Depreciation

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In accountancy, depreciation is a term that refers to two aspects of the same concept: first, the actual decrease of
fair value In accounting and in most schools of economic thought, fair value is a rational and unbiased Prediction, estimate of the potential market price of a good, service, or asset. The derivation takes into account such objective factors as the costs a ...
of an
asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that c ...
, such as the decrease in value of factory equipment each year as it is used and wear, and second, the allocation in accounting statements of the original cost of the assets to periods in which the assets are used (depreciation with the matching principle). Depreciation is thus the decrease in the value of assets and the method used to reallocate, or "write down" the cost of a tangible asset (such as equipment) over its useful life span. Businesses depreciate long-term assets for both accounting and tax purposes. The decrease in value of the asset affects the
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a busine ...
of a business or entity, and the method of depreciating the asset, accounting-wise, affects the net income, and thus the
income statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''stateme ...
that they report. Generally, the cost is allocated as depreciation expense among the periods in which the asset is expected to be used. Methods of computing depreciation, and the periods over which assets are depreciated, may vary between asset types within the same business and may vary for tax purposes. These may be specified by law or accounting standards, which may vary by country. There are several standard methods of computing depreciation expense, including fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service. For example, a depreciation expense of 100 per year for five years may be recognized for an asset costing 500. Depreciation has been defined as the diminution in the utility or value of an asset and is a non-cash expense. It does not result in any cash outflow; it just means that the asset is not worth as much as it used to be. Causes of depreciation are natural wear and tear.

# Accounting concept

In determining the net income (profits) from an activity, the receipts from the activity must be reduced by appropriate costs. One such cost is the cost of assets used but not immediately consumed in the activity. Such cost allocated in a given period is equal to the reduction in the value placed on the asset, which is initially equal to the amount paid for the asset and subsequently may or may not be related to the amount expected to be received upon its disposal. Depreciation is any method of allocating such net cost to those periods in which the organization is expected to benefit from the use of the asset. Depreciation is a process of deducting the cost of an asset over its useful life. Assets are sorted into different classes and each has its own useful life. The asset is referred to as a depreciable asset. Depreciation is technically a method of allocation, not valuation, even though it determines the value placed on the asset in the balance sheet. Any business or income-producing activity using tangible assets may incur costs related to those assets. If an asset is expected to produce a benefit in future periods, some of these costs must be deferred rather than treated as a current expense. The business then records depreciation expense in its financial reporting as the current period's allocation of such costs. This is usually done in a rational and systematic manner. Generally, this involves four criteria: *Cost of the asset *Expected salvage value, also known as the residual value of the assets *Estimated useful life of the asset *A method of apportioning the cost over such life

## Depreciable basis

Cost generally is the amount paid for the asset, including all costs related to acquiring and bringing the asset into use. In some countries or for some purposes, salvage value may be ignored. The rules of some countries specify lives and methods to be used for particular types of assets. However, in most countries the life is based on business experience, and the method may be chosen from one of several acceptable methods.

## Impairment

Accounting rules also require that an impairment charge or expense be recognized if the value of assets declines unexpectedly. Such charges are usually nonrecurring, and may relate to any type of asset. Many companies consider write-offs of some of their long-lived assets because some property, plant, and equipment have suffered partial obsolescence. Accountants reduce the asset's carrying amount by its fair value. For example, if a company continues to incur losses because prices of a particular product or service are higher than the operating costs, companies consider write-offs of the particular asset. These write-offs are referred to as impairments. There are events and changes in circumstances might lead to impairment. Some examples are: * Large amount of decrease in fair value of an asset * A change of manner in which the asset is used * Accumulation of costs that are not originally expected to acquire or construct an asset * A projection of incurring losses associated with the particular asset Events or changes in circumstances indicate that the company may not be able recover the carrying amount of the asset. In which case, companies use the recoverability test to determine whether impairment has occurred. The steps to determine are: 1. Estimate the future cash flow of asset (from the use of the asset to disposition) 2. If the sum of the expected cash flow is less than the carrying amount of the asset, the asset is considered impaired

## Depletion and amortization

Depletion and amortization are similar concepts for natural resources (including oil) and intangible assets, respectively.

