The matching principle of accounting explains when an expense should be realized. In any business, expenses are incurred to generate revenues. Any cost incurred by a business to earn an income should be offset against that revenue. In other words, the recording of incomes and expenses should be done on a cause and effect basis.
Moving forward, we all know that any business owns assets; some are physical while others are non-physical. For instance, imagine an ice-cream vendor. He bought the ice cream truck, and that truck helps him to earn money. The truck is going to help him earn income over the years. And consequently, some parts of the truck will become obsolete- decreasing the economic life.
According to the matching principle, you cannot record the truck’s cost in one year’s income statement. However, the cost will be spread over the number of years you will use the truck. This method of writing off an asset’s cost is known as depreciation.
We will discuss the concept of depreciation, its types, and formulas. It will help you understand how to treat your assets and write them off over time.
Tangible And Intangible Assets
We talked about physical and non-physical assets. It is the same thing as tangible and intangible assets.
Tangible assets are physical assets that can be touched –think of plant, land, machinery, your laptop, building, office stationery.
Intangible assets are non-physical assets that cannot be touched or felt –a business’s goodwill, patents, copyrights, brand value, etc.
Depreciable assets are physical assets, but not all physical assets are depreciable. For instance, the one characteristic of a depreciable asset is that it does not lose its shape and size. However, the asset becomes obsolete or less useful over time.
The second characteristic of the depreciable asset is that you cannot physically consume it. Think of office supplies. The economic utility of the depreciable asset is decreased, however.
By the characteristics of depreciable assets, we can define them as
Depreciable assets provide economic benefits for more than one accounting period. These assets cannot be physically consumed or lose their shape. However, the economic usefulness of these assets declines over time.
Examples of depreciable assets are:
- Furniture and Fixtures
The land is not a depreciable asset because it does not fulfill all characteristics of a depreciable asset. The land does not lose its shape, and it cannot be physically consumed. But, the other characteristic of becoming obsolete or less useful does not hold for land. Therefore, it is not treated as a depreciable asset.
What Is Depreciation?
Now we can define depreciation as,
The periodic allocation or writing off of a depreciable asset’s cost to expense over its useful life is termed depreciation.
The International Accounting Standards(IAS 16) defines depreciation as,
The systematic allocation of the cost of a depreciable asset to expense over the asset’s useful life.
Breaking Down Depreciation
To fully understand the process of depreciation, some points need to be cleared.
Depreciation is not a valuation method
Most people often confuse depreciation as the valuation of the asset’s market value every year. However, the case is the opposite. Depreciation is the process of cost allocation instead of asset valuation.
An asset’s depreciation has nothing to do with its market value. Book value is considered for calculating depreciation on any asset. Book value is the cost of the asset minus the depreciation every year.
Residual Value And Useful Life
The whole depreciation mechanism is working on two important aspects of any tangible asset: an asset’s useful life and its residual value after economic life.
The estimated useful life is an important measure that determines the cost written off for every accounting period. If the useful life is longer, you will write off lower cost every year and vice versa.
Any asset’s residual value is carrying value or salvage value at the end of the useful life. A business calculates the residual value of assets to estimate what it can receive in exchange for an asset at the end of its useful life.
When a business depreciates its assets, a certain method of depreciation is adopted. According to the regulations for financial disclosures, a business must use consistent accounting methods. The principle of consistency also applies to writing off an asset in terms of depreciation.
Although, it is encouraged to use different depreciation methods for different assets. However, there should be consistency in the methods. For instance, you depreciate certain equipment over the straight-line method. The method should be consistent throughout the life of that equipment.
Whereas different depreciation methods might be used for accounting purposes and tax returns.
Reasons Of Depreciation
There are mainly two reasons that cause an asset to depreciate in value and utility.
The most common reason for the decline in asset efficiency and value is a deterioration or wear tear. Generally, the deterioration is caused by exposure to the sun, climatic conditions, wind, and usage. For instance, a building will deteriorate over time due to climate changes, wear and tear, and new. Although a good repair policy can help to increase the life of an asset. But, ultimately, it has to be discarded.
