Depreciation in accounting is a concept that allocates the total cost of the physical asset over its estimated useful life. Depreciation decreases the value of the equipment due to its wear and tear during its useful life. There are two aspects to the concept. The first involves the actual decrease in the fair value of an asset and the second is the tax implications.
Depreciation expense allows a business to write off the cost of an asset over time. Typically, this period is the asset’s estimated useful life. This can be useful in smoothing out large purchases that can skew an income statement.
If you’re looking to measure net income for an accounting period, depreciation is an important component to consider.
Example
Let’s say a retailer buys a $70,000 truck on the first day of the current year and expects to use it for the next seven years. That means that the retailer cannot report the entire $70,000 expense in the current year, but must instead report a $10,000 expense for each year the truck is used.
Depreciation Expense = Total cost of the asset/Estimated useful Life
i.e., in this example – $70,000/7 = $10,000 as depreciation expense
There are three methods to determine the depreciation expense
Straight Line Depreciation
A business’s assets can depreciate over time. This means that they should be replaced or repaired to maintain their value. To calculate this, the business can use a straight-line method. This method assumes that an asset will be used throughout its legal life.
To calculate through straight line method , subtract the purchase price of an asset from its salvage value. This is the estimated sell-on value for an asset when it is no longer needed. Then, divide that amount by the number of years the asset is expected to be in use. For example, assume that company “ABC” purchases a piece of equipment for $10,500 and expects the useful life to be ten years. At the end of the ten-year-life cycle, the equipment will have a salvage value of $500. Therefore, using straight-line depreciation, the company will depreciate the equipment at a rate of $1000 per year.
Determination of Straight line depreciation method
Purchased Equipment Cost – $10,500
Salvage Value – $500
Estimated Useful Life – 10 years
Depreciation Expense = Total cost of the asset – Salvage value/Estimated useful Life
i.e., in this example – $10,500 – $500/10 = $1000 as depreciation expense
Advantage of Straight Line Method
The main advantage of this method is that it makes it easier to calculate fixed-asset expenses. Using a straight-line method can be particularly advantageous during tax time, since it reduces the value of your tangible assets. It also makes it easy to calculate your fixed asset expense, since you can charge depreciation to each month. In some cases, you can even put depreciation expenses as a credit.
Straight-line method is the most common and straightforward method. Regardless of the size of your business, straight-line depreciation will help you make more money while reducing your total costs. It’s important to remember that the value of your asset will fluctuate over time, so it’s important to keep that in mind when depreciating assets.
Reducing Balance Method
The reducing balance method is a type of depreciation accounting. It is useful for companies that want to accurately match their expenses to revenues. It helps businesses recognize more expenses in the early years of an asset’s life and allocate them less throughout the rest of its useful life. However, this method is more complicated than the straight line depreciation method and requires more numbers crunching. It is therefore recommended to consult an accountant before using this method.
The reducing balance method of depreciation allows companies to maximize the tax savings from depreciating assets. However, the method also reduces the net income for early years of the asset’s life. However, this method can result in higher taxes in the later years.
Determination of Depreciation through Reducing Balance Method
The reducing balance depreciation uses a formula to calculate depreciation expenses. The first step is to determine the cost of the asset. This is also called the salvage value. This is the amount an asset will be worth at the end of its life. The second step is to determine the recovery period, or the time period during which the asset can be depreciated. The third step is to determine the useful life of the asset. This is the number of years that you expect to use the asset in your business. The fourth step is to divide the cost of the asset by its useful life, which will give you a depreciation rate per year.
The reducing balance method accelerates depreciation during the early years of an asset’s life. This method is useful when the utility of an asset is rapidly consumed during the early years. This method is also useful in allowing a company to shift profit recognition into the future, which may be useful in deferring income taxes.
The reducing balance depreciation method allocates higher depreciation expenses in the early years of an asset’s life. This method matches the cost of an asset with its benefit better. For example, an ice cream truck that costs $30,000 is depreciated over a five-year recovery period, the initial years see the highest cost/value for the ice cream truck on the balance sheet, then its value decreases significantly over the period of years, and at the end of it’s useful life, i.e. after 5 years, the salvage value is only taken into consideration in the balance sheet for this asset.
Comparison between Reducing Balance and Straight Line
The reducing balance method of depreciation is different from the straight-line method because it depreciates an asset twice as fast. It works by dividing the straight-line depreciation for year one by the number of years left, multiplying the result by two, and repeating the process until the asset reaches its final use year. The final year is then used to depreciate the remaining over-salvage value of the asset.
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Unit of Production
Unit of production is an accounting method that accounts the depreciation value of tangible assets in terms of their production capability. This method of depreciation can help businesses track the value of assets in a more accurate manner. However, it can be time-consuming to implement. Moreover, it requires a thorough record-keeping process. Businesses must keep track of all the documents related to their depreciation schedule for tax purposes and audits.
While unit of production depreciation is widely used in manufacturing companies, it is not practical for every business. Service industries and trading companies usually use different methods of depreciation. Moreover, this method can be confusing as there are many assets involved in the production of a single product. In addition, this method gives a different book value for a single asset, which may not be appropriate for tax purposes.
Uses of Unit of Production Depreciation Method
Unit of production is the most commonly used method of depreciation for production assets. It’s a more accurate method than the chronology-based methods and helps businesses better track their profits. This method also gives businesses the benefit of showing higher depreciation expenses during productive years. This, in turn, can help them offset increased production costs.
A depreciation expense is calculated by dividing the original cost of an asset by its expected unit of production over a certain period of time. The cost is comprised of the asset’s purchased price, delivery charges, and incidental expenses. The estimated unit of production is the amount of output that the asset can produce over its useful life.
Unit of production depreciation is easy to calculate, but it must be updated annually for accuracy. This method requires a detailed record of the actual units produced. Unit of production depreciation charges must match the revenues and expenses of a business. It is not appropriate for tax deductions, however. Therefore, it’s important to consult an accountant if you are unsure of the proper way to depreciate a certain asset.
A better method of depreciation is by using the unit of production as the basis of valuation. It is more logical and will help a business to evaluate the efficiency of assets. It also helps businesses track profit more accurately. By assessing the efficiency of an asset across its useful life, depreciation expenses can align with revenue and profit.
Tax Consequences of Depreciation
Depreciation is a type of expense in accounting. It’s used to reduce a property’s adjusted basis as a percentage of its original cost. This method can save a taxpayer money by reducing the taxable gain on the sale of an asset. However, it also increases the recapture liability. It is important to consult a tax expert before depreciating a property.
It can help businesses reduce their taxable earnings by reducing the cost of an asset over its useful life. Because of this, businesses can write off the depreciation expense on their tax returns. This allows them to reduce their taxable income and minimize their tax liability. However, this method is only available for fixed tangible assets. Intangible assets can be amortized instead.
The most commonly used method is straight-line. This method is simple to use and is less error-prone. However, it does not take into account the likelihood of an asset losing value in the short term and the cost of ongoing maintenance. In addition, the cost of depreciating an asset requires a substantial amount of guesswork.
There are several depreciation methods. Each method recognizes depreciation expense differently, and each depreciation method reduces taxable earnings. However, when calculating a company’s tax obligations, a company should know the cost of an asset before depreciating it.
The basis for tax depreciation is the cost of an asset multiplied by the percentage of time it will be used in the business. There are different time limits for depreciation based on the type of asset. The easiest method to apply is the straight-line method, which spreads out the cost over time.