Depreciation Explanation

Depreciation is a complex and very significant part of accounting today. Most companies have tangible assets that provide cash flows in future periods. Each of these assets needs to be depreciated in some way. There are two kinds of depreciation recognized. First is the lowering in value of assets. This is shown on a balance sheet of a business as a contra-asset account. The second type is the allocation of the cost of an asset over its useful life. This is shown on an income statement as an expense account. In order to calculate depreciation a company must consider the cost or purchase price of the asset, the useful life of the asset, any salvage value that could exist at the end of its useful life and the method of depreciation they decide to use.

In the 1900’s accountants often argued about what should be depreciated and what should not. Some believed that all capital expenditures should be while others thought only realizable property should be recognized as permanent. For example, if a company were to plant trees in land that they owned, they could be depreciated because they are a permanent part of their assets (land). However if a company planted a tree in a pot and placed it on their property this is not considered permanent and cannot be depreciated.

There are some cases in which people want more depreciation of their assets over a shorter period of time and other cases for which less depreciation is wanted over a longer period. For tax purposes one wants more depreciation. This gives you more expenses and lowers your taxable income. The opposite goes for companies that want to report a higher net income and have higher earnings per share for its stock holders.

The method of depreciation is a key decision a company must make when evaluating their assets. Straight-Line Method is the most common today and is very easy to use. To calculate, you simply subtract the salvage value, if any, from the cost of the asset and divide that number by the total useful life. For an asset costing $45,000, with a salvage of $5,000 and a useful life of 5 years the depreciation is allocated as follows:

Depreciation
expense

Accumulated depreciation
at year-end

Book value
at year-end

(original   cost) $45,000

$8,000

$8,000

$37,000

8,000

16,000

29,000

8,000

24,000

21,000

8,000

32,000

13,000

8,000

40,000

(salvage value) 5,000

Another commonly used method is double-declining-balance. In this method you first find the depreciation rate under straight line method [(1/useful life) x100]. Then double that percentage to find the depreciation rate for this method. For example, an asset cost $2,000 and has a useful life of 5 years. The rate under Straight-Line depreciation is 20%. The table demonstrates double-declining-balance method:

Depreciation
rate

Depreciation
expense

Accumulated
depreciation

Book value at
end of year

original   cost $2,000.00

40%

800.00

800.00

1200.00

40%

480.00

1280.00

720.00

40%

288.00

1568.00

432.00

40%

172.80

1740.80

259.20

259.20 – 100.00

159.20

1900.00

scrap value 100.00

Sum-of-year’s-digits is an accelerated depreciation method. First you find the yearly deprecation rate. The denominator is found by adding up the years of an asset’s useful life (5 year useful life=5+4+3+2+1=15). The numerator is the number of years remaining in the useful life. Follow this table for an asset that has a useful life of 5 years, a cost of $1,000 and no salvage value:

Total
depreciable
cost

Depreciation
rate

Depreciation
expense

Accumulated
depreciation

Book value at
end of year

$1,000 (original cost)

1,000

5/15

333.33 (1,000 x 5/15)

333.33

666.67

1,000

4/15

266.67 (1,000 x 4/15)

600.00

400.00

1,000

3/15

200.00 (1,000 x 3/15)

800.00

200.00

1,000

2/15

133.33 (1,000 x 2/15)

933.33

66.67

1,000

1/15

66.67 (1,000 x 1/15)

1,000.00

0 (no scrap value)

Units-of-production is another commonly used depreciation method. First you must find the depreciation cost per unit. To do this you subtract salvage value from cost and divide that by total estimated units of production. Each period you multiply actual units of production by the depreciation cost per unit to find the depreciation expense. This example shows an assets costing $60,000, with a salvage value of $5,000 and 5,000 estimated units of production:

Units of
production

Depreciation
cost per unit

Depreciation
expense

Accumulated
depreciation

Book value at
end of year

$60,000 (original cost)

1,500

11

16,500

16,500

40,000

1,000

11

11,000

27.500

49,000

1,000

11

11,000

38,500

37,000

1,000

11

11,000

49,500

24,000

500

11

5,500

55,000

5,000 (scrap value)

There are many more methods along with many other exceptions and techniques to using depreciation in accounting. Each company is different in their way of finding depreciation and they have different reasons as to why they choose one method over another.

