Depreciation – A non-cash expense involving allocating the cost of an asset over a period of time deemed to be its useful life.
The cost of an asset, whether it be plant, property used for business purposes, or equipment, is often too large to pay off on a single income statement and for accounting purposes, this expense is spread over a time period of the asset’s useful life. As defined by the Generally Accepted Accounting Principles, the matching principle links an expense with the revenue it creates. Depreciation is an example of this. Over the given useful life of any asset, it makes sense to balance expenses with revenue until the asset is no longer useful. Assets that can be depreciated range from things like food handling devices and computers to municipal sewers, residential properties and non-residential property. Depreciation differs from amortization in that it does not specifically take into account the value of intangible assets like trademarks, patents, and goodwill. The cash flow that results from the salvage value is also known as residual value. It is possible for the salvage value to be negative if the asset needs to be disposed of in a specific and expensive manner such as nuclear waste facilities. There are several methods of depreciation; the following are some of the better known or popular.
Methods of Depreciation (used based on time line or level of use of asset) Straight Line Depreciation - The simplest example of depreciation often used in teaching the subject, this method uses an estimation of a Salvage (Scrap) Value of a given estimate at the end of its useful life. Over this time, equal increments of the original cost are expensed. The value at the end of this time line can be estimated at zero. The formula for the Annual Depreciation Expense is expressed as the (Cost of the fixed Asset – Scrap value) / Life Span of Asset.
Declining Balance - An example of an accelerated depreciation method, the declining balance method is one that incurs a larger cost in the first year and gradually decreases over time. The logic with this method is that an asset is generally more useful closer to the time of purchase than later on, so the allocation of expenses closer to the beginning of the time frame will match the hopeful level of generated income. Annual depreciation through this method is expressed as Depreciation Rate * Book Value at Beginning of Year. The rate applied in this method is most commonly double the straight-line rate. This rate can be found with the expression 2/(100%*N) with N being the number of years in the useful life. At any time in this depreciation, book value of an asset is found by original cost minus accumulated depreciation. Drawbacks to this method are that the asset might not be fully depreciated by the end of the calculated useful life, requiring an additional subtraction at the end or a process of declining balance for the first half of the useful life followed by a straight-line depreciation for the remainder.
Activity Depreciation - Depreciation calculated based on the level of activity of an asset. In this opinion, activity depreciation is most practically used in terms of vehicles used for business where the per mile or distance depreciation amount can be expressed by (Original Cost – Salvage Value) / Distance or other amount of activity.
MACRS (Modified Accelerated Cost Recovery System) - MACRS is the method of asset depreciation required by the United States income tax code. This system designates all assets into classes determining the useful life for each. Introduced in a 1986 tax reform, MACRS provides more property classes than its predecessor ACRS, as well as a provision for biannual periods in first and last years of the useful life to speed up depreciation processes similar to the declining balance method. The benefit of this is a front end oriented cash flow for a business on a given time period. The front-loaded schedule increases the net present value of the asset and increases income early in the schedule for the firm. A predetermined depreciation schedule has been created for each MACRS class, which for each class draws out the percentage of original cost that must be depreciated each year for an asset in that class.