Features of Depreciation
Following are the main features of depreciation:
- Depreciation is decline in the book value of fixed assets.
- Depreciation includes loss of value of assets due to passage of time, usage or obsolescence.
- Depreciation is a continuing process till the end of the useful life of assets.
- Depreciation is an expired cost and hence must be deducted before calculating taxable profits.
- Depreciation is a non-cash expense. It does not involve cash flow.
- Depreciation is the process of writing-off the capital expenditure already incurred.
- Loss should be gradual and constant.
- Depreciation is the exhaustion of the effective life of business.
- Depreciation is the normal feature.
- Maintenance of assets is not depreciation.
Depreciation is an accounting process by which a company allocates an asset’s cost throughout its useful life. In other words, it records how the value of an asset declines over time. Each time a company prepares its financial statements, it records a depreciation expense to allocate a portion of the cost of the buildings, machines or equipment it has purchased to the current fiscal year. The purpose of recording depreciation as an expense is to spread the initial price of the asset over its useful life. For intangible assets—such as brands and intellectual property—this process of allocating costs over time is called amortization. For natural resources—such as minerals, timber, and oil reserves—it’s called depletion.
Critical assumptions about expensing depreciation are up to the company’s management. Management makes the call on the following things:
- Method and rate of depreciation
- The useful life of the asset
- Scrap value of the asset
Depending on their preferences, companies are free to choose from several methods to calculate the depreciation expense. To keep things simple, we’ll summarize just the two most common methods:
This takes an estimated scrap value of the asset at the end of its life and subtracts it from its original cost. This result is then divided by management’s estimate of the number of useful years of the asset. The company expenses the same amount of depreciation each year. Here is the formula for the straight-line method: Straight-line depreciation = (original costs of asset – scrap value)/estimated asset life
These methods write-off depreciation costs more quickly than the straight-line method. Generally, the purpose behind this is to minimize taxable income. A popular method is the ‘double declining balance,’ which essentially doubles the rate of depreciation of the straight-line method: Double Declining Depreciation = 2 x (original costs of asset – scrap value / estimated asset life)