000
$11,000 $3,000 $9,000 $8,000
$8,000 $3,000 $12,000 $5,000
$5,000 $3,000 $15,000 $2,000 (scrap value)

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 departments and company's view of the profit.

Declining-balance method
Depreciation methods that provide for a higher depreciation charge in the first year of an
asset's life and gradually decreasing charges in subsequent years are called accelerated
depreciation methods. 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. One
popular accelerated method is the declining-balance method. Under this method the book
value is multiplied by a fixed rate.

annual depreciation = depreciation rate * book value at beginning of year

The most common rate used is double the straight-line rate. For this reason, this technique is
referred to as the double-declining-balance method. To illustrate, suppose a business has an
asset with $1,000 original cost, $100 salvage value, and 5 years useful life. First, calculate
straight-line depreciation rate. Since the asset has 5 years useful life, the straight-line
depreciation rate equals (100% / 5) 20% per year. With double-declining-balance method, as
the name suggests, double that rate, or 40% depreciation rate is used. The table below illustrates
the double-declining-balance method of depreciation.

Book value at Depreciation Depreciation Accumulated Book value at

beginning of year rate expense depreciation end of year
$1,000 (original cost) 40% $400 $400 $600
$600 40% $240 $640 $360
$360 40% $144 $784 $216
$216 40% $86.40 $870.40 $129.60
$129.60 $129.60 - $100 $29.60 $900 $100 (scrap value)

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. The process continues
until the salvage value or the end of the asset's useful life, is reached. In the last year of
depreciation a subtraction might be needed in order to prevent book value from falling below
estimated Scrap Value.

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.

It is possible to find a rate that would allow for full depreciation by its end of life with the
formula:

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

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, 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 rate by the actual activity level.

Sum-of-years' digits method

Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than
straight line, but less than declining-balance method. Under this method 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. 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
Book value at Depreciation Depreciation Accumulated Book value at
depreciable
beginning of year rate expense depreciation end of year
cost
$1,000 (original $300 ($900 *
$900 5/15 $300 $700
cost) 5/15)
$240 ($900 *
$700 $900 4/15 $540 $460
4/15)
$180 ($900 *
$460 $900 3/15 $720 $280
3/15)
$120 ($900 *
$280 $900 2/15 $840 $160
2/15)
$60 ($900 * $100 (scrap
$160 $900 1/15 $900
1/15) 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:

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 x actual production will give you the depreciation cost of the current year.

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

Book value at Units of Depreciation Depreciation Accumulated Book value at

beginning of year production cost per unit expense depreciation end of year
$70,000 (original
1,000 $10 $10,000 $10,000 $60,000
cost)
$60,000 1,100 $10 $11,000 $21,000 $49,000
$49,000 1,200 $10 $12,000 $33,000 $37,000
$37,000 1,300 $10 $13,000 $46,000 $24,000
$10,000 (scrap
$24,000 1,400 $10 $14,000 $60,000
value)

Depreciation stops when book value is equal to the Scrap Value of the asset. In the end the
sum of accumulated depreciation and scrap value equals to the original cost.

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 companies, where some equipment is used
only for some specific purpose. Depending on the number of projects, the equipment will be
used and depreciation charged accordingly.

Group depreciation method

Group depreciation method is used for depreciating multiple-asset accounts using straight-line-
depreciation method. Assets must be similar in nature and have approximately the same useful lives.

Historical Salvage Depreciable Depreciation

Asset Life
cost value cost per year
Computers $5,500 $500 $5,000 5 $1,000

Composite depreciation method

The composite method is applied to a collection of assets that are not similar, and have different
service lives. For example, computers and printers are not similar, but both are part of the office
equipment. Depreciation on all assets is determined by using the straight-line-depreciation method.

Historical Salvage Depreciable Depreciation

Asset Life
cost value cost per year
Computers $5,500 $500 $5,000 5 $1,000
Printers $1,000 $100 $ 900 3 $ 300
Total $ 6,500 $600 $5,900 4.5 $1,300

Composite life equals the total depreciable cost divided by the total depreciation per year.
$5,900 / $1,300 = 4.5 years.

Composite depreciation rate equals depreciation per year divided by total historical cost.
$1,300 / $6,500 = 0.20 = 20%

Depreciation expense equals the composite depreciation rate times the balance in the asset
account (historical cost). (0.20 * $6,500) $1,300. Debit depreciation expense and credit
accumulated depreciation.

When an asset is sold, debit cash for the amount received and credit the asset account for its
original cost. Debit the difference between the two to accumulated depreciation. Under the
composite method no gain or loss is recognized on the sale of an asset. Theoretically, this
makes sense because the gains and losses from assets sold before and after the composite life
will average themselves out.

To calculate composite depreciation rate, divide depreciation per year by total historical cost.
To calculate depreciation expense, multiply the result by the same total historical cost. The
result, not surprisingly, will equal to the total depreciation Per Year again.

Common sense requires depreciation expense to be equal to total depreciation per year,
without first dividing and then multiplying total depreciation per year by the same number.
Creators of accounting rules sometimes are very creative, as was noted on the discussion
forum of accounting coach at [1]

Taxes
Main article: Modified Accelerated Cost Recovery System

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.[3]

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
large 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 arbitrary 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, including landscaping, are usually depreciable.

In the U.S., there are generally five variables that a taxpayer must take into account when
computing the correct depreciation deduction:

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
Models
In economics, the value of a capital asset may be modeled as 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 or a reduction in the discount rate, its value may increase rather than
decline. Depreciation is then negative.

Depreciation can alternatively be measured as the change in the market value of capital over
a given period: the market price of the capital at the beginning of the period minus its market
price at the end of the period.

Such a method in calculating depreciation differs from other methods, such as straight-line
depreciation in that it is included in the calculation of implicit cost, and thus economic profit.

Modeling depreciation of a durable as delivering the same services from purchase until
failure, with zero scrap value (rather than slowing degrading and retaining residual value), is
referred to as the light bulb model of depreciation, or more colorfully as the one-hoss shay
model, after a poem by Oliver Wendell Holmes, Sr., about a carriage which worked perfectly
for exactly one hundred years, then fell completely apart in an instant.[4]

National accounts

In national accounts the decline in the aggregate capital stock arising from the use of fixed
assets in production is referred to as consumption of fixed capital (CFC). Hence, CFC is
equal to the difference between aggregate gross fixed capital formation (gross investment)
and net fixed capital formation (net investment) or between Gross National Product and Net
National Product. Unlike depreciation in business accounting, CFC 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 to be derived from their use.