Depreciation Accounting In the United States, businesses can take a deduction for depreciation. Depreciation is the reduction in an asset's value caused by the passage of time due to use or abuse, wear and tear. Depreciation is a method of cost allocation. The cost allocation can be based on a number of factors, but it is usually related to the estimated period of time the product can generate revenues for the company, also known as the asset's economic life. Depreciation expense is the amount of cost allocation within an accounting period. Only items that lose useful value over time can be depreciated. Depreciation can be calculated in more than one way. Straight-line Depreciation The simplest and most commonly used method, straight-line depreciation is calculated by taking the purchase or acquisition price of an asset, subtracting the salvage value (value at which it can be sold once the company no longer needs it) and dividing by the total productive years for which the asset can reasonably be expected to benefit the company (or its useful life). Example: For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts. Depreciation Expense = Total Acquisition Cost – Salvage Value / Useful Life Straight-line depreciation produces a constant depreciation expense. At the end of the asset's useful life, the asset is accounted for in the balance sheet at its salvage value. Unit-of-Production Depreciation This method provides for depreciation by means of a fixed rate per unit of production. Under this method, one must first determine the cost per one production unit and then multiply that cost per unit with the total number of units the company produced within an accounting period to determine its depreciation expense. Depreciation Expense = Total Acquisition Cost - Salvage Value / Estimated Total Units Estimated total units = the total units this machine can produce over its lifetime Depreciation expense = depreciation per unit * number of units produced during an accounting period Example: Company ABC purchased a machine for $2 million that can produce 300,000 products over its useful life. The company estimates that this machine has a salvage value of $200,000. Unit-of-production depreciation produces a variable depreciation expense and is more reflective of production-to-cost (see matching principle). At the end of its useful life, the asset's accumulated depreciation is equal to its total cost minus its salvage value. Furthermore, its accumulated production units equal the total estimated production capacity. One of the drawbacks of this method is that if the units of products decrease (due to slowing demand for the product, for example), the depreciation expense also decreases. This results in an overstatement of reported income and asset value. Hours-of-Service Depreciation This is the same concept as unit of production depreciation except that the depreciation expense is a function of total hours of service used during an accounting period. Accelerated Depreciation Accelerated depreciation allows companies to write off their assets faster in earlier years than the straight-line depreciation method and to write off a smaller amount in the later years. The major benefit of using this method is the tax shield it provides. Companies with a large tax burden might like to use the accelerated-depreciation method, even if it reduces the income shown on the financial statement. This depreciation method is popular for writing off equipment that might be replaced before the end of its useful life if it becomes obsolete ( computers, for example). Companies that have used accelerated depreciation will declare fewer earnings in the beginning years and will seem more profitable in the later years. Companies that will be raising financing (via an IPO or venture capital) are more likely to use accelerated depreciation in the first years of operation and raise financing in the later years to create the illusion of increased profitability (and therefore higher valuation). The two most common accelerated-depreciation methods are the sum-of-year (SYD) method and double-declining-balance method (DDB): Sum-of-Year Method: Depreciation In Year i = ((n-i+1) / n!) * (total acquisition cost - salvage value) Example: For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts. n! = 1+2+3+4+5 = 15 n = 5 The sum-of-year depreciation method produces a variable depreciation expense. At the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straight-line depreciation. Double-Declining-Balance Method The DDB method simply doubles the straight-line depreciation amount that is taken in the first year, and then that same percentage is applied to the un-depreciated amount in subsequent years. DDB In year i = (2 / n) * (total acquisition cost - accumulated depreciation) n = number of years Example For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years the company will be able to sell it for $200,000 for scrap parts. The double-declining-balance method produces a very aggressive depreciation schedule. The asset cannot be depreciated beyond its salvage value.
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