What Is Depreciation? | Seeking Alpha

Depreciation is an accounting methodology that distributes the estimated cost of an asset over its expected useful life. By depreciating their assets, companies are also adjusting their balance sheets to reflect the age and usefulness of their assets.

Loss in asset value can be the result of multiple factors, including wear and tear, deterioration, or obsolescence. Depreciation techniques allow companies to expense (or ‘write off’) the cost of an asset over its expected life, which reduces their taxable net income and saves money on taxes.

There are a number of different depreciation methods allowed in standard accounting practice and guidance on depreciation is issued as part of generally accepted accounting principles (GAAP). Companies may use the method they prefer, as long as they are consistent over time.

Depreciation is only permitted on physical assets. For intangible assets, such as intellectual property, amortization techniques are used instead.

Depreciation is an expense that reduces a company’s taxable income on its income statement, which results in the company paying less income tax than if no depreciation was charged for the period.

However, depreciation is a non-cash item that has no direct effect on the cash position or cash flow of a business. The Cashflow From Operations (CFO) section of a company’s cashflow statement will usually add back depreciation from Net Income, in reflection that depreciation expense is not a cash charge.

Types of Depreciation

There are four major types of depreciation. This offers businesses a choice as to how they want to depreciate their assets, given the type of assets they own and the nature of their business. All are acceptable, as long as the company is consistent. The four types include:

1. Straight-line
2. Units of Production
3. Double declining balance
4. Sum of the years’ digits

Straight-line depreciation is the simplest and most commonly used method of depreciation. This is the most common and simplest depreciation method. The asset’s full value is simply allocated evenly over the entire course of its estimated useful life.

The double declining balance method of depreciation is an accelerated option. It results in businesses being able to write off more of an asset’s value faster and is geared for assets that tend to be more productive in their early years.

The sum of the years’ digits depreciation method is also somewhat accelerated. It results in writing off assets faster than with straight-line depreciation but not quite as fast as the double declining balance method.

The units of production method is geared to assets such as equipment, where the asset’s useful life is more accurately described by its production capacity than by its age.

What is Accumulated Depreciation?

Accumulated depreciation is the cumulative amount of an asset’s value that has been depreciated up to a specified point in time. It can apply to a single asset or be shown as a line item representing depreciation on all of a company’s assets on its balance sheet.

Accumulated depreciation is only shown on financial statements for assets that are still in service. Once an asset has been disposed of and is no longer included in a company’s net assets, depreciation on it is removed from accumulated depreciation.

As a balance sheet item along with total net asset value, accumulated depreciation indicates how much of a company’s asset value has been depreciated as of the balance sheet date. This can provide investors with a useful snapshot of the nature of a company’s assets and its tax liabilities.

How to calculate Depreciation?

Investors do not need to calculate depreciation on companies they invest in, as public companies will all report depreciation on their balance sheets and will disclose the method they use for calculating it.

EXAMPLE: Depreciation under various methods

Assumptions:

• Asset cost = $100,000
• Asset salvage value = $10,000
• Asset expected life = 10 years
• Asset lifetime productive capacity = 50,000 units
• First-year production = 6,000 units
• Second-year production = 6,200 unit

Straight-line method: Depreciation Expense = (Asset cost – salvage value) /no. of years of useful life

= ($100,000 – 10,000) / 10

= $9,000 depreciation expense per year

Double declining balance method: Depreciation Expense = (Undepreciated asset cost balance – salvage value) / No. of remaining years of useful life X 2

YEAR 1 = (($100,000 – 10,000) / 10) X 2

= $18,000

YEAR 2 = (($82,000 – 10,000) / 9) X 2

= $16,000

Sum of the years’ digits depreciation: Depreciation Expense = (Undepreciated asset cost balance – salvage value) X Remaining asset life / Sum of years’ digits

YEAR 1 = ($100,000 – 10,000) X 10/ 55

(where 10+9+8+7+6+5+4+3+2+1 = 55)

= $16,364

YEAR 2 = ($83,636 – 10,000) X 9/ 55

= $12,050

Units of production method: Depreciation Expense = (Asset cost – salvage value) X Units produced / Expected Life in units

YEAR 1 = ($100,000 – $10,000) X 6,000 / 50,000

(where 6,000 is the unit production in Year 1)

= $10,800

YEAR 2 = ($100,000 – $10,000) X 6,200 / 50,000

(where 6,200 is the unit production in Year 2)

= $11,160

What Assets cannot be depreciated?

• Raw land that has an unlimited useful life
• Assets that don’t lose value over time
• Assets that are not being used to generate current income
• Current assets such as accounts receivable and inventory
• Low-cost items with minimal useful lives such as office supplies
• Investment assets such as stocks and bonds
• Personal assets such as cars, boats, or jewelry

Depreciation Subjectivity

While the Generally Accepted Accounting Principles (GAAP) lay out specific rules for depreciation calculations, company management teams are given a certain amount of leeway in the decisions affecting depreciation expense, including:

• Estimating an asset’s useful life (for instance, certain asset types are guided to be depreciated over a 20-25 year timespan, with management determining the actual useful life used for depreciation purposes)
• Estimating the salvage value (which is very challenging given the need to forecast many years into the future)
• Determining which depreciation method to use

How is Depreciation different from Amortization?

Depreciation and amortization are similar in that both are methods of allocating the cost of an asset over time. Depreciation applies to tangible assets that are expected to have a limited life and there are four major methodologies that can be used to calculate the depreciation expense for a given time period. Depreciation is also shown in a separate line item on a balance sheet as accumulated depreciation.

Amortization applies to intangible assets and is calculated in only one way, using a straight-line method. Amortization is credited against the asset line item on a balance sheet and is not shown separately.