The Positive Side of Depreciation
Depreciation may not sound like a positive term to be applied to a business but it can be. Part of running a successful company is planning for the future and proper depreciation of assets can play a key role. The definition of depreciation is a reduction in the value of an asset of the passage of time, due primarily to wear and tear. An asset can be computers, copy machines, vehicles, furniture, appliances, buildings, etc. In financial accounting, depreciation is realized as a portion of the asset's cost being subtracted from the revenues of the business that are generated through the use of that asset. Depreciation is not meant to recognize a loss in the market value of the asset.
There are two main categories of methods for calculating depreciation. Each method involves spreading the amount to be depreciated over the useful life of the asset; they are straight-line and accelerated. The straight-line depreciation methods charge a lower depreciation expense in the early years resulting in higher reported net income. In the later years when the accelerated methods expense is low, the straight-line remains at a constant and higher in comparison.
For the straight-line calculation method we apply the following equation:
(Cost of the asset – Estimated salvage value) / Estimated useful life = Annual depreciation expense
Example:
Cost of the asset: $11,000
Estimated salvage value: $1,000
Estimated useful life: 5 years
($11,000 - $1,000) / 5 years = $2,000 per year
In this case the straight-line depreciation calculation results in a flat annual depreciation expense of $2,000 per year. From the first fiscal year to the fifth there will be a $2,000 dollar depreciation expense each year ultimately totaling $10,000 over the assets useful life.
The most popular accelerated depreciation method is declining-balance depreciation. The annual depreciation expense for the declining-balance method is calculated with the following equation:
(Double the straight-line depreciation rate x Asset's net book value at the beginning of each year)
Using the same asset we would first calculate the following:
1 / Estimated useful life of the asset = the straight-line depreciation rate
1 / 5 years = 20%
2 x 20% = 40% (Double the straight-line depreciation rate)
For our first year, the depreciation calculation would be as follows:
$10,000 x 40% = $4,000
For our second year, we see the depreciation expense drop significantly. Net book value of the asset for year 2 would be $10,000 - $4,000 = $6,000. That would make the depreciation expense $6,000 x 40% = $2,400 yielding a net book value of $3,600. The total accumulated depreciation over 5 years would match that of the straight-line method at $10,000.
The two main benefit of applying depreciation over the useful life of an asset are to gradually take a loss rather than incurring an excessive loss when the asset is sold and to reduce revenue which lessens the taxes a company is required to pay thereby boosting cash.
There are two main categories of methods for calculating depreciation. Each method involves spreading the amount to be depreciated over the useful life of the asset; they are straight-line and accelerated. The straight-line depreciation methods charge a lower depreciation expense in the early years resulting in higher reported net income. In the later years when the accelerated methods expense is low, the straight-line remains at a constant and higher in comparison.
For the straight-line calculation method we apply the following equation:
(Cost of the asset – Estimated salvage value) / Estimated useful life = Annual depreciation expense
Example:
Cost of the asset: $11,000
Estimated salvage value: $1,000
Estimated useful life: 5 years
($11,000 - $1,000) / 5 years = $2,000 per year
In this case the straight-line depreciation calculation results in a flat annual depreciation expense of $2,000 per year. From the first fiscal year to the fifth there will be a $2,000 dollar depreciation expense each year ultimately totaling $10,000 over the assets useful life.
The most popular accelerated depreciation method is declining-balance depreciation. The annual depreciation expense for the declining-balance method is calculated with the following equation:
(Double the straight-line depreciation rate x Asset's net book value at the beginning of each year)
Using the same asset we would first calculate the following:
1 / Estimated useful life of the asset = the straight-line depreciation rate
1 / 5 years = 20%
2 x 20% = 40% (Double the straight-line depreciation rate)
For our first year, the depreciation calculation would be as follows:
$10,000 x 40% = $4,000
For our second year, we see the depreciation expense drop significantly. Net book value of the asset for year 2 would be $10,000 - $4,000 = $6,000. That would make the depreciation expense $6,000 x 40% = $2,400 yielding a net book value of $3,600. The total accumulated depreciation over 5 years would match that of the straight-line method at $10,000.
The two main benefit of applying depreciation over the useful life of an asset are to gradually take a loss rather than incurring an excessive loss when the asset is sold and to reduce revenue which lessens the taxes a company is required to pay thereby boosting cash.