What is Depreciation?
Depreciation is 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 of a business or entity, and the method of depreciating the asset, accounting-wise, affects the net income, and thus the income statement that they report. Generally, the cost is allocated as depreciation expense among the periods in which the asset is expected to be used.
An asset depreciation at 15% per year over 20 years In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, 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).
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.
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
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.
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.
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).