Depreciation of fixed assets

From CEOpedia | Management online
The printable version is no longer supported and may have rendering errors. Please update your browser bookmarks and please use the default browser print function instead.

Depreciation (depreciation / amortization write-off) is the monetary equivalent of consumption of fixed and intangible assets caused by its physical consumption - resulting from exploitation and economic (moral) - resulting from technical progress related to the possibility of obtaining modern machines, more efficient, cheaper in use, allowing to obtain products of better quality. This impairment is transferred to the value of products produced using amortized fixed assets. Depreciation is a type of cost that does not constitute a monetary expense. These costs include deductions due to systematic and planned distribution of the initial value of both fixed assets and intangible assets (excluding goodwill). Depreciation is an objective expression of the expenditures incurred that are needed to produce goods and services.

Depreciation starts no earlier than after being accepted for use (according to the balance sheet law), in the month following the month of entry into the register (according to tax law), and the ending when the write-offs are equal to the initial value of a specific fixed asset or put into liquidation, shortage.

Depreciation primarily has the following functions

  • amortization
  • the cost
  • reinstatement
  • revenue at

Depreciation characteristics

Depreciation is subject to

Fixed assets already owned by the enterprise, newly acquired in a given financial year and adopted from completed investments, intangible assets, investments in external fixed assets, e.g. used on the basis of a lease or ([Rental agreement], buildings, structures on another land), other assets that are not owned by the taxpayer but meet the conditions for considering them as fixed assets, with an expected period of use longer than one year, used for business purposes.

Depreciation is not applicable

Museum exhibits, works of art and other objects included in long-term investments and land not exploiting open-cast minerals. Fixed assets and intangible assets that have been withdrawn are intended for liquidation or sale.

Kinds (methods) of depreciation

Linear depreciation

This is one of the most commonly used methods in business practice. It is based on an even distribution of the value of a fixed asset (WNiP) over time, as a rule it is a calendar year. It assumes that the object being used consumes evenly throughout its lifetime - this causes that the depreciation rate is constant and results from the formula

where:

Ar - annual depreciation rate
Wp - initial value of a fixed asset
Wr - residual value
Ou - predicted period of use expressed in years

Diminishing depreciation

According to this method, the economic usefulness of a non-current asset decreases as it is used, which translates into the fact that depreciation write-offs in the initial years of using a fixed asset are higher than in the subsequent years. This allows faster to include the greater part of the initial value of the facility in costs, which is usually beneficial for the company (but not always). When calculating the depreciation amount, the depreciation rate does not change, but the basis from which we count changes. We count it on the net value, i.e. minus the existing write-offs.

In the Polish legal system, a specific variation of this method applies, sometimes called the degressive-linear method. In this method, write-downs are made using the degressive method, but starting from the year in which the depreciation calculated in this way would be lower than the depreciation calculated using the straight-line method, the straight-line method is used,

Natural depreciation

It reflects the natural and physical consumption of a given fixed asset. It assumes that the object's consumption is the same for every unit of work (e.g. art, kilogram, hour, etc.), so the amount of depreciation depends on the amount of work done in a given period of time. We calculate it from the formula

where:

Pw - work done in a given period
Pp - work planned over the entire period of use
other designations as above

Progressive cushioning

According to this method, the depreciation amount increases with the end of the service life. It results from the assumption that the "older" object, the more it requires more expenditure on repairs, repairs, etc., so the costs of its exploitation increase. This method is beneficial for companies that for the first few years, from the introduction of a fixed asset to the records, incur a loss.

Depreciation of the revenue margin

For example, the method of net income - in accordance with this method, the value of a non-current asset is amortized proportionally to the net profit margin achieved in particular periods.

where:

Mp - expected net revenue margin in a given period
Psz - estimated net revenues achieved using this facility
other designations as above

Inventory depreciation (estimated)

It consists in estimating the current value of a given object and by comparing this value with the value at the beginning of the period, the amount of depreciation for a given period is determined.

where:

ΔW - increase in value
W_k - value at the end of the period
other designations as above

The disadvantage of this method is high objectivity and the fact that the valuation is subject to a very strong change in prices on the market, which may lead to incorrect conclusions,

Group depreciation

In this method, a group of assets with similar utilization in the enterprise, a similar initial value and a similar period of economic usefulness are depreciated. This method usually applies to objects with a low unit value.

The most common methods are: linear, degressive and natural, while for objects with a low unit value also a group method. The other methods are definitely less important.

Examples of Depreciation of fixed assets

  • Buildings: Buildings depreciate over time due to normal wear and tear. The cost of any repairs or renovations that are needed to maintain the property must be taken into account when calculating depreciation.
  • Machinery: Machinery used in production processes also depreciates over time. The cost of repairs and maintenance must be taken into account as well as the cost of any new machines that are purchased to replace older ones.
  • Furniture: Furniture used in the office or other workplace environment also depreciates over time. The cost of repairs and maintenance must be taken into account as well as the cost of any new pieces of furniture that are purchased to replace older ones.
  • Vehicles: Vehicles used in business operations also depreciate over time. The cost of repairs and maintenance must be taken into account as well as the cost of any new vehicles that are purchased to replace older ones.
  • Software: Software used in business operations also depreciates over time. The cost of repairs, upgrades, and maintenance must be taken into account as well as the cost of any new software that is purchased to replace older ones.
  • Intangible assets: Intangible assets such as copyrights, patents, trademarks, and goodwill also depreciate over time. The cost of any new intangible assets that are purchased to replace older ones must be taken into account when calculating depreciation.

Advantages of Depreciation of fixed assets

The advantages of depreciation of fixed assets include:

  • Improved financial reporting accuracy: Depreciation provides a more accurate reflection of the actual cost of a business’s fixed assets. It allows for more accurate financial reporting of the true value of a company’s assets and liabilities, which can be beneficial for investors, lenders, and other stakeholders.
  • Tax benefits: Depending on the type of asset and the tax laws in the country, depreciation of fixed assets can provide tax benefits. This can help a business to reduce their overall tax liabilities and increase their cash flow.
  • Increased cash flow: Depreciation of fixed assets decreases the amount of taxable income, which increases the amount of cash available to a business. This can be beneficial to businesses that need cash to invest in growth or invest in new projects.
  • Easier budgeting: Depreciation of fixed assets can help businesses to more accurately predict their future expenses. This can help them to more accurately forecast their future earnings and make more informed decisions about their budget and future investments.

Limitations of Depreciation of fixed assets

  • Depreciation of fixed assets is limited in terms of how much it can be deducted in one year. The IRS limits the amount of depreciation that can be claimed per year, and the maximum amount is equal to the cost of the asset minus its salvage value.
  • Depreciation is limited in terms of the type of assets that can be depreciated. Assets must meet certain conditions to be depreciated, such as being used for business purposes and having a useful life of more than one year.
  • Depreciation is also limited in terms of the methods that can be used to calculate the amount of depreciation. The IRS requires that taxpayers use one of the accepted methods of depreciation when calculating the amount of depreciation that can be claimed.
  • The amount of depreciation that can be claimed is also limited by the adjusted basis of the asset. The adjusted basis is the original cost of the asset minus any prior depreciation taken.
  • Additionally, depreciation of fixed assets is limited by the tax laws of the jurisdiction in which the asset is located. Each jurisdiction has its own set of tax laws, and the amount of depreciation that can be claimed may be different from jurisdiction to jurisdiction.

Other approaches related to Depreciation of fixed assets

One of the other approaches related to the depreciation of fixed assets is the Straight Line Method. This method is based on the assumption that the asset will be used at the same rate throughout its useful life, and the cost is divided evenly over the life of the asset. Another approach is the Declining Balance Method, which is based on the assumption that the asset will be used more in the early years of its life, so a larger amount of depreciation is taken in the earlier years. The Sum of Years Digits Method is based on the assumption that the asset will be used more in later years, so more depreciation is taken in the later years. Lastly, the Unit of Production Method is based on the assumption that the asset will be used at different rates over its useful life and depreciation is based on the number of units produced. All of these approaches are used to calculate the depreciation of fixed assets and should be taken into consideration when making this decision.

In summary, there are four different approaches to calculating the depreciation of fixed assets: Straight Line Method, Declining Balance Method, Sum of Years Digits Method, and Unit of Production Method. Each of these approaches has different assumptions and should be taken into consideration when determining the depreciation of fixed assets.


Depreciation of fixed assetsrecommended articles
Annual depreciationSum of years digits methodDepreciation rateDepreciable costNormal costAmortization of intangible assetsDepreciation vs. amortizationGross fixed assetsAccrual method

References