Depreciation

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Depreciation Meaning

Depreciation in accounting refers to an indirect and explicit cost that a company incurs
every year while using a fixed asset such as equipment, machinery, or expensive tools. It is
the depleting value of a tangible asset.

The value of the assets gets depleted due to constant use for business purposes.
Companies depreciate to account for this value throughout the useful life of that asset. It
is a fixed cost for the companies, and the amount depreciated can be used to purchase
new machinery after the old one turns into a scrap. Also, it is seen as a business expense
despite being a non-cash expense.

Key Takeaways
Depreciation is a non-cash business expense incurred by a company for employing a
tangible asset like machinery, tools, and equipment for business use.
It is accounted for throughout the asset’s life expectancy. After that, the asset is
discarded at salvage or residual value.
Companies depreciate assets using these five methods: straight-line, declining
balance, double-declining balance, units of production, and sum-of-years digits.
In the balance sheet, the amount shown as a depreciation expense charged goes into
the accumulated depreciation account.

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Depreciation in Accounting Explained

Companies depreciate to allocate the cost of a , over its . When the asset is used, wear and
tear occur from erosion, dust, and decay. Despite proper maintenance and precaution, it
is impossible to preserve the original form and quality of the asset. Therefore,
depreciation expense is used to recognize the amount of wear and tear. Firms depreciate
because the technology used in the machine may become obsolete, or the asset may
become inoperable due to an accident.

In depreciation, there is no cash outflow. Instead, while accounting, this expense is

transferred to the . It is an essential part of accounting that facilitates companies to record
the real-time of tangible assets. Also, this sum can be used for purchasing a new asset in
the future. Now, let us understand some of the terminologies used in this concept:

Fixed Asset Cost: It is the cost at which the organization buys a tangible asset.
Salvage Value: The residual cost can be recovered from selling the asset after its
useful life.
Useful Life of Fixed Asset: It is the estimated number of years for which an asset
remains productive and efficient.
Depreciation Rate: It is the percentage charged as depreciation on the fixed asset.

Types of Depreciation Methods

All tangible assets depreciate with time. Therefore, firms use the following five methods to
charge for it.  

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#1 – Straight-Line Method (SLM)

This is the simplest method of calculating used most of the time. In SLM, a constant
depreciation amount is charged every year. First, corporations have to estimate the
salvage (residual) value. The represents the cost the company expects to recover at the
end of the machine’s useful life. After deducting this residual value from the fixed asset
cost, the value acquired is divided by the useful life of the .

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Straight-Line Method Formula:

#2 – Declining Balance Method

In this method, the depreciated percentage is charged on the net book value of a fixed
asset. This netbook value is the remaining balance of fixed asset cost after deducting the
overall depreciation charged for the previous years. Thus, the depreciable value
diminishes every year, and so does the depreciated expense.

Declining Balance Method Formula:

#3 – Double Declining Balance Method

This method works similar to the declining balance method; however, it charges double
the depreciated rate on the fixed asset’s balance or net book value. Therefore, it is also
known as an accelerated method.

Double Declining Balance Method Formula:

#4 – Units of Production Method

Under this method, the fraction of the number of fixed asset units (machinery) produced
per year and the total number of units generated in a lifetime is multiplied with the fixed
asset cost to yield the depreciated expense of each year. Hence, if the production
decreases, the depreciated cost also steeps down and vice versa.

Units of Production Method Formula:

#5 – Sum-of-Years Digits Method

As the name indicates, this method takes the total useful years. Here the digits are
arranged in descending order. Then the remaining number of useful years are divided by
this sum and multiplied by 100 to get the depreciated rate for the particular year. Finally,
the depreciated expense is computed by multiplying this rate with the remaining fixed
asset cost after deducting the salvage value.

Sum-of-Years Digits Method Formula:

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Accounting Depreciation Calculation
Following are examples where the depreciated amount is calculated using different
methods.

#1 – Straight-Line Method

XYZ Inc. is a manufacturer of aerated drinks. It bought a bottling machine worth

$108000 in 2016. Titus, the plant supervisor, determined the technical feasibility test of
the bottling machine. Titus believes it will last for 5 years with a salvage value of $8000.
Find out the depreciated expense for each year using the straight-line method.

Given:

Cost of Bottling Machine = $108,000

Salvage Value = $8,000
Useful Life of Bottling Machine = 5 years

Solution:

Depreciation = (Cost of Bottling Machine – Salvage Value)/ Useful Life of

Bottling Machine.

Depreciation = (108,000 – 8,000)/ 5

Depreciation = $20,000

#2 – Declining Balance Method

For the same example, what will be the depreciating expense if the company charges 20%
per annum? Use the declining balance method.

Given:

Depreciating Rate = 20% p.a.

Solution:

Depreciation = (Net Book Value – Salvage Value) × Rate of Depreciation

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 Depreciable Asset Depreciation Depreciation Net Book
Year Value ($) Rate Amount ($) Value ($)

2017 108,000-8,000 = 20% 20,000 80,000

100,000

2018 80,000 20% 16,000 64,000

2019 64,000 20% 12,800 51,200

2020 51,200 20% 10,240 40,960

2021 40,960 20% 40,960 –

Note: The machinery will depreciate with the whole amount in 2025, i.e., in the last year
of its useful life.

