Depreciation is a fundamental accounting, finance, and business-management concept that concerns all organizations, large and small. Understanding depreciation and its calculation is essential, whether you are a business owner, accountant, or new to managing business finances.
In this blog, we will learn about what is depreciation, its purpose, various depreciation methods, and how businesses use it to track assets and taxes. We will also cover some other commonly asked questions, such as “Should you purchase an asset based on appropriating value or depreciation value? What does ‘depreciable’ mean??
What Is Depreciation?
Depreciation refers to allocating the cost of a physical asset over its useful lifespan. The term is most often encountered in accounting and tax filings, and it describes how assets such as machines, buildings, equipment, and cars depreciate over time. Depreciation allows businesses to spread the cost of an asset over its useful life, rather than accounting for it entirely in the year of purchase.
Many assets lose value through deterioration, replacement, or other reasons. Depreciation is the process of quantifying this loss of value systematically and consistently so that the cost of usage equals the profit generated by the asset over its useful life.
What Is The Use of Depreciation?
Depreciation plays a key role in accounting and taxation and has several positive advantages for companies. Let’s take a closer look at how it is used.
1. Matching Expenses with Revenues
Depreciation aligns the cost of an asset with the revenue it generates over its useful life. It is crucial for accounting to follow the matching principle, where expenses are computed at the same time as revenues. When depreciating an asset over time, companies accurately represent the asset’s contribution to revenue.
2. Accurate Financial Reporting
Depreciation ensures that a company’s balance sheet reflects the realistic value of its assets over time. As assets decline over time, depreciation revises the value of an asset in the balance sheet, thereby providing a better reflection of the company’s value and not overrepresenting its assets.
3. Tax Deductions
Business owners can offset their taxes by subtracting the costs of amortizing property through depreciation. This reduces overall taxes, increasing the company’s cash flow. For example, if a company buys equipment for 500,000 and depreciates it for 5 years, the cost of depreciation is deducted as an item from taxable income and this saves a company thousands of rupees per year in taxes.
4. Investment and Financing Decisions
Depreciation impacts key financial metrics (like cash flow, profitability, etc.) that investors and lenders see. It helps companies identify the real value of assets and helps them make the right decisions to borrow money, invest in capital or replace equipment.
5. Budgeting and Future Planning
Organisations can repair or replace assets as they become devalued. Intangible asset depreciation helps companies set aside funds each year for the expense of capital so that they can afford to replace assets after their useful life is over.
6. Improving Cash Flow
Although depreciation is a monetary expense, it lowers taxable income, which reduces the taxes a business has to pay. This increases the cash flow, allowing for more capital to operate, invest, or pay off debt.
Read more: Account Receivable Process
Depreciation Calculation
Let’s understand these things first for depreciation calculation.
1. Cost of the Asset
The cost of an asset includes its purchase price along with any additional expenses required to make it operational (such as taxes, shipping, installation, and setup). For instance, if one buys a machine for ₹100,000 and another ₹5,000 is used to install the machine, the total price is ₹105,000. That total cost becomes the basis of depreciation.
2. Salvage Value
The salvage value represents the approximate market value of the asset at the end of its useful life. It is the amount the business expects when it sells or disposes of the asset after it is depreciated. For instance, if a machine bought for ₹105,000 has a salvage value of ₹10,000 at the end of 5 years, then the depreciable value would be ₹95,000 (₹105,000 buy price – ₹10,000 salvage value).
3. Useful Life
It is the useful life of the asset that is estimated by the business for which the asset would be utilised. It estimates how long the asset will remain valuable before becoming obsolete or non-functional. Office furniture, for instance, may last 10 years, while a car may last 5 years.
4. Depreciation Method
- Straight-Line Method (SLM): The depreciation is amortised over the asset’s useful life. For instance, if the depreciable value is ₹95,000 and the asset has a 5-year lifespan, the annual depreciation is ₹19,000 ( ₹95,000÷5).
- Declining Balance Method: A sped-up approach where an increased depreciation expense is recorded in the early part of the asset’s life. Each year, it subtracts a percentage from the asset book value.
- Double Declining Balance (DDB): More quickly amortised; twice as much depreciation compared to straight-line amortisation, causing more depreciation during the first couple of years.
- Units of Production: Depreciation is calculated based on how often the asset is used and works very well with assets such as machines or vehicles where usage varies.
Once these parameters are set, businesses can use the right technique to depreciate in a way that will enable them to report correctly and handle their taxes.
