Depreciation is an accounting practice that helps companies allocate costs of non-current assets. It helps companies to follow the matching principles of accrual accounting as well.
Let us discuss what is depreciation and the top reasons for companies to calculate depreciation.
What is Depreciation?
Depreciation expense or simply depreciation is the process of cost allocation of a tangible and physical asset over its useful life.
IAS defines depreciation as:
“The systematic allocation of the depreciable amount of an asset over its useful life.”
Here depreciable amount refers to the cost of acquiring an asset. The useful life means the economic usefulness of an asset for which it can be used by an entity.
Depreciation allows companies to spread the total cost of purchasing a physical asset over several accounting periods. It is commonly used for physical and tangible assets that have a useful economic life of over one year.
We can also describe depreciation as an accounting concept. It is a non-cash accounting entry that helps a business match revenue and expenses arising due to the usage of an asset.
Depreciation Methods
There are several accounting methods to calculate depreciation. Entities can choose a method of their choice. However, the depreciation method used should be compliant with the reporting standards (IAS or GAAP) that an entity follows.
Straight-Line Methods
It is the most common and easiest method of calculating depreciation. Under this method, a company spreads the total cost of an asset equally until it reduces to the salvage value.
This method is easy and simple to implement. It provides equal depreciation costs and matches the revenue and expense of the asset for the same accounting period.
Declining Balance Method
This method uses a depreciation calculation factor that offers higher depreciation costs in earlier years and gradually reduces the costs over the useful life of the asset.
A similar accelerated depreciation method is the double-declining method. It uses a double factor to calculate the depreciation costs that further accelerate it in earlier years.
Sum of the Digits Method
This method first calculates the sum of the years for the estimated useful life of an asset. That sum is then used as a calculation factor to calculate the yearly depreciation expense.
Why Do Companies Need to Calculate Depreciation?
Companies need to calculate depreciation for several purposes. Fixed assets come with long economic usage for businesses. Companies also need to identify and report accurate costs of doing business.
Let us briefly discuss key reasons for companies to calculate depreciation.
Accounting Purposes
Accrual accounting requires matching revenues and expenses for the same accounting periods. It means when a company utilizes an asset, it generates revenues and incurs costs.
These expenses and costs related to an asset should be allocated in the same accounting period under the matching principle. However, it is extremely difficult for a business to identify and calculate revenue and expenses directly linked with a specific asset.
Depreciation provides a useful tool for companies to allocate matching costs to earned revenue from physical and tangible assets.
Cost of Doing Business
Without depreciation, calculating the accurate costs of doing a business will be difficult. Physical assets require significant initial investments.
It means without depreciation; a business will allocate the total cost of purchasing an asset immediately. It will deplete the profits substantially and even will result in heavy losses until the full cost of the asset is recovered.
Then, a business will witness significant revenue in later years when there will be no cost allocation for non-current assets.
Simply, a business will not be able to report accurate income and expenses without using depreciation.
Compliance Purposes
Accounting rules such as those developed by IAS or GAAP require companies to follow certain accounting principles.
Tax regulatory authorities also require reporting accurate income and expenses of a business.
Using depreciation for non-current assets means compliance with accounting and tax regulatory requirements.
For all businesses, the implementation of internal controls will require calculating the depreciation of non-current assets.
Useful Economic Life of an Asset
Business owners and managers will be interested in knowing their capital investment requirements. It means they’d like to know when and how much they need to replace their aging non-current assets.
Depreciation is a useful tool to inform business managers about the replacement costs of non-current assets. Once a business reaches the residual value of a non-current asset, it can consider replacing it.
What Does not Depreciation Reveal?
Calculating depreciation offers several benefits and serves many purposes for companies. However, companies must be careful about using depreciation because it does not offer a few points that are generally linked with it.
No Fair Value Estimation of Assets
Unlike the common notion, depreciation is not an estimation of the fair value of non-current assets.
The fair value of an asset depends on its usability and demand in the market. Therefore, even when depreciation allocates the costs of an asset, it does not offer market fair value.
Cash flow
Depreciation is a non-cash entry. Therefore, a company implementing depreciation does not offer information about the exact cash flow movement linked with an asset.
Overall, a business must also adjust for depreciation amounts in every accounting period to calculate its actual cash flows.
Net Profit in the long-term
Depreciation only allocates costs of non-current assets. It means it evens the profits and losses of a company.
Therefore, the net profit of a company due to depreciation calculation will be the same in the long term. However, efficient use of depreciation will improve the financial metrics of a business that can be fruitful for the business in the long run.
Causes of Depreciation
Let us briefly discuss the main causes of depreciation for non-current assets and why companies should care about them.
Wear and Tear of Assets
Non-current assets used for several years will break down. Natural wear and tear due to the usage of assets such as machinery is inevitable.
Companies need to allocate costs accurately through depreciation so that assets are replaced when needed.
Obsolescence of Assets
Many companies will replace their old equipment and machinery with new and more efficient assets.
It means some non-current assets will require replacement due to their obsolescence against newly available assets.
Limited Usage Rights
Some non-current assets will come with limited usage rights. For instance, mineral exploration rights for a company will be limited by contract.
Therefore, a company will need to allocate project costs and depreciate its assets over the useful life of the available resources with limited usage rights.
Depletion of Resources
Similarly, some natural resources such as oil, minerals, and other commodities will deplete over the years.
A company would want to precisely spread the cost and match the revenue arising from these depleting resources through depreciation.
Replacement of Obsolete Technology
Newer and advanced machinery will perform efficiently. Technological advancements make older assets obsolete.
Businesses often require replacing older technology to keep their competitive advantages. Therefore, using depreciation helps them keep a track of these assets and their replacement costs.
Features of Depreciation
Depreciation is not a one-time process. It is a gradual and consistent approach that allows businesses to monitor their expenses and revenues in the long term.
Here are a few key features of depreciation accounting:
- Depreciation decreases the book value of non-current assets gradually
- It is a consistent, gradual, and ongoing process of cost allocations
- It links the allocated expenses with the earned revenue arising from non-current assets of a company
- It is an accounting entry that does not affect the net profits of a business in the long run
Depreciation Vs Amortization Vs Depletion
Amortization and depletion are similar concepts to depreciation.
Amortization is the cost allocation process for non-current and intangible assets. It can be used in the same way as depreciation is used for tangible assets.
Intangible assets are difficult to measure in terms of usage, useful economic life, and hence cost allocation. Therefore, amortization is a useful tool to spread the cost and match revenues.
Depletion is used for the cost allocation of natural resources. For instance, when a company applies the depreciation concept for oil or minerals as assets, it will be termed depletion instead of depreciation.
In short, depreciation, amortization, and depletion are similar accounting concepts for different types of non-current assets.
Important Considerations
Depreciation is a non-cash charge used by companies to spread the costs of non-current assets. There are several methods to calculate depreciation.
Some methods such as double-declining depreciation are used to accelerate the depreciation charge initially. It means the charge or expense will gradually decrease in the following years.
Companies must remain cautious about the selection of depreciation methods. Managers can manipulate the usage of depreciation to distort income and expenses to artificially improve their profits.
Tax regulators also monitor the implementation of depreciation expenses closely to avoid any tax evasion.
The usefulness of depreciation also depends on a few assumptions that may change over time. For instance, the salvage or residual value of a used asset is an estimation of the fair market value of an asset after it becomes obsolete for the company.
