Depreciation

What is Depreciation?

Depreciation refers to spreading out the original cost of a fixed asset, such as a factory or equipment, over the estimated useful life of this asset.  Depreciation reduces the taxpayers taxable income, but not their actual cash balance.  It is essentially a method of compensating businesses for the wear and tear, depletion, obsolescence or deterioration of an asset.  There are many items that are depreciable; they are tangible assets such as buildings, machinery, furniture, automobiles, etc.  When you are talking about intangible items such as copyrights, patents, trademarks, goodwill, etc., the term amortization is more applicable.

As suggested above, depreciation will not affect the cash balance of a company nor will it have any material impacts to cash flow statement or income statement; however, it will reduce cash flows of the company for purposes of deriving taxable income.

At the end of the useful life of this asset(in accounting terms), the asset is said to have a salvage value.  This is considered the scrap value or residual value of the asset and will result in a net cash inflow once the asset is sold.

Types of Depreciation


The tax code allows for a few different calculations to determine the amount of tax deductions as a result of asset depreciation.  Straight line, Units of Production, Sum of Years, and Double Declining Balance are all different forms of depreciation that are acceptable.

Straight Line Depreciation

Straight line depreciation provides an equal distribution of asset depreciation over the useful life of an asset.  This is the most popular method for calculating depreciation, primarily due to its ease of use.  To calculate the depreciable amount, one would subtract the salvage value of the asset from the acquisition cost of the asset and divide that over the useful life to arrive at a yearly depreciation amount.  For example, assume that company XYZ purchased a truck which has a useful life of 4 years and a salvage value of $2500.  Also assume that the truck was purchased for $22,500.  To calculate the yearly depreciation, you would use the following formula:  ($22,500 - $2,500) / 4, or $5,000 per year.

Sum of Years - Digits Depreciation

The sum of years - digits method of depreciation is an accelerated form of depreciating the asset.  It takes a greater percentage of the depreciation in the earlier years, rather than spreading it out equally as the straight line method does. 

First, understand the useful life of the asset.  Once that has been determined, you can proceed to calculate the Sum of Years (in digits) method of weighting the yearly depreciation amounts.  Here is how it works.  Assume that an asset has a depreciable life of 5 years.  Assign the number 1 to 5 to each of the years, starting with 5 and moving to 1. 

Example: 

2008 - 5
2009 - 4
2010 - 3
2011 - 2
2012 - 1

Now, sum up the total of these numbers (5 + 4  + 3 + 2 + 1) = 15.  Now, let's look at the entire formula for determining the depreciable amount to get a better understanding how this fits in.

The number we just calculated above is called the Sum of Years Digits in our image below.  As you can see in the first formula, there is an easier way to calculate this number using the formula.  The second formula below allows us to calculate the total depreciable amount for the year.  Notice how it is weighted by the remainder of the useful life.  This is how most of the depreciation takes place in the first year and steadily declines until the end of the useful life.  For year 1, you would insert 5 for "Remaining Useful Life" and deduct 1 from that number in every subsequent year. 
Sum of Years Depreciation Calculation

Units of Production Depreciation

The units of production method depreciates an asset by using deriving the total units produced in a specific year and dividing that by the projected number of units for the estimated useful life of the asset.  Once you have calculated this ratio, multiply this by the assets total depreciable cost.  Let's cover a quick example.  Assume that Company XYZ purchases a piece of equipment that automates a certain production process.  Assume that this asset is expected to have a useful life of 10 years.  Now also assume that this machine is estimated to produce 100,000 units in that lifetime and has a depreciable value of $80,000.  In year 1, this machine produced an output of 14,000 units.  Therefore, we can depreciate this asset using the following formula:  (14,000 / 100,000) * $80,000 = $11,200.

Double Declining Balance Depreciation

The Double declining balance method is an accelerated form of straight line depreciation.  It applies a constant percentage factor which is double that of the straight line method and multiplies that by the  book value of the asset at the beginning of the reporting period.  To calculate the double declining percentage, basically use the following formula:  (1 / Estimated Life) * 2.  Therefore, over a 5 year useful life, multiply .20 * 2 to arrive at .4 or 40%.  Basically, you can continue to depreciate the asset at double the rate until the asset is depreciated to the salvage value.  An asset is not allowed to be depreciated to a value below salvage. 
Tim Ord
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