Depreciation Calculation
Vernon Butte
Conceptually, depreciation is the reduction in the value of an asset over time due to elements such as wear and tear. For instance, a widget-making machine is said to "depreciate" when it produces fewer widgets one year compared to the year before it, or a car is said to "depreciate" in value after a fender bender or the discovery of a faulty transmission.
For accounting, in particular, depreciation concerns allocating the cost of an asset over a period of time, usually its useful life. When a company purchases an asset, such as a piece of equipment, such large purchases can skewer the income statement confusingly. Instead of appearing as a sharp jump in the accounting books, this can be smoothed by expensing the asset over its useful life. Within a business in the U.S., depreciation expenses are tax-deductible.
There are many methods of distributing depreciation amount over its useful life. The following are some of the widely used methods. The total amount of depreciation for any asset will be identical in the end no matter which method of depreciation is chosen; only the timing of depreciation will be altered. Keep in mind that accelerated depreciation methods (such as declining balance or sum of the years' digits) can artificially reduce profit in the near term, followed by higher profits in later terms, which can influence reported cash flows.
For specific assets, the newer they are, the faster they depreciate in value. As these assets age, their depreciation rates slow over time. In these situations, the declining balance method tends to be more accurate than the straight-line method at reflecting book value each year.
Double declining balance is the most widely used declining balance depreciation method, which has a depreciation rate that is twice the value of straight line depreciation for the first year. Use a depreciation factor of two when doing calculations for double declining balance depreciation. Regarding this method, salvage values are not included in the calculation for annual depreciation. However, depreciation stops once book values drop to salvage values.
Similar to declining balance depreciation, sum of the years' digits (SYD) depreciation also results in faster depreciation when the asset is new. It is generally more useful than straight-line depreciation for certain assets that have greater ability to produce in the earlier years, but tend to slow down as they age.
Not all assets are purchased conveniently at the beginning of the accounting year, which can make the calculation of depreciation more complicated. Depending on different accounting rules, depreciation on assets that begins in the middle of a fiscal year can be treated differently. One method is called partial year depreciation, where depreciation is calculated exactly at when assets start service. Simply select "Yes" as an input in order to use partial year depreciation when using the calculator.
In regards to depreciation, salvage value (sometimes called residual or scrap value) is the estimated worth of an asset at the end of its useful life. If the salvage value of an asset is known (such as the amount it can be sold as for parts at the end of its life), the cost of the asset can subtract this value to find the total amount that can be depreciated. Assets with no salvage value will have the same total depreciation as the cost of the asset.
Depreciation recapture is a provision of the tax law that requires businesses or individuals that make a profit in selling an asset that they have previously depreciated to report it as income. In effect, the amount of money they claimed in depreciation is subtracted from the cost basis they use to determine their gain in the transaction. Recapture can be common in real estate transactions where a property that has been depreciated for tax purposes, such as an apartment building, has gained in value over time.
This calculation method also applies to most of the structural components of your dwelling or building that wear out over time, such as the roof. If your dwelling has a 25-year composition shingle roof, it would depreciate at 4% a year under normal conditions. If the roof is 10 years old at the time of your loss and it requires replacement, we would subtract 40% depreciation (10 years x 4% a year) from your replacement cost estimate to determine the ACV of your roof.
This is the most commonly used method to calculate depreciation. It is also known as fixed instalment method. Under this method, an equal amount is charged for depreciation of every fixed asset in each of the accounting periods. This uniform amount is charged until the asset gets reduced to nil or its salvage value at the end of its estimated useful life.
This method is also known as reducing balance method, written down value method or declining balance method. A fixed percentage of depreciation is charged in each accounting period to the net balance of the fixed asset under this method. This net balance is nothing but the value of asset that remains after deducting accumulated depreciation.
Thus, it means that depreciation rate is charged on the reducing balance of the asset. This asset is the one reflected in the books of accounts at the beginning of an accounting period.So, the book value of the asset is written down so as to to reduce it to its residual value.
Now, as the book value of the asset reduces every year so does the amount of depreciation. Accordingly, higher amount of depreciation is charged during the early years of the asset as compared to the later stages.
Thus, the method is based on the assumption that more amount of depreciation should be charged in early years of the asset. This is on account of low repair cost being incurred in such years. As an asset forays into later stages of its useful life, the cost of repairs and maintenance of such an asset increase. Hence, less amount of depreciation needs to be provided during such years.
So, as an asset moves towards the end of its useful life, the benefit gained out of such an asset declines. That is to say, highest amount of depreciation is allocated in the first year since no amount of capital has been recovered till then. Accordingly, least amount of depreciation should be charged in the last year as major portion of capital invested has been recovered.
This method is a mix of straight line and diminishing balance method. Thus, depreciation is charged on the reduced value of the fixed asset in the beginning of the year under this method. This is just like the diminishing balance method. However, a fixed rate of depreciation is applied just as in case of straight line method. This rate of depreciation is twice the rate charged under straight line method. Thus, this method leads to an over depreciated asset at the end of its useful life as compared to the anticipated salvage value.
Therefore, companies adopt various approaches in order to overcome such a challenge. Firstly, the amount of depreciation charged for the last year is adjusted. This is done to make salvage value equal to the anticipated salvage value. Secondly, many companies choose to use straight line depreciation method in the last year to adjust the over depreciated salvage value.
Kapoor Pvt Ltd. purchased machinery worth Rs. 1,00,000 on March 31st, 2018. However, in 2018 a new variant of the same machinery comes into the market due to innovation in technology. As a consequence, the machinery purchased by Kapoor Pvt. Ltd. becomes outdated.This technological innovation causes the value of the old machinery to decline. Say, the profit before depreciation and tax for Kapoor Pvt. Ltd for the year ended December 2018 is Rs.50,000. And depreciation for the same accounting period is Rs. 10,000. Hence, depreciation for plant and machinery is shown as under:
You need to determine a suitable way to allocate cost of the asset over the periods during which the asset is used. Generally, the method of depreciation to be used depends upon the patterns of expected benefits obtainable from a given asset. This means different methods would apply to different types of assets in a company.
Each depreciable entity may have most of the same depreciable factors but different beginning points for depreciation calculations. Therefore, for a single component, one depreciable entity (layer) may be fully depreciated while another depreciable entity (representing a later fiscal year) may still be depreciating.
How do you plan to accommodate for depreciation? unless a user puts in via a journal (and obviously remembers/or knows how to do it) there is no way QF prompts the user to account for depreciation. Depreciation calculations will be crucial part of any tax estimates/over view reports.
We need to be mindful of whether the average Quick File user will be able to handle depreciation on fixed assets. Some of these areas are more complex and often left in the hands of their accountants/bookkeepers to correct at the year-end. What we want to avoid is over complicating the system for 90% of our user-base in order to accommodate for 10%.
With regards to depreciation calculation, please see email from a client below. this just shows the need to have something in place which can prompt user to calculate depreciation as soon as a new fixed asset is tagged in the system. I would really appreciate it if this feature is given some consideration.
You cannot revalue Book value depreciation for assets in the current period (Asset Revaluation) once you have run the Asset Depreciation Calculation program and selected the Generate & update option for Book value depreciation.
The program can only be run ONCE per period in Generate & update mode for Book value depreciation, and must be run before the month end or year end functions of the Asset Period End program can be selected.
You must therefore only run the report in Generate & update mode for Book value depreciation after you have processed all your asset transactions for the month (i.e. acquisitions, disposals, revaluations, etc).
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