The following topics will be addressed in this post:
The concept of depreciation. The components of depreciation. Techniques to record depreciation.
Capital investment signals economic growth. When firms make long-term asset acquisitions, the financial implications are communicated through a concept called depreciation. Firms use depreciation for tangible assets such as land improvements, equipment, and structures. Depreciation communicates that these asset values decline over time as they are used (Epstein, 2009). Additionally, depreciation communicates the rate that the firm will expense the asset in their financial statements (Kimmel, Weygandt, & Kieso, 2010). Fundamentally, depreciation minimizes the effects of large purchases on the net income of a firm during a period and on the tax receipts of government authorities.
Depreciation entails multiple components: cost, useful life, salvage value, and depreciation calculation method (Kimmel, Weygandt, & Kieso, 2009). Each of these components will be discussed in turn.
Cost comprises all the expenses of acquiring the asset and readying it for use. Most often costs are purchase price and transport. In the case of unique or custom made assets, cost may also contain design and manufacture expenses. Moreover, costs for preparing the location for an asset may be included, such as additional electrical needs, structural modifications, and the like.
Useful life estimates the time the asset will be in operation. The useful life typically begins when the asset is first placed in operation not when purchased. Firms estimate the useful life of an asset using past experience, industry standards, and tax law. For tax purposes, the IRS publishes a list of items and their useful lives that can be found at http://www.irs.gov/pub/irs-pdf/p946.pdf. Firms will indicate the basis for their useful life decisions in the “Summary of significant accounting policies” sections of their financial reports (Epstein, 2009; Randolph, 2011 personal communication).
Salvage estimates the value of the asset after the end of the useful life period. The firm chooses a salvage value based upon plans for the asset at the end of the useful life. Often, firms will assign a salvage value of zero. Despite a zero salvage value at the end of the useful life, the asset may still be used by the firm and may even have a market value if sold.
Depreciation calculation methods indicate how quickly or under what conditions depreciation will be expensed. Many different depreciation calculation methods exist but most methods are a variation on two themes (Kimmel et al., 2009). One theme focuses on time where a mathematical formula expenses depreciation each period. The other theme focuses on usage where depreciation is expensed based upon the pace the asset is used. A firm may employ any calculation method, but for tax reporting the IRS desires straight-line depreciation or an accelerated depreciation such as the double-declining-balance method (Tracy, 2008).
People should remember some things when working with depreciation. For example, the depreciation calculation–and for that matter the useful life and salvage value–can be affected by events such as obsolescence, damage, or sale (Kimmel et al., 2009). Also, because depreciation does not involve cash, depreciation subtracted on an income statement must be added back for the statement of cash flows. Moreover, when evaluating the balance sheet a large accumulated depreciation figure relative to fixed assets may signal hefty future expenditures for replacement assets (Siciliano, 2003).
Depreciation is an important concept for firms of any size. Depreciation allows firms to grow beyond the physical and financial limitations of a sole proprietor. Managers should learn to use depreciation with other capacity-extending tools such as credit, employees, and strategic partnerships.
Epstein, L. (2009). Reading Financial Reports for Dummies, Second Edition. Hoboken, NJ: Wiley Publishing.
Kimmel, P.D., Weygandt, J.J., & Kieso, D.E.
(2010). Managerial Accounting: Tools for Business Decision Making, Fifth Edition. Hoboken, NJ: John Wiley and Sons.
(2009). Financial Accounting: Tools for Business Decision Making, Fifth Edition. Hoboken, NJ: John Wiley and Sons.
Siciliano, G. (2003). Finance for Non-Financial Managers. New York, NY: McGraw Hill.
Tracy, J.A. (2008). Accounting for Dummies, Fourth Edition. Hoboken, NJ: Wiley Publishing.