## Effect on cash

Depreciation expense does not require a current outlay of cash. However, since depreciation is an expense to the P&L account, provided the enterprise is operating in a manner that covers its expenses (e.g. operating at a profit) depreciation is a source of cash in a statement of cash flows, which generally offsets the cash cost of acquiring new assets required to continue operations when existing assets reach the end of their useful lives.

## Accumulated depreciation

While depreciation expense is recorded on the income statement of a business, its impact is generally recorded in a separate account and disclosed on the balance sheet as accumulated under fixed assets, according to most accounting principles. Accumulated depreciation is known as a contra account, because it separately shows a negative amount that is directly associated with an accumulated depreciation account on the balance sheet. Depreciation expense is usually charged against the relevant asset directly. The values of the fixed assets stated on the balance sheet will decline, even if the business has not invested in or disposed of any assets. Theoretically, the amounts will roughly approximate fair value. Otherwise, depreciation expense is charged against accumulated depreciation. Showing accumulated depreciation separately on the balance sheet has the effect of preserving the historical cost of assets on the balance sheet. If there have been no investments or dispositions in fixed assets for the year, then the values of the assets will be the same on the balance sheet for the current and prior year (P/Y).

# Methods for 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.

## Sum-of-years-digits method

Sum-of-years-digits is a spent depreciation method that results in a more accelerated write-off than the straight-line method, and typically also more accelerated than the declining balance method. Under this method, the annual depreciation is determined by multiplying the depreciable cost by a schedule of fractions. Sum of the years' digits method of depreciation is one of the accelerated depreciation techniques which are based on the assumption that assets are generally more productive when they are new and their productivity decreases as they become old. The formula to calculate depreciation under SYD method is: SYD depreciation = depreciable base x (remaining useful life/sum of the years' digits)
depreciable base = cost − salvage value 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 the years' digits. Since the asset has a 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 in years. 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.

## Units-of-production depreciation method

Units-of-production depreciation method calculates greater deductions for depreciation in years when the asset is heavily used :$\mbox = \times \mbox$ DE= ((OV-SV)/EPC) x Units per year 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 × actual production will give the depreciation cost of the current year. The table below illustrates the units-of-production depreciation schedule of the asset. 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 the original cost.

## Group depreciation method

The group depreciation method is used for depreciating multiple-asset accounts using a similar depreciation method. The assets must be similar in nature and have approximately the same useful lives.

## 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. 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 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.

# Tax Depreciation

Most income tax systems allow a
tax deduction Tax deduction is a reduction of income that is able to be taxed and is commonly a result of expenses, particularly those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and tax credits. T ...
for recovery of the cost of assets used in a business or for the production of income. Such deductions are allowed for individuals and companies. Where the assets are consumed currently, the cost may be deducted currently as an expense or treated as part of
cost of goods sold Cost of goods sold (COGS) is the carrying value of goods sold during a particular period. Costs are associated with particular goods using one of the several formulas, including specific identification, first-in first-out (FIFO), or average cost. ...
. The cost of assets not currently consumed generally must be deferred and recovered over time, such as through depreciation. Some systems permit the full deduction of the cost, at least in part, in the year the assets are acquired. Other systems allow depreciation expense over some life using some depreciation method or percentage. Rules vary highly by country, and may vary within a country based on the type of asset or type of taxpayer. Many systems that specify depreciation lives and methods for financial reporting require the same lives and methods be used for tax purposes. Most tax systems provide different rules for real property (buildings, etc.) and personal property (equipment, etc.).

## Capital allowances

A common system is to allow a fixed percentage of the cost of depreciable assets to be deducted each year. This is often referred to as a capital allowance, as it is called in the
United Kingdom The United Kingdom of Great Britain and Northern Ireland, commonly known as the United Kingdom (UK) or Britain, is a country in Europe, off the north-western coast of the European mainland, continental mainland. It comprises England, Scotlan ...
. Deductions are permitted to individuals and businesses based on assets placed in service during or before the assessment year.
Canada Canada is a country in North America. Its Provinces and territories of Canada, ten provinces and three territories extend from the Atlantic Ocean to the Pacific Ocean and northward into the Arctic Ocean, covering over , making it the world ...
's Capital Cost Allowance are fixed percentages of assets within a class or type of asset. Fixed percentage rates are specified by the type of asset. The fixed percentage is multiplied by the tax basis of assets in service to determine the capital allowance deduction. The tax law or regulations of the country specifies these percentages. Capital allowance calculations may be based on the total set of assets, on sets or pools by year (vintage pools) or pools by classes of assets... Depreciation has got three methods only.

## Tax lives and methods

Some systems specify lives based on classes of property defined by the tax authority. Canada Revenue Agency specifies numerou
classes
based on the type of property and how it is used. Under the United States depreciation system, the
Internal Revenue Service The Internal Revenue Service (IRS) is the revenue service for the Federal government of the United States, United States federal government, which is responsible for collecting Taxation in the United States, U.S. federal taxes and administerin ...
publishes
detailed guide
which includes a table of asset lives and the applicable conventions. The table also incorporates specified lives for certain commonly used assets (e.g., office furniture, computers, automobiles) which override the business use lives. U.S. tax depreciation is computed under the double-declining balance method switching to straight line or the straight-line method, at the option of the taxpayer. IRS tables specify percentages to apply to the basis of an asset for each year in which it is in service. Depreciation first becomes deductible when an asset is placed in service.

Many systems allow an additional deduction for a portion of the cost of depreciable assets acquired in the current tax year. The UK system provides a first year capital allowance of £50,000. In the United States, two such deductions are available.
deduction
for the full cost of depreciable tangible personal property is allowed up to $500,000 through 2013. This deduction is fully phased out for businesses acquiring over$2,000,000 of such property during the year. In addition, additional first year depreciation of 50% of the cost of most other depreciable tangible personal property is allowed as a deduction. Some other systems have similar first year or accelerated allowances.

## Real property

Many tax systems prescribe longer depreciable lives for buildings and land improvements. Such lives may vary by type of use. Many such systems, including the United States, permit depreciation for real property using only the straight-line method, or a small fixed percentage of the cost. Generally, no depreciation tax deduction is allowed for bare land. In the United States, residential rental buildings are depreciable over a 27.5 year or 40-year life, other buildings over a 39 or 40-year life, and land improvements over a 15 or 20-year life, all using the straight-line method.

## Averaging conventions

Depreciation calculations require a lot of record-keeping if done for each asset a business owns, especially if assets are added to after they are acquired, or partially disposed of. However, many tax systems permit all assets of a similar type acquired in the same year to be combined in a "pool". Depreciation is then computed for all assets in the pool as a single calculation. These calculations must make assumptions about the date of acquisition. The United States system allows a taxpayer to use a half-year convention for personal property or mid-month convention for real property.26 USC 168(d)
Under such a convention, all property of a particular type is considered to have been acquired at the midpoint of the acquisition period. One half of a full period's depreciation is allowed in the acquisition period (and also in the final depreciation period if the life of the assets is a whole number of years). United States rules require a mid-quarter convention for per property if more than 40% of the acquisitions for the year are in the final quarter.

# Economics

* Amortization (accounting) * Construction in progress * Consumption of fixed capital * Cost segregation study * Deferred financing costs * Deferred tax * Depletion (accounting) * DIRTI 5 * Expense * John I. Beggs * Product lifetime * MACRS * Revaluation of fixed assets * Writing down allowance

# References

Accounting https://www.investopedia.com/terms/s/straightlinebasis.asp *Kieso, Donald E; Weygandt, Jerry J.; and Warfield, Terry D.: ''Intermediate Accounting'', Chapter 11. . *Financial Accounting Standards Board (U.S.) ''Accounting Standards Codification'
360-10-35
International Financial Reporting Standards International Financial Reporting Standards, commonly called IFRS, are accounting standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB). They constitute a standardised way of describing the company's fina ...
IAS 16
Depreciation Journal Entries