The second reason for depreciation is an asset might become out of date or obsolete after a certain period. For instance, the advent of new technology brings better products than existing ones.
Imagine a new airplane becoming obsolete because of better technologically equipped airplanes.
Methods Of Depreciation
We have understood the concept of depreciation very well. Let’s discuss some most commonly used methods of depreciation.
Straight Line Method
The most commonly used depreciation method across different business organizations is the straight-line method. The straight-line method divides the cost of the asset into equal parts over the useful life. Equal depreciation expense is realized in every accounting period.
Let’s see how to calculate the straight-line method.
The formula is
Depreciation = Cost -Residual Value
Years of Useful Life
Let’s do this by an example.
The cost of machinery is $18000. According to the company’s estimates, the residual value will be $3000. The estimated useful life of machinery is 5 years.
The annual depreciation expense will be calculated as:
Depreciation expense= 18000 – 3000
Depreciation expense= $3000
The depreciation schedule under this method will look like this
|Year||Computation||Depreciation Expense||Accumulated Depreciation||Book Value|
|1||16000 * 1/5||$3200||$3200||$14800|
|2||16000 * 1/5||$3200||$6400||$11600|
|3||16000 * 1/5||$3200||$9600||$8400|
|4||16000 * 1/5||$3200||$12800||$5200|
|5||16000 * 1/5||$3200||$16000||$2000|
The important thing to be noticed is that an asset’s residual value is not accounted for depreciation. The reason is that residual value is the amount a company expects to recover at the disposal of the discarded asset.
Many businesses used accelerated methods instead of the straight-line methods for depreciation calculation. In the accelerated method, the early years of an asset’s life are charged high, and smaller accounts are written off in later years.
The most common practice under the accelerated depreciation method is the declining balance method.
Declining Balance Method
The declining balance method or fixed-percentage-of-declining-balance depreciation method is the most widely used accelerated depreciation method. This method is not common for financial reporting. However, it is more commonly adopted for tax purposes.
An accelerated depreciation rate is calculated at a fixed percentage of straight-line depreciation rate in the declining balance method.
The accelerated depreciation rate is applied on the remaining book value of the asset for annual depreciation expense.
Depreciation Expense = Remaining Book Value X Accelerated Depreciation Rate
The accelerated depreciation rate is the ‘specific percentage’ of the straight-line rate. In most cases, it is 200% of the straight-line rate. Hence, it is called a double-declining balance.
Let’s understand this by the same example of $18000 worth of machinery with $2000 residual value and 5 years useful life.
The straight-line rate was 20%(1 divided by 5). For the accelerated rate, we will take 200% of 20%. It will become 40% that is an exact double of 20%.
The depreciation schedule for machinery is given below.
|Year||Computation||Depreciation Expense||Accumulated Depreciation||Book Value|
|1||18000 * 40%||$7200||$7200||$10800|
|3||6480 * 40%||$2592||$14112||$3888|
In some cases, the 150 Percent declining method is also used. It takes 150% of the straight-line depreciation rate. For the above example, the 150% of 20% will be 30%, and the depreciation schedule will be made by the declining method.
Which Method Is Most Suitable?
Most businesses use the straight-line method for the purpose of financial reporting. At the same time, the declining balance method is used for tax return purposes.
To comment on the suitability of any method is not possible because both have a different story.
The accelerated balance method charges more expense to the early years. It results in lower net income than the straight-line method. Most companies want to be as profitable as their market competitors are. Higher-income is needed to meet this goal. Therefore, most publicly owned companies use the straight-line method for financial reporting.
The story of the accelerated balance method is the opposite. The companies use it for tax returns because the management wants to show less income. As a result, less tax. They use the accelerated balance method for tax return filing.
Both methods have a different use, and not a single one can be the most suitable method.