Annual depreciation

Annual depreciation
See also
Long-Term Assets Underapplied Overhead Applied overhead Closing stock Gross fixed assets Non-operating expense Normal account balance Net yield Opening balance sheet Effective annual interest rate

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.

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