Read more: Cost Accounting Types
Types of Depreciation Methods
Understand some types of depreciation and know how to calculate depreciation with different depreciation formulas.
1. Straight-Line Depreciation
Straight-line depreciation is the simplest and most commonly used method. It takes the premise that an asset is worth nothing in proportion to its useful life. If you want to deduct straight-line depreciation, you divide the salvage value of the asset by its purchase price and then divide it by the useful life.
Formula:
Annual Depreciation (Value of Asset-Salvage Value)/Useful Life.
For instance, if you purchase a machine at ₹5,000 with a salvage value of ₹1,000 and a useful life of 5 years, your annual depreciation would be:
(₹5000−₹1000)/5=₹800 per year
So for 5 years, the firm would deduct ₹800 per year.
2. Declining Balance Method
The declining balance approach is an accelerated approach to depreciation that leads to higher depreciation costs in the early years of the asset’s life. Depreciation decreases each year as the asset’s book value diminishes. This approach is typically used when assets become worthless sooner in the first few years.
Formula:
Depreciation=Book Value×(1/Useful Life)
For instance, for a machine purchased at 5,000 and having a 5-year useful life, the first year’s depreciation is:
₹5000×1/5=₹1000
If depreciation is applied to the book in the following year, the book value will be lower than that in the previous year (₹5,000 – ₹1,000 = ₹4,000), then depreciation for the second year would be:
₹4000×1/5=₹800
3. Double Declining Balance (DDB) Method
Another accelerated depreciation strategy is the double-declining balance method. It doubles the depreciation rate of the declining balance method and depreciates even more in the first few years of the asset’s life.
Formula:
Depreciation=Book Value×(2/Useful Life)
For example, if you buy the machine at ₹5,000 and the machine lasts for 5 years, then the first year of depreciation is:
₹5000×2/5=₹2000
In the second year, depreciation would be based on the balance book value of ₹3,000:
₹3000×2/5=₹1200
4. Sum-of-the-Years’ Digits (SYD)
The sum-of-the-years digits approach is another accelerated depreciation approach where the asset’s value depreciates faster in the previous years. This method totals the years of a property’s useful life and assigns higher depreciation rates in the first few years.
Formula:
Amount depreciated in Year n=(End of Life/Total Number of Years’ Digits)Depreciable Value
For instance, in a machine with a 5-year useful life, the number of years divided by the years is:
1+2+3+4+5=15
For the first year, the depreciation would be:
5/15×(5000−1000)=1333.33
5. Units of Production Method
The units of production approach applies when the asset’s depreciation is proportional to its consumption. Typically, it is a machine or car where wear and tear varies based on the number of miles driven or units produced.
Formula:
Depreciation =(Total Depreciable Amount/Total Expected Usage)Usage during the Period.
For instance, if the machine costs 5,000 with a salvage value of 1,000 and would generate 100,000 copies during its lifespan, then:
5000−1000/100000=0.04 per unit
For example, if the machine makes 10,000 units per year, the annual depreciation would be:
0.04×10000=400.
What Does Depreciable Mean?
The term depreciable is used for assets that depreciate with time and thus can be depreciated to be accounted for and taxed. Depreciable assets are often physical things that we use to conduct business, like buildings, equipment, and machinery. Intangible assets, like patents or trademarks, are not amortised.
Should You Buy Appropriating or Depreciation Value?
Businesses should take into account the strategy of appropriation or depreciation value when buying assets to decide whether to pursue this approach or match it with their financial plans. “Appropriating” refers to allocating funds for a specific business activity, such as acquiring a resource, and ensuring adequate financial preparation. It helps businesses budget and regulate their cash flow so that you can see where they’re going without worrying about short-term liquidity.
The depreciation value, by contrast, represents how the asset depreciates through usage, damage, and replacement. Investing in depreciation can help businesses take advantage of deductions throughout the asset lifecycle, reducing taxable income and maximizing cash flow. Companies can take advantage of the straight-line or the written-down value approach of depreciation, in which the cost is related to the use of the asset and the revenue it generates.
When buying assets, depreciation value can be an important tool if you are trying to lower taxes and boost immediate cash flow. Tax deductions in the first few years as a result of accelerated depreciation are an ideal solution for businesses wanting to reduce cash flow or spend on growth. However, borrowing plays a crucial role for companies that are attempting to plan for asset acquisition in a more structured manner, especially when it comes to the company’s longer-term financial stability and liquidity.
