In this section, you will learn about less commonly used financial statements such as the Statement of Equity and the Free Cash Flow Statement (which is different from The Statement of Cash Flows) and their uses in finance. It also explains the difference between economic value and market value.
Depreciation refers to the allocation of the cost of assets to periods in which the assets are used.
Calculate depreciation expense using different methods
- Depreciation refers to the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle).
- Generally this involves four criteria: cost of the asset, expected salvage value (residual value of the asset), estimated useful life of the asset, and a method of apportioning the cost over such life.
- There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity of the asset: straight-line depreciation, accelerated depreciation methods, activity depreciation methods, sum-of-years' digits method, and units-of-production method.
- salvage value
The estimated value of an asset at the end of its useful life.
Depreciation refers to two very different but related concepts: the decrease in value of assets (fair value depreciation) and the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle). The former affects values of businesses and entities. The latter affects net income.
Generally the cost is allocated, as a depreciation expense, among the periods in which the asset is expected to be used. Such expense is recognized by businesses for financial reporting and tax purposes. Methods of computing depreciation may vary by asset for the same business. Several standard methods of computing depreciation expense may be used, such as fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service. Depreciation is generally recognized under historical cost systems of accounting. Generally this involves four criteria: cost of the asset, expected salvage value (residual value of the asset), estimated useful life of the asset, and a method of apportioning the cost over such life.
There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity or use of the asset.
1. Straight-line depreciation is the simplest and most often used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenue (useful life). The company will then expense a portion of original cost in equal increments over that period. The salvage value (residual value or scrap value) is an estimate of the value of the asset at the time it will be sold or disposed of.
Depreciation: This is the formula used to calculate straight-line depreciation.
2. Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decrease charges in subsequent years are called accelerated depreciation methods. This may be a more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are new. One popular accelerated method is the declining-balance method. Under this method the book value is multiplied by a fixed rate. The most common rate used is double the straight-line rate: Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year.
3. Activity depreciation methods are not based on time, but on a level of activity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life is estimated in terms of this level of activity. Each year, the depreciation expense is then calculated by multiplying the rate by the actual activity level.
4. Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than straight line, but less than the declining-balance method. Under this method, annual depreciation is determined by multiplying the depreciable cost by a schedule of fractions.
- depreciable cost = original cost − salvage value
- book value = original cost − accumulated depreