When we come across the word ‘depreciation’, it sounds negative. However, it is the opposite of what we consider negative in the business landscape. Considering business, it amplifies tax benefits. In the company, an accountant or financial manager will oversee the functions of depreciation to document in the account book. Plus, accounting software or an ERP system will automate and document the depreciating asset value every year accurately.
In this blog, let us learn more about depreciation in detail—
Depreciation of Assets Meaning
What is depreciation? Depreciation is the process of deducting the value of an asset over time, such as after one year. In simple words, there are two aspects of depreciation. The first is that the asset value will depreciate over a period of time. The second component involves spreading out the initial cost of an asset over the duration of its usage.
The asset’s useful life(estimated value) is determined by the number of years an asset is depreciated. Take, for example, a laptop or a computer, its useful life is estimated to be 5 years. Assets can be categorised into many types including commodities and properties. When preparing your annual budget or balance sheet, asset depreciation is typically classified as a fixed cost, except when employing a method like the unit of production, which causes the depreciable amount to vary each year, making it a variable cost in such cases.
In accounting, depreciation is done for tangible assets. In the case of intangible assets, it is amortized. Amortization is similar to depreciation, but only the asset types become distinct in both cases. The difference between tangible and intangible assets is that the former has a physical form and the latter does not have a physical presence. Some examples of tangible assets are furniture, land, equipment, vehicles, computers etc.
During the useful years of an asset, wear and tear charges will appear. Once a company has exhausted the utility of the asset during its expected lifespan, it may opt to deprive it by determining its salvage value through calculations. These calculations are done to compute the profit and loss of the business every accounting period. Before learning more about depreciating the cost of an asset, let us learn a few terminologies.
→Fixed Asset Cost – The original cost at which a company buys an asset.
→Salvage Value – A salvage value of the asset is the remaining cost that can be recovered by selling the asset once its useful lifespan has ended.
→Useful life of Fixed Asset – The useful life of fixed assets in their productive years.
→Depreciation Rate – It comprises the percentage charged as depreciation on the fixed asset.
Businesses take advantage of the assets for tax purposes and for accounting benefits.
What Kind of Assets cannot be Depreciated?
All the assets that do not meet the IRS’ requirements can be depreciated. The wear and tear or obsolete or getting used up does not impact these assets :
- Investments
- Land
- Collectables
- Any asset used less than a year
- Personal property
Also Read : What is Asset Management Software?
Types of Depreciation
There are five types of depreciation methods which are applied across the business. The calculations for each method are distinct. Because of varying calculations, the depreciation expense amount differs as well, leading each method to influence the company’s taxable earnings and, consequently, its tax deductions. More about these types are enumerated below.
1. Straight-line Depreciation
The straight-line depreciation method is the simplest for calculating the value of an asset. The total assets value is split equally for multiple years during the assets’ useful life. It means that the same amount is paid every year over its useful life. The straight-line method is best applied for small businesses with simple accounting systems or for businesses where the owner prepares and files for the tax return.
The benefit of the straight-line method is that it is efficient and has fewer errors. In this, the business owners can deduct a consistent amount in each accounting period. The disadvantage of the straight-line depreciation method is that the calculation is based on guesswork or estimation which can be a drawback sometimes.
The formula for the straight-line depreciation method is given below.
(Cost of an asset – Salvage value of an asset) / Useful life of asset = Depreciation expense
2. Declining Balance Method
The depreciation value is calculated based on the diminishing value of the asset. Depending on the diminishing value of the asset, the varying value of the depreciation asset is calculated each year. This method helps in the rapid deterioration of assets each year.
Formula: Depreciation Asset – (Cost of Asset – Rate of Depreciation)/ 100
3. Double Declining Balance Method
It is also known as declining balance depreciation. The double declining balance method enables you to depreciate a larger portion of an asset’s value shortly after acquisition, with a decreasing amount as time progresses. This option is favourable for businesses aiming to recoup a significant portion of the asset’s value early on, as opposed to waiting for a specific number of years. This is particularly beneficial for small businesses with substantial initial expenses and a need for additional cash flow.
The benefit of this method is that it increases the maintenance costs as the asset ages. Nevertheless, it won’t provide an extra tax deduction if your business is already incurring a tax loss during a particular year, although it can still enhance tax deductions by enabling greater depreciation expenses in the initial years. However, if your business has a tax loss for the current year, your business will not benefit from additional tax deductions.
Formula: 2 x (Single-line depreciation rate) x (Book value at the beginning of the year) = Double declining balance
4. Sum of the years Digits Depreciation
The sum of the years digits(SYD) depreciation is the same as the double declining balance method. Rather than decreasing the book value, the useful life of the asset depends on a weighted percentage calculated by the sum of the years digits depreciation method. SYD is a favourable choice for businesses aiming to achieve a higher initial value recovery while maintaining a more consistent distribution over time, as opposed to the more uneven pattern typically seen with the double-declining method.
It reduces taxable income and the taxes owed in the early years of the assets life, these are the two aspects of SYD. The disadvantage of this method is that it is more complex than other accounting methods of depreciation.
Formula: (Remaining lifespan / SYD) x (Asset cost – Salvage value) = Depreciation expense
5. Units of Production Depreciation
Units of production is the simplest method to depreciate the value of the assets. In the units of production method, productivity is given consideration rather than its useful life. This method is also known as the unit-based method as other methods are time-based. This approach allows for more substantial depreciation deductions during the period of intensive machine or asset utilization, helping to balance out the periods when it will see less usage.
For example, units of production method considers the number of pizzas that are produced using the equipment(oven), or the duration the equipment is in use. The benefit of units of production methods is that the value they give is accurate depreciation costs. The disadvantage of this system is that it is impossible to track the assets producing the number of units in their useful life. Hence, its application in business has to be done after careful consideration.
Formula: Depreciation Expense = (Orginal value – Salvage value)/ Estimated production capacity * units per year
Causes of Accounting Depreciation
Every company has the responsibility to examine and calculate the actual consumption of the asset and depreciate it accordingly over the years. This procedure assists them in estimating the asset’s residual value once it has been fully utilized. Enumerated below are some of the top reasons for accounting depreciation.
1. Deterioration – When the assets are used continuously, they tend to deteriorate and become unproductive over time. For example, the production equipment faces maintenance issues after it produces many units of products. The asset’s useful life deteriorates and causes a lot of wear and tear. These type of assets cannot be repaired, it has to be replaced with new equipment. Whereas, some assets such as buildings and construction establishments can be repaired.
2. Rights to use – A business obtains the right to use a fixed asset for a specific period of time. Here, the right to use an asset depends on the duration of its useful life in the company. Hence, in order to acquire the actual value of the asset, the business must depreciate the value of the assets in its useful life.
3. Perishability – The assets with a short lifespan have to be depreciated sooner. The best example of this is inventory goods.
4. Obsolescence – When some assets become outdated, their depreciation expense will deteriorate. The best example of this type is technological devices.
5. Asset used as a natural resource – In the case of an oil and gas company, the focus shifts towards assessing depletion levels instead of depreciation, given that oil is a finite natural resource. The depletion rate is a critical consideration in such instances, as it can fluctuate over time depending on the remaining reserves.
How do depreciating assets affect accounting ratios?
Depreciating assets impacts multiple factors like financial ratios and accounting books, which is enumerated below :-
- Depreciating assets affects three aspects – Income statement, Balance Sheet and capital-intensive firms.
- Depreciation is impacted by the assets useful life and salvage value. If any asset has a shorter useful life and lower salvage value, the assets will depreciate more.
- Increased depreciation expenses can dampen return ratios, and when comparing firms that use different depreciation methods, analysts should be mindful of this factor. In contrast to the straight-line method (SLM), accelerated depreciation methods typically result in lower net income and shareholder’s equity, particularly in the early years.
- Furthermore, the use of accelerated depreciation methods generally leads to lower return ratios, reflecting a more conservative approach. However, this impact tends to reverse in later years as depreciation expenses decrease.
- A company with substantial capital reserves may opt for a conservative strategy by embracing the accelerated depreciation method. This choice is justified by the notion that depreciating less on ageing assets can be offset by depreciating more on newly acquired assets.
- The asset turnover ratios will increase if the assets are depreciated using conservatory methods.
Why are Assets Depreciated over time?
New assets are prioritised more than the old ones everywhere. The main objective of a depreciating asset is to calculate the asset value that it loses over its useful life. The loss is calculated considering the factors like introducing new models and inflation.
How are Assets depreciated for Tax purposes?
Assets depreciation is done to balance the expenses of the deteriorating value of the assets with the revenue generation. Accounting depreciation is also created with the intention of acquiring tax benefits as depreciating expense is deductible. Depreciation schedules can vary, encompassing straightforward straight-line methods as well as more complex accelerated or per-unit measures.
What is the difference between depreciation and amortization?
Depreciation specifically pertains to tangible assets or property, while amortization is an accounting concept that primarily allocates the cost of intangible assets like intellectual property or loan interest over a period of time.
Depreciation Expense vs Accumulated Depreciation
One major difference between Accumulated Depreciation and Depreciation expense is that one is a contra asset reported on the balance sheet and the other is an expense incurred in the income statement.
Depreciation expense and accumulated depreciation processes relate to the gradual reduction in the value of equipment, machinery, or other assets, serving to accurately reflect their worth. This is crucial for year-end tax deductions and when a company undergoes a sale, requiring a precise assessment of asset values.
It is vital for both of the depreciation entries to be listed on year-end and quarterly reports. However, the depreciation expense will immensely help with the tax deductions. if you want to forecast the lifecycle of an asset or to track depreciation every year, then the accumulated depreciation is the right method of evaluation.
Conclusion
Depreciation is a financial strategy that helps businesses lower their tax liabilities by accounting for the decline in the value of their assets. By recognizing depreciation as an expense, your business can effectively reduce its taxable earnings, resulting in a decreased tax obligation to the IRS. In essence, a higher depreciation expense leads to a reduction in your taxable income.
In addition, we learned the types of Depreciation of Assets which are straight-line depreciation, declining balance depreciation, double declining balance depreciation, sum of the years digits depreciation and units of production method. The depreciation rate of an asset can be accurately calculated with the help of ERP software. Its advanced solution will give accurate information regarding deteriorating assets and market value in real-time. Invest in this solution and accurately achieve your organizational goals.