Depreciation is a complex and very significant part of accounting today. Most companies have tangible assets that provide cash flows in future periods. Each of these assets needs to be depreciated in some way. There are two kinds of depreciation recognized. First is the lowering in value of assets. This is shown on a balance sheet of a business as a contra-asset account. The second type is the allocation of the cost of an asset over its useful life. This is shown on an income statement as an expense account. In order to calculate depreciation a company must consider the cost or purchase price of the asset, the useful life of the asset, any salvage value that could exist at the end of its useful life and the method of depreciation they decide to use.

In the 1900’s accountants often argued about what should be depreciated and what should not. Some believed that all capital expenditures should be while others thought only realizable property should be recognized as permanent. For example, if a company were to plant trees in land that they owned, they could be depreciated because they are a permanent part of their assets (land). However if a company planted a tree in a pot and placed it on their property this is not considered permanent and cannot be depreciated.

There are some cases in which people want more depreciation of their assets over a shorter period of time and other cases for which less depreciation is wanted over a longer period. For tax purposes one wants more depreciation. This gives you more expenses and lowers your taxable income. The opposite goes for companies that want to report a higher net income and have higher earnings per share for its stock holders.

The method of depreciation is a key decision a company must make when evaluating their assets. Straight-Line Method is the most common today and is very easy to use. To calculate, you simply subtract the salvage value, if any, from the cost of the asset and divide that number by the total useful life. For an asset costing $45,000, with a salvage of $5,000 and a useful life of 5 years the depreciation is allocated as follows:

Depreciation expense

Accumulated depreciation at year-end

Book value at year-end

(original cost) $45,000

$8,000

$8,000

$37,000

8,000

16,000

29,000

8,000

24,000

21,000

8,000

32,000

13,000

8,000

40,000

(salvage value) 5,000

Another commonly used method is double-declining-balance. In this method you first find the depreciation rate under straight line method [(1/useful life) x100]. Then double that percentage to find the depreciation rate for this method. For example, an asset cost $2,000 and has a useful life of 5 years. The rate under Straight-Line depreciation is 20%. The table demonstrates double-declining-balance method:

Depreciation rate

Depreciation expense

Accumulated depreciation

Book value at end of year

original cost $2,000.00

40%

800.00

800.00

1200.00

40%

480.00

1280.00

720.00

40%

288.00

1568.00

432.00

40%

172.80

1740.80

259.20

259.20 – 100.00

159.20

1900.00

scrap value 100.00

Sum-of-year’s-digits is an accelerated depreciation method. First you find the yearly deprecation rate. The denominator is found by adding up the years of an asset’s useful life (5 year useful life=5+4+3+2+1=15). The numerator is the number of years remaining in the useful life. Follow this table for an asset that has a useful life of 5 years, a cost of $1,000 and no salvage value:

Total depreciable cost

Depreciation rate

Depreciation expense

Accumulated depreciation

Book value at end of year

$1,000 (original cost)

1,000

5/15

333.33 (1,000 x 5/15)

333.33

666.67

1,000

4/15

266.67 (1,000 x 4/15)

600.00

400.00

1,000

3/15

200.00 (1,000 x 3/15)

800.00

200.00

1,000

2/15

133.33 (1,000 x 2/15)

933.33

66.67

1,000

1/15

66.67 (1,000 x 1/15)

1,000.00

0 (no scrap value)

Units-of-production is another commonly used depreciation method. First you must find the depreciation cost per unit. To do this you subtract salvage value from cost and divide that by total estimated units of production. Each period you multiply actual units of production by the depreciation cost per unit to find the depreciation expense. This example shows an assets costing $60,000, with a salvage value of $5,000 and 5,000 estimated units of production:

Units of production

Depreciation cost per unit

Depreciation expense

Accumulated depreciation

Book value at end of year

$60,000 (original cost)

1,500

11

16,500

16,500

40,000

1,000

11

11,000

27.500

49,000

1,000

11

11,000

38,500

37,000

1,000

11

11,000

49,500

24,000

500

11

5,500

55,000

5,000 (scrap value)

There are many more methods along with many other exceptions and techniques to using depreciation in accounting. Each company is different in their way of finding depreciation and they have different reasons as to why they choose one method over another.

Source by Erin Bacon

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