Depreciation is the method by which companies extend the cost of an asset over its expected useful life. Assets used in the operation of a business and not being sold as part of the business are classified as fixed assets. Sometimes fixed assets are also referred to as plant assets. Fixed assets would include furniture, machinery, buildings, computer equipment, etc. Items used irregularly such as standby equipment are also considered fixed assets. The cost of a plant asset includes all expenses necessary to get the asset where it needs to go and in working order. These expenses would include such things as shipping fees, insurance to ship the item, taxes, and labor to get the equipment in place and working. If you are purchasing second hand equipment, there could be many expenses in addition to the purchased price of the equipment such as painting the equipment, new parts and repairs, etc. All of these combined expenses added to the purchased price would be considered as part of the initial cost of the equipment.
Companies keep track of the value of their assets to help determine the value of their business.
The Accounting equation for determining the value of a business is:
Assets (what you own) + Liabilities (what you owe) = Owners Equity (value of your business).
If a company buys an asset for $50,000 that has an expected life of ten years its value doesn’t remain constant throughout the ten years.
Its value goes down each year. This decrease in value is called depreciation.
In accounting revenues (incomes) are matched to costs therefore we want to spread out the cost of assets to periods in which the assets are used. When a company determines its profit for the year it needs to relate its revenues to expenses occurred in that year. That is why the cost of an asset is spread over time. The asset most likely isn’t going to be used up in a single year. If the Assets useful life is one year or less, it can be written off as an expense rather than computed using one of the depreciation methods.
Depreciation for accounting purposes has nothing to do with the decline in the market value of fixed assets.
Note: All fixed assets except land depreciate over time and, depending on what your land is used for, you might even be able to
depreciate it.
If your business is extracting minerals from the land, that land will depreciate as you extract more from it. Rarely can one know with certainty how long a fixed asset will last before it will be sold and how much it can be sold for when its useful life is over. Therefore the useful life and the salvage value of a fixed asset must be estimated. Some company policies may determine the life of equipment such as a company that trades in their salesmen’s cars every five years. A company is not required to use only one method of depreciation. It can use different depreciation methods for different types of fixed assets. Companies must pay taxes on the value of their assets. Companies pay less tax on their assets as their value goes down. The salvage value of an asset is the amount of money you expect to get by selling the asset after its useful life. The asset may have to be sold as scrap.
The salvage value may be zero or it could even be a negative value if you will need to pay someone to dispose of it.
There are five methods for determining depreciation:
- Straight-Line Depreciation
- Sum-of-Years Digits Method
- Fixed-declining Balance Method
- Double-declining Balance Method
- Variable Declining Balance Method
These depreciation methods can be placed in one of two categories; straight depreciation and accelerated depreciation. Straight
depreciation spreads the amount of depreciation evenly over the life of the asset. Accelerated depreciation methods depreciate
more of the asset in its earlier years rather than spreading the cost evenly through the years as is done in a Straight-Line
depreciation. The Sum-of-Years, Fixed-declining, Double-declining and Variable-declining balance methods are all accelerated
depreciation methods.