Depreciation of Assets
Depreciation can be defined as an expense that reduces the value of an asset over a certain period of time due to usage, wear and tear, decay, age or other factors.Â Depreciation does not recognize a loss in market value or difference between original cost and replacement cost of an asset; rather it is a process of allocating the cost of an asset to the years in which the benefits of the asset are realized.
There are two broad categories of depreciation calculation methods for financial accounting purposes, namely the straight-line methods and the accelerated depreciation methods.
Straight line depreciation method is the most commonly used depreciation method among a lot of companies.Â The depreciation expense using this method can be calculated as the difference between the asset's cost and its estimated salvage value over its estimated useful life.Â The salvage value of an asset is the estimated value at the end of its useful life. Hence if a company bought a machine for $57,000 with an estimated useful life of 5 years and a salvage value of $7,000, the annual depreciation expense would be ($57,000 - $7,000) / 5 years = $10,000 and the depreciation rate would be 1 / estimated life in years = 1 / 5 = 20%
Accelerated Depreciation methods cause higher depreciation expenses during the early years of the asset's life and hence a lower net income than straight-line depreciation.Â The most commonly used accelerated depreciation method is the declining balance method where a constant depreciation rate is applied each year to the declining balance of the net book value.Â The net book value is calculated at the end of each year after deducting the depreciation expense from the net book value from the beginning of the year. Double declining balance calculation is where the depreciation rate used is twice the straight line rate.Â Â For e.g. for the same machinery, the annual depreciation expense would be $57,000 * 40% = $22,800 for the first year.Â For the second year, the net book value will be first calculated as $57,000 - $22,800 = $34,200 which is now used to calculate the depreciation expense for the second year as $34,200 * 40% = $13680.Â However, the net book value of the asset at the end of its useful life has to be equal to the salvage value and not less than that.Â Hence in this depreciation method, the salvage value is only considered near the end of the asset's life and not before.Â However, the other depreciation methods such as straight-line, units of production and the sum of the years' digits methods involve determining the amount to be depreciated by subtracting the salvage value from the cost of the asset right from the start.
It is important to understand that the useful life and the salvage value which are used in the calculations are still estimates.Â However, accountants today are making more accurate calculations for these estimated values with the availability of better data and tools.
Depreciation is also important for income tax purposes as the total taxable income is reduced by this amount.Â The US Government initially created the Accelerated Cost Recovery System (ACRS) to simplify the determination of the useful life of an asset and allowed rapid write off patterns.Â ACRS ignored the salvage value and used relatively short useful lives for assets.Â However, the government later created the Modified Accelerated Cost Recovery System (MACRS) to address certain shortfalls in the original standards.Â Some of the fixes were lengthier recovery periods, additional categories for assets and enforcement of specific depreciation methods based on the type of assets.Â For e.g. machinery and equipment were depreciated using the double declining balance while the straight line method was used for buildings.
Firms can use accelerated depreciation method for some of its assets and the straight line method for other assets.Â Hence for proper analysis of a firm's financial statements, it is important to find out which depreciation methods are used for which assets.Â Also, firms may use different depreciation methods for book keeping and tax purposes.Â Most firms use straight line methods for book keeping while using the MACRS for tax purposes. Â Â This ensures that the firm obtains the maximum tax deductions and hence a bigger tax refund and smaller cash outflow.