What is depreciation? What are the different definitions of depreciation?

 Let us study definitions of depreciation.

Depreciation Depreciation is the process of allocating the cost of long-lived assets over the useful life of the asset Depreciation base = cost of the asset - residual value Amount to be depreciated each period is determined by the depreciation method applied Residual value The value expected to remain when the asset is retired at the end of useful life Depreciation base The total amount to be depreciated over the life of the asset Depreciation base = cost of the asset - residual value An example Entity A purchased an equipment at the cost of $800,000 Useful life of the equipment = 10 years Estimated residual value = $50,000 What is the amount of depreciation base? Depreciation base = $800,000 - $50,000 = $750,000 Depreciation methods To allocate the deprecation base to each period over the life of the asset, depreciation methods are applied Depreciation methods should be systematic and rational Depreciation can be based on the time elapsed or the specific usage of the asset Depreciation methods based on the time elapsed 1. Straight line deprecation method 2. Declining balance deprecation method 3. Sum-of-the-years'-digits depreciation method Depreciation methods based on the specific usage of the asset 1. Based on the units of production 2. Based on the operation hours of the asset Straight line depreciation method Under the straight line method, depreciation amount for each period is same for all periods Depreciation = (cost - residual value) / use life An example Entity A purchased an equipment at the cost of $650,000 Useful life = 10 years Residual value = $50,000 Entity A uses the straight line depreciation method for equipment What is the amount of annual depreciation of this equipment? What is the amount of monthly depreciation of this equipment? Annual depreciation = (cost - residual value) / useful life = ($650,000 - $50,000) / 10 = $600,000 / 10 = $60,000 Monthly depreciation = annual depreciation / 12 = $60,000 / 12 = $5,000

Declining balance depreciation method Under the declining balance method, depreciation is calculated by multiplying a depreciation rate to the beginning book value of the asset Depreciation = beginning book value x depreciation rate Book value = cost - accumulated depreciation Depreciation rate is determined as a percentage of the straight line method depreciation amount Examples of depreciation rates under straight line method Useful life of the asset = 10 years Yearly depreciation rate = 1/10 = 10% Useful life of the asset = 20 years Yearly depreciation rate = 1/20 = 5% Declining balance deprecation methods 1. Double declining balance method Depreciation rate = straight line depreciation rate x 200% 2. 150% declining balance method Depreciation rate = straight line depreciation rate x 150% Double declining balance depreciation method Under the double declining balance method Depreciation rate = straight line depreciation rate x 200% Depreciation = beginning book value x depreciation rate An example On January 1, 20X1, Entity A purchased an equipment at the cost of $500,000 Residual value = $40,000 Useful life = 10 years Entity A applies double declining balance method to depreciate equipment What is the amount of deprecation for the year ended December 31, 20X1? Straight line depreciation rate = 1/10 = 10% per year Double declining balance depreciation rate = straight line depreciation rate x 200% = 10% x 2 = 20% per year Depreciation = beginning book value x depreciation rate Beginning book value = cost - accumulated depreciation = $500,000 - 0 = $500,000 Depreciation = $500,000 x 20% per year = $100,000 150% declining balance depreciation method Under the 150% declining balance method Depreciation rate = straight line depreciation rate x 150% Depreciation = beginning book value x depreciation rate An example On January 1, 20X1, Entity A purchased an equipment at the cost of $500,000 Residual value = $40,000 Useful life = 10 years Entity A applies 150% declining balance method to depreciate equipment What is the amount of deprecation for the year ended December 31, 20X1? Straight line depreciation rate = 1/10 = 10% per year 150% declining balance depreciation rate = straight line depreciation rate x 150% = 10% x 1.5 = 15% per year Depreciation = beginning book value x depreciation rate Beginning book value = cost - accumulated depreciation = $500,000 - 0 = $500,000 Depreciation = $500,000 x 15% per year = $75,000 Sum-of-the- years'-digits depreciation method Under the sum-of-the-years'-digits method, depreciation = (cost - residual value) x depreciation factor An example Entity A purchased an equipment at the cost of $500,000 Residual value = $50,000 Useful life = 5 years Sum-of-the-years'-digits = 1 + 2 + 3 + 4 + 5 = 15 Depreciation factor for year 1 = 5 / 15 Depreciation factor for year 2 = 4 / 15 Depreciation factor for year 3 = 3 / 15 Depreciation factor for year 4 = 2 / 15 Depreciation factor for year 5 = 1 / 15 Depreciation for year 1 = ($500,000 - $50,000) x (5/15) = $450,000 x 5/15 = $150,000 Depreciation for year 2 = ($500,000 - $50,000) x (4/15) = $450,000 x 4/15 = $120,000 Depreciation for year 3 = ($500,000 - $50,000) x (3/15) = $450,000 x 3/15 = $90,000 Depreciation for year 4 = ($500,000 - $50,000) x (2/15) = $450,000 x 2/15 = $60,000 Depreciation for year 5 = ($500,000 - $50,000) x (1/15) = $450,000 x 1/15 = $30,000 Units of production based depreciation method Depreciation = (cost - residual value) x depreciation factor Depreciation factor = (A) / (B) (A) = Number of units produced during the year using the asset (B) = Total number of units expected to be produced during the life of the asset An example Entity A purchased an asset at the cost of $270,000 Residual value = $20,000 Useful life = 5 years (A) = Number of units produced during the year using the asset = 25,000 units (B) = Total number of units expected to be produced during the life of the asset = 125,000 units Depreciation for the year = ($270,000 - $20,000) x (25,000/125,000) = $250,000 x 1/5 = $50,000 Hours of operation based depreciation method Depreciation = (cost - residual value) x depreciation factor Depreciation factor = (C) / (D) (C) = Number of hours the asset was in operation during the year (D) = Total number of operation hours expected during the life of the asset = 18,000 hours An example Entity A purchased an asset at the cost of $390,000 Residual value = $30,000 Useful life = 5 years (C) = Number of hours the asset was in operation during the year = 3,000 hours (D) = Total number of operation hours expected during the life of the asset = 18,000 hours Depreciation for the year = ($390,000 - $30,000) x (3,000/18,000) = $360,000 x 1/6 = $60,000