Depreciation
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Depreciation is an estimate of the decrease in the value of an asset, caused by "wear and tear", obsolescence, or impairment. The use of depreciation affects a company's (or an individual's) financial statements, and, in some countries, their taxes.
In economics, depreciation is the decrease in value of the capital stock (physical depreciation). Depreciation is caused mainly by deterioration, or wear and tear of equipment, and obsolescence. If capital stock is <math>C_0<math> at the beginning of a period, investment is <math>I<math> and depreciation <math>D<math>, the capital stock at the end of the period, <math>C_1<math>, is <math>C_0 + I - D<math>.
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Accounting
A company needs to report depreciation accurately in its financial statements in order to achieve two main objectives. Firstly, to match its expenses with the income generated by means of those expenses. Secondly, to ensure that the asset values in the balance sheet are not overstated: an asset acquired in Year 1 is unlikely to be worth the same amount in Year 5.
It is important to understand that depreciation is an average or expected view of the decline in value of an asset. For example, an entity may depreciate its equipment by 15% per year. This rate should be reasonable in aggregate (such as when a manufacturing company is looking at all of its machinery), but there is no expectation that each individual item declines in value by the same amount.
Accounting standards bodies have detailed rules on which methods of depreciation are acceptable, and auditors will express a view if they believe the assumptions underlying the estimates do not give a true and fair view.
Recording depreciation
For historical cost purposes, assets are recorded on the balance sheet at their original cost. Depreciation is not taken out of these assets directly. It is instead recorded in a contra asset account: an asset account with a normal credit balance, typically called "accumulated depreciation". Balancing an asset account with its corresponding accumulated depreciation account will result in the net book value. The net book value will never fall below the salvage value, meaning that once an asset is fully depreciated, no further expenses will be taken during its life. Companies have no obligation to dispose of depreciated assets, of course, and many depreciated assets continue to generate income.
Recording a depreciation expense will involve a credit to an accumulated depreciation account. The corresponding debit will involve either an expense account or an asset account which represents a future expense, such as work in process. Depreciation is recorded as an adjusting journal entry.
Methods
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.
Straight-line depreciation
Straight-line depreciation is the simplest and most often used technique, in which the company estimates the "salvage value" of the asset after the length of time over which it is depreciated, and assumes the drop in the asset's value is in equal, yearly increments over that amount of time. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero. For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a "salvage value" of US$2000 will depreciate at US$3,000 per year.
If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess depreciation would be considered as income by the tax office.
If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.
Declining-balance
The declining-balance method is a type of accelerated depreciation, because it recognizes a higher depreciation cost earlier in an asset's lifetime. This may be a more realistic reflection of an asset's actual resale value, as well as the expected benefit from the use of the asset: many assets are most useful when they are new. In the U.S., a form of declining-balance depreciation, MACRS, is used for tax purposes.
In declining-balance depreciation, each period's depreciation is based on the previous year's net book value, the estimated useful life, and a factor. The factor is commonly two; this is known as double declining-balance. Each period we calculate depreciation:
<math>{Depreciation\ expense} = {Previous\ period's\ NBV} \times {factor \over N}<math>
For the double-declining balance method, using the vehicle example from above, we compute the depreciation after the first year:
<math>{Previous\ period's\ NBV} \times {factor \over N} = $17000 \times {2 \over 5} = $6800<math>
We subtract $6800 from our previous year's net book value to obtain our new net book value: <math>NBV_1 = $17000 - $6800 = $10200<math>. For the second year, we use this new value to calculate depreciation. Notice that it is significantly lower than the first year:
<math>$10200 \times {2 \over 5} = $4080<math>
This process continues until we reach the salvage value or the end of the asset's useful life. Since declining-balance depreciation doesn't always depreciate an asset fully by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This has the effect of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the asset's life.
Activity
Activity methods are not based on time, but on a level of activity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, we estimate its life in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. We calculate a per-mile depreciation rate: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, we then calculate the depreciation expense by multiplying the rate by the actual activity level.
Taxes
When a company spends money for a service or anything else that isn't a tangible asset, this expenditure is usually immediately tax deductible, and the company enjoys an immediate tax benefit.
However, when a company buys some physical asset that will last longer than one year, like a computer, car, or building, the company cannot immediately deduct the cost and enjoy an immediate tax benefit. Instead, the company must depreciate the cost over the useful life of the asset, taking a tax deduction for a part of the cost each year. Eventually the company does get to deduct the full cost of the asset, but this happens over several years; the number of years depends on an estimate of how long it typically takes that type of asset to become effectively useless, and require a replacement. A computer may depreciate completely over five years; a factory building, over 30 years. The maximum allowable useful life estimate under U.S. income tax regulations is 40 years. Other countries have other systems, many of which remove the choice of depreciation rate and method from the company altogether. In these jurisdictions accounting depreciation and tax depreciation are almost always significantly different numbers.