#3 – Double Declining Balance Method

Again, for the same example, assume that the company charges using the double-
declining balance method. Determine the amount charged on the depreciating asset each
year.

Depreciation = (Net Book Value – Salvage Value) × 2 × Depreciating Rate

New Depreciating Rate = 2×20% p.a. = 40% p.a.

Solution:

Depreciable Bottling Depreciation Depreciation Net Book

Year Machine Value ($) Rate Amount ($) Value ($)

2017 108,000-8,000 = 100,000 40% 40,000 60,000

2018 60,000 40% 24,000 36,000

2019 36,000 40% 14,400 21,600

2020 21,600 40% 8,640 12,960

2021 12,960 40% 12,960 –

Note: Here also, the machinery will depreciate with the whole amount in 2025, i.e., in the
last year of its useful life.

#4 – Units of Production Method

In the above example, now assume that the bottling machine filled the following units of
bottles for the respective years:

14,600,000 bottles in 2020,

15,700,000 bottles in 2021,

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 12,400,000 bottles in 2022,
14,900,000 bottles in 2023,
13,500,000 bottles in 2024.

Here, the estimated lifetime bottling capacity of the machine is 100,000,000 bottles.
Now, find out the depreciating amount using the .

Given:

Total number of bottles filled during the useful life of bottling machine = 100,000,000

Solution:

Depreciating Rate Per Unit = (Cost of Bottling Machine – Salvage Value)/

Total number of bottles filled during the useful life of bottling machine

Depreciating Rate Per Unit = (108,000 – 8,000)/ 100,000,000

Depreciating Rate Per Unit = $0.001
Depreciation = number of bottles filled in a given year × depreciation

Number of bottles filled in a Depreciable Rate Per Depreciation

Year given year ($) Unit ($) Amount ($)

2020 14,600,000 0.001 14600

2021 15,700,000 0.001 15,700

2022 12,400,000 0.001 12,400

2023 14,900,000 0.001 14,900

2024 13,500,000 0.001 13,500

2025 16,500,000 0.001 16,500

2026 12,400,000 0.001 12,400

Total 100,000,000 – 100,000

Note: We can see that the machine depreciates entirely in 2027 when its lifetime capacity
of bottling is attained.

#5 – Sum-of-Years Digits Method

Now, assume XYZ Inc. depreciates the bottling machine through the sum-of-years digits
method; what will be the depreciating amount?

Solution:

Depreciation = [(Useful Life Remaining / Sum of Years Digits) × 100] ×

Depreciable Bottling Machine Value

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 Sum of Years Digits = 5+4+3+2+1
Sum of Years Digits = 15
Depreciable Bottling Machine Value = Bottling Machine Cost – Salvage Value
Depreciable Bottling Machine Value = 108,000 – 8,000
Depreciable Bottling Machine Value = $100,000

Depreciation Rate = Depreciation =

Useful Life Sum [Useful Life Remaining / Depreciation Rate ×
Remaining of Sum of Years Digits] × Depreciable Bottling
Year (in years) Digits 100 Machine Value

2017 5 15 33% 33,000

2018 4 15 27% 27,000

2019 3 15 20% 20,000

2020 2 15 13% 13,000

2021 1 15 7% 7,000

Total – – 100% 100,000

How Depreciation Affects Accounting Ratios?

Depreciating assets impacts various financial ratios and accounting books in the following
manner:

Choice of useful life and salvage value also impacts depreciating expense and the
stated asset values. Assets depreciate more when they have a shorter useful life and
lower salvage values.  
Higher depreciation expense subdues the return ratios. An analyst should take care
of this while comparing firms with different methods. Compared to SLM, the
accelerated depreciating method tends to depress both net income and
shareholder’s equity during the initial years.  
Also, return ratios are lower when Accelerated methods are used, hence more
conservative. The impact, however, reverses in the later years with a lower
depreciating expense.
A firm with high capital may take a conservative approach of adopting the
Accelerated approach as depreciating less with aging assets is compensated by
depreciating more on new assets.

Frequently Asked Questions (FAQs)

How is depreciation calculated?

The most common way of calculating depreciating expense is the straight-line method.
The difference between the fixed asset cost and its salvage value is divided by the useful
life of that asset in years to get the depreciating value for each year.

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Is depreciation a fixed cost?
The business entities depreciate fixed assets every year irrespective of production or sales.
Fixes assets include machinery, tools, equipment, and vehicles. In accounting, therefore,
depreciating of asserts comes under fixed cost. However, when computed using the units
of production method, it is taken as a variable cost.  This is because the rise or fall in
production causes the asset to depreciate more or less.

Why is depreciation important?

It is the depletion in the value of something. In accounting, fixed assets’ value declines
every year due to wear and tear caused by constant usage. This happens throughout the
useful life of an asset.

Companies depreciate to account for the cost of fixed assets. After all, every asset has a
specific lifespan and turns into scrap after this period. Therefore, recording the
appropriate book value of an asset helps accumulate funds for its future replacement.

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