Depreciation and Taxes
Depreciation is used as a planning tool and accounting instrument for businesses around the world, and it is particularly significant for Indian businesses. Indian businesses can use depreciation to minimize their taxable income and reduce their total tax burden. Under the Income Tax Act, a company can deduct tangible fixed assets such as machinery, buildings, and vehicles. This lowers the tax burden on a company and provides essential cash flow relief, particularly for capital-intensive businesses.
Businesses in India must comply with the Income Tax Act of India and follow the prescribed depreciation rates for all assets. Rates and techniques are decided by the Income Tax Department, and businesses can either opt for straight-line depreciation (SLM) or written-down value depreciation (WDV), WDV being more common. The WDV method enables businesses to claim larger depreciation deductions in the initial years of an asset’s life, accelerating cost recovery. This rapid depreciation is especially beneficial to companies that invest in heavy machinery or technology.
Depreciation also makes it possible to connect the expense of an asset to the income that it will yield in the long run. This allows enterprises to deduct wear and tear, obsolescence, and use from their operating costs. Additionally, the federal government provides tax breaks such as Section 35AD, which allows deductions for capital investments in certain industries so that companies can claim higher depreciation on some qualifying assets and reduce their taxes.
Conclusion
Depreciation must be a core factor for any business with physical assets. Whether you’re doing it for taxes or accounting reasons, it helps companies account for the cost of assets throughout their useful lives. Depreciation types such as straight-line, declining balance, and units of production give companies a choice in how they distribute the asset cost over time.
Including depreciation in budgets tax liability and simplifies financial reporting. If you’re going to buy something or do a depreciation calculation on something, you need to know how to get the most out of this and continue to be successful.
FAQs
What is depreciation in layman’s terms?
Depreciation is dividing the value of a physical thing over its life. When an asset is spent, its worth diminishes. Depreciation allows companies to deduct this loss and spread it across multiple years instead of one year, impacting taxes and cash flows.
What is the importance of depreciation for businesses?
Businesses value depreciation because they can deduct the cost of an asset over the useful life of an asset while reducing tax revenue. When businesses take depreciation deductions yearly, they save on taxes and generate cash. This lowers the cost for organizations to handle large capital investments.
What assets can be depreciated?
Depreciable assets are physical things like buildings, machines, machinery, equipment, cars, and computers. These are assets that become obsolete through aging, obsolescence, or wear. But land is not depreciable because, unlike other tangible goods, it increases in value rather than declines.
How to calculate depreciation?
Depreciation is determined by calculating the cost, useful life, and salvage value of the asset. Different methods (such as straight-line, declining balance, and units of production) distribute the cost of the asset over the expected life of the asset. The way you choose will determine the way the expense is distributed over each year of the asset’s life.
What is the straight-line depreciation method?
The straight-line method is the simplest approach to depreciation, which simply allocates an asset’s depreciable value over its useful life. This approach results in a fixed annual depreciation expense. For instance, if an asset costs 100,000 and has a salvage value of 10,000 and a lifespan of 5 years, the annual depreciation is 18,000.
What is accelerated depreciation?
Accelerated depreciation methods such as declining balance or double-declining balance make it possible to deduct more in the first few years of ownership of an asset. This method grants companies more upfront tax advantages. The rate of depreciation decreases as the asset loses its value at a faster rate during the first decades of its life.
What is the difference between depreciation and amortization?
Depreciation is applied to real-world assets (like equipment and buildings) because they lose value over time. Amortization, on the other hand, means to amortize immaterial assets such as patents or trademarks. Both ideas aim to spread the cost of things across their lifecycles to help organizations balance expenses and revenues.
Does a company need to modify its depreciation method?
Yes, a company can amend its depreciation method, but that would require tax authorities’ clearance and accounting standards. If a variation is implemented, the company must be able to justify the new method’s use for the asset. This modification typically happens in the future, not in the past.
What is the difference between the book value and the market value of an asset?
The book value of an asset in the balance sheet is the initial cost minus the accumulated depreciation of an asset. Market value, in contrast, refers to the price that an asset would trade at on the open market. The two values might vary drastically depending on the market.
Is it possible to depreciate leased assets?
You can get depreciation on the assets you lease if it’s a finance lease. These leases put the lessee essentially into control of the property for tax and accounting purposes. Under operating leases, the asset is the landlord’s possession, and the lessee cannot deduct depreciation.
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