DEPRECIATION

A decrease in value over time. A non-cash expense that gradually reduces the value of an asset over time as a result of wear and tear, age or obsolescence. In finance it refers to the decrease in value of a currency compared with a foreign currency.

Depreciation does not affect the cash flow of a company because it is a non-cash expense. This means that the company is not spending money as a result of an asset´s depreciation; it means that the asset will not be worth as much. Some reasons why this happens are because of wear and tear, age, or obsolescence. Wear and tear means that the asset is depreciating as a result of its use, for example a vehicle used for distribution in a company that has a certain mileage, or a specific machine used in the productive system.

Obsolescence means that a certain asset is replaced by a new, improved, or superior one, but not due to physical use; it is very common in technology, for example computers; last year´s computer is less valuable because there is a newer model in the marketplace. Depreciation is a term also used for tax and accounting purposes, and it describes the method that a company uses to account for the declining value of its assets. The different methods can be either based on time or on activity:
Based on time:

  • Straight line: It is the most frequently used method in which the asset loses value in equal parts over its estimated useful life. Annual depreciation expense= (cost – Residual value) / Useful life The company will charge the same amount to depreciation each year for as long as the useful life, until the value shown for the asset has reduced from the original cost to the residual value.
  • Accelerated depreciation: with this method, the greatest depreciation deductions occur in the first years of an assets´ useful life, this is because the asset is expected to be much more productive during its first years.
  • Declining balance method: In this case, the residual value is not considered in determining the annual depreciation. depreciation rate = 1 – (N x Square root of (residual value / cost of fixed asset)), where N is the estimated life of the asset. In a double-declining balance method, the rate used will be double of what you obtain from the formula.
  • Sum-of-years-digits method: it turns out to be a more accelerated method that the straight line method.

The annual depreciation is determined by multiplying the depreciable cost by a schedule of fractions: Depreciable cost = original cost – residual value Imagine equipment that has a 4 year useful life. The years´ digits would be 1, 2, 3 and 4, and the sum of the digits would be: 1+2+3+4=10. So the schedules of fractions are: for the first year; 4/10, for the second year; 3/10, for the third year: 2/10, and for the fourth year: 1/10.

  • • Capitalized: with this method, a particular asset is never depreciated.
  • • Expensed: with this method, the asset is fully depreciated in the first year.

– Based on activity:

  • Units-of-production-depreciation method: useful life of the asset is expressed in terms of the total number of units expected to be produced: Annual dep. expense = ((cost – Residual value)/Estimated total production) x Actual production An accumulated depreciation is the sum of the depreciation expense during one year and the depreciation expense from the year/s before that. An asset´s carrying value on a balance sheet is the difference between its purchase price and the accumulated depreciation