Each asset suffers wear and tear according to its specifications, which reduces its operational life until it finally becomes obsolete or unusable. Some assets wear out faster than others, and their value must be recognised on time. This is where the concept of depreciation comes in. Depreciation seeks to recognise this wear and tear of the asset. In this blog, we will discuss the concept of depreciation and its role in a company’s financial planning and asset investment.
Table of Content
- What is Depreciation?
- Depreciation Formula
- Types of Depreciation Methods
- How to Calculate Depreciation?
- The Financial Impact of Depreciation on a Company
What is Depreciation?
Depreciation Meaning: Depreciation is an accounting method that allocates the cost of tangible assets (machinery, buildings, vehicles, and equipment) and intangible assets (patents or copyrights) over their usable lifespan. It reflects the gradual reduction in the value of these assets as they are used in a business's operations or due to the passage of time.
Depreciation Expense = (Cost - Salvage value) ÷ Useful life
Cost = Original purchase price of the asset
Salvage value = Estimated value of the asset at the end of its useful life
Useful life = Number of years that the asset is expected to be used
Types of Depreciation Methods
Different depreciation methods are used in accounting to allocate the cost of assets over their useful lives. Here are some of the most popular ones -
Method: Straight-line depreciation allocates a fixed asset's cost over its useful life. It is a simple and widely used depreciation method, often used for financial reporting purposes.
Formula: Depreciation Expense = (Cost of Asset - Salvage Value) ÷ Useful Life
Example: If a machine costs $50,000, has a useful life of 5 years, and has no salvage value, the annual depreciation expense is $10,000.
Double-Declining Balance Depreciation
Method: It is an accelerated depreciation method with higher depreciation in the early years and decreasing amounts in subsequent years.
Formula: Double Declining Balance Method = 2 x Cost of the asset x Depreciation rate
Example: For a $50,000 asset with a 5-year useful life, the first-year depreciation is $20,000, decreasing yearly.
Method: Depreciation is based on the asset's usage or output rather than time. The cost per unit is determined, and depreciation is calculated based on the actual production or usage.
Formula: Depreciation Expense = (Cost of Asset - Salvage Value) x (Units Produced or Used / Total Expected Units)
Example: If a machine costs $100,000, is expected to produce 100,000 units, and produces 20,000 units in a year, the depreciation expense is based on 20% of the asset's cost.
Method: Accelerated depreciation method where the depreciation expense decreases each year. Sum-of-the-years' digits depreciation method determines an asset's expected depreciation over time.
Formula: Depreciation Expense = (Remaining Useful Life / Sum of the Years' Digits) x (Cost of Asset - Accumulated Depreciation)
Example: For a $60,000 asset with a 5-year useful life, the depreciation expense in the first year is $24,000.
The choice of depreciation method depends on factors like the nature of the asset, its expected usage, tax regulations, and financial reporting requirements.
How to Calculate Depreciation?
Scenario: Imagine you own a small cakery and purchased a delivery van for daily deliveries. The van costs $30,000 and is expected to last five years before it's no longer valuable to your business. At the end of those five years, you don't expect to be able to sell it for any significant amount
We will calculate the depreciation of the van using the Straight-Line Depreciation Method:
Step 1: Determine the cost of the van, which is $30,000
Step 2: Determine the useful life of the van, which is 5 years
Step 3: Determine the salvage value (the van's value at the end of its useful life), which is $0
Step 4: Calculate the depreciation cost (the cost that will be depreciated over time).
- Depreciable cost = Cost of Van - Salvage Value
- Depreciable Cost = $30,000 - $0
- Depreciable Cost = $30,000
Step 5: Calculate the Annual Depreciation Expense.
- Annual Depreciation Expense = Depreciable Cost ÷ Useful Life
- Annual Depreciation Expense = $30,000 ÷ 5 years
- Annual Depreciation Expense = $6,000 annually
In this example, we saw that the annual depreciation expense for the delivery van was $6,000. This means that after each year, the van's value on your balance sheet decreases by $6,000, reflecting its decreasing value over its useful life.
The Financial Impact of Depreciation on a Company
Depreciation holds significant financial implications for any company. Understanding its effects is crucial for effective financial management. Here's how depreciation affects a company's financial management -
Impact on Profit and Loss Statement
- Depreciation represents the wear and tear experienced by a company's fixed assets in its profit and loss statement.
- These depreciation expenses are recorded in the income statement, reducing the company's reported income.
- As expenses increase due to depreciation, overall profitability decreases.
Key Insight: More asset utilisation generates higher income and accelerates depreciation, lowering net profit.
Effect on Financial Structure (Balance Sheet)
- Depreciation directly influences the value of assets on the company's balance sheet.
- Over time, as assets depreciate, their book value decreases.
- This process continues until the asset's value becomes zero.
Key Insight: Depreciation gradually reduces the book value of assets on the balance sheet.
Purpose of Depreciation
- Depreciation serves a critical purpose – it recognises that assets degrade and eventually become unusable.
- As assets wear out or become obsolete, they must be replaced to ensure the company's continued operation and income generation.
Key Insight: Depreciation ensures resources are set aside to replace worn-out assets.
- When depreciated assets need replacement, the company must have the necessary resources.
- Depreciation allocates resources that would otherwise have been distributed as profit.
Key Insight: Depreciation reserves resources for asset replacement, safeguarding the company's long-term viability.
- Depreciation affects taxable income since it reduces reported profits.
- Lower profits result in reduced tax liabilities, potentially benefiting the company.
Key Insight: Depreciation can lead to tax savings for the company.
- Distributing greater profits to partners means distributing the resources set aside for asset replacement through depreciation.
Key Insight: Partners indirectly benefit from depreciation through their share of profits.
Depreciation is like recognizing that things, like machines or buildings, become less valuable as they age or wear out. So, in accounting, we spread out the cost of these things over time to show how they lose value. This helps us make better financial reports and manage our money wisely. Remember, depreciation is vital to keeping our financial records accurate and making smart financial decisions for businesses and organizations.
FAQs - What is depreciation
Why is depreciation necessary in accounting?
Depreciation is necessary to match the cost of an asset with the revenue it generates over its useful life, ensuring accurate financial reporting.
What types of assets are subject to depreciation?
Tangible assets like buildings, machinery, vehicles, and intangible assets such as patents, copyrights, and trademarks are subject to depreciation.
What is the purpose of determining the useful life of an asset?
Determining the useful life helps estimate how long an asset will generate value for the business, which is crucial for calculating depreciation.
How does depreciation impact a company's financial statements?
Depreciation reduces an asset's book value on the balance sheet and decreases net income on the income statement, affecting both financial statements.
Are there tax benefits associated with depreciation?
Yes, depreciation can lower a company's taxable income, reducing its tax liability and providing potential tax savings.