Annual depreciation

Annual depreciation is -  in a general term - the annual reduction of the value of a tangible asset, which is used by the company for the period longer than one accounting year. Often, terms "amortization" and "depreciation" are used simultaneously, but in fact, there is a small difference between them. The term "amortization" refers to the group of intangible assets only, while "depreciation" - as mentioned previously - refers only to the group of tangible assets. However, there is one exception to that rule - a land cannot be depreciated due to its infinite useful life. Every year, the value of a tangible asset should be lowered because of its usage, wear & tear, technological outdating, passage of time or obsolescence. Additionally, there are a few phrases connected with "depreciation", which are residual value, book value and the period of depreciation. The residual value is the amount obtained from the sale of an asset at the end of its life (so called scrap value). The book value is the original cost of an asset minus accumulated depreciation. Period of depreciation is the difference in time between the purchase of a machine and its sale or destruction.

Depreciation is a cost, which is presented in the financial document - profit and loss statement - in the section of operating expense. However, this is not a "real" cost, since there is no real outflow of cash. The process of depreciation consists of writing-off the capital expense which has been already incurred.

There are several types of depreciation, such as:     

• Straight-line depreciation;   
• Unit-of-Production depreciation;     
• Sum-of-years’-digits depreciation.

Straight-line depreciation

This type of depreciation is the simplest one and the most popular. Under this method, a tangible asset is depreciated each year with an equal amount from its original cost until the scrap value at the end of an asset's estimated lifespan. The source of the name for this method comes from the fact, that if the consecutive annual depreciation of an asset are shown on a graph, the obtained result will  be visible as a line with a slope identical to the amount of annual depreciation. The method is also known as "Fixed Installment Method" since the same depreciated amount is assigned as a cost in Profit and Loss document. The formula for this method is as follows:

$D={\frac {C-S}{n}}$

• D =Amount of annual depreciation
• C = Cost of purchase of an asset
• S = scrap value
• n = The estimated lifespan of an asset

Unit-of-production (UOP) Method

This type of depreciation bases on the amount of units produced or used by the asset during one accounting period in comparison to all units estimated to be produced or used during the lifespan of the asset. The formula for this method is given as follows:

$E={\frac {C-R}{L}}$

• E = Depreciation rate per unit
• C = Cost of purchase of an asset
• R = Residual value
• L = Life in units

Depreciation expense = depr. Rate per unit x units used.

Sum-of-years’-digits depreciation

Last mentioned type of depreciation is the sum-of-years’-digits depreciation. This method is also known as "accelerated depreciation" which was introduced in 1954 by US Internal Revenue Code. It consists of allocating bigger amounts of depreciation as a cost in the early years of life of an asset. The formula used to calculate this particular type of depreciation uses a reducing fraction which is later multiplied by the book value of an asset, which is cost - residual value. Such operation is performed to obtain the amount of depreciation to be booked as an expense in every operating period.

Examples of Annual depreciation

• Straight-line depreciation: Straight-line depreciation is the most common method used to calculate the annual depreciation of a tangible asset. In this method, the depreciation amount is calculated by dividing the cost of the asset by its estimated useful life. It is calculated by taking the cost of the asset minus its estimated residual value, and then dividing that result by the estimated useful life of the asset. For instance, a company has purchased a machine for $10,000 that has an estimated useful life of 5 years and a residual value of $2,000. The annual depreciation of the machine using the straight-line method would be $1,800 per year ($10,000 - $2,000/5 years).
• Double-declining balance depreciation: Double-declining balance depreciation is an accelerated method of depreciation. It is calculated by multiplying the straight-line depreciation rate by two, and then applying that rate to the depreciable cost of the asset. For example, a company has purchased a machine for $10,000 that has an estimated useful life of 5 years and a residual value of $2,000. The annual depreciation of the machine using the double-declining balance method would be $3,600 per year ($10,000 - $2,000 x 2/5 years).
• Units of production depreciation: The units of production depreciation method is used to calculate the annual depreciation of an asset based on the number of units it produces. For example, a company has purchased a machine for $10,000 that has an estimated useful life of 5 years and a residual value of $2,000. The machine is expected to produce 10,000 units during its useful life. The annual depreciation of the machine using the units of production method would be $1,000 per year ($10,000 - $2,000/10,000 units).

Advantages of Annual depreciation

Annual depreciation is a beneficial tool for businesses as it allows them to reduce their taxable income and manage their cash flow. Here are some of the advantages of annual depreciation:

• It allows businesses to reduce their taxable income by accounting for the decrease in value of tangible assets over time. This makes it easier for businesses to manage their cash flow and remain profitable.
• It can be used to offset other income, such as profits or capital gains. This allows businesses to reduce the amount of taxes they need to pay.
• It can help businesses allocate resources more efficiently by allowing them to accurately track the cost of their assets over time. This helps with decision making and budgeting.
• It can also be used to reduce the cost of borrowing as lenders may be willing to offer lower interest rates if they can see that a company has a plan in place to manage their assets.

Limitations of Annual depreciation

One of the main limitations of annual depreciation is that it does not take into account the changing value of an asset over time. Some of the other limitations of annual depreciation include:

• It does not take into account any future cash flows associated with the asset, such as from increases in asset value, repairs, or improvements.
• It does not reflect the true cost of the asset as it does not consider the asset's useful life expectancy, cost of ownership and maintenance, or other external factors.
• It fails to account for the differences in the life expectancies of different asset types, as the same depreciation amount is applied to each asset regardless of the differences in their useful life.
• It does not take into account any changes in market conditions, such as inflation, which can affect the value of the asset.
• It can lead to an inaccurate assessment of an asset’s value, as it does not take into account the actual cost of the asset or any potential appreciation or depreciation in its future value.

Other approaches related to Annual depreciation

There are various methods to calculate annual depreciation, some of which are described below.

• Straight-line depreciation: This method assumes a uniform rate of depreciation each accounting year. The amount of depreciation is calculated by dividing the asset's purchase price by its expected lifetime.
• Reducing balance depreciation: This method assumes that the asset depreciates at a higher rate during the early years of its life and then the rate of depreciation decreases with time.
• Accelerated depreciation: This method accelerates the amount of depreciation by using higher depreciation rates in the early years.
• Unites of production depreciation: This method assumes that the depreciation amount is calculated based on the number of units produced by the asset.
• Sum-of-the-years-digits depreciation: This method assumes that the depreciation amount is calculated by weighting the remaining life of the asset.

In conclusion, there are various approaches to calculate annual depreciation such as straight-line depreciation, reducing balance depreciation, accelerated depreciation, units of production depreciation and sum-of-the-years-digits depreciation.

Footnotes

Annual depreciation — recommended articles

Depreciation of fixed assets — Sum of years digits method — Depreciation rate — Book profit — Normal cost — Gross fixed assets — LIFO Liquidation — Going-concern value — Accounting profit

References

• NCERT. (2015), Depreciation, Provisions and Reserves, Accountancy, New Delhi, p. 228
• Petronijevic P. (red.) (2012), Methods of Calculating Depreciation Expenses of Construction Machinery, "Faculty of Civil Engineering", no. 10, p. 43
• Rahman N. (2013), Methods of Depreciation, Vancouver Community Learning Centre, p.1
• Reimer M. (2012), Financial Accounting, Red River College, p.2

Author: Justyna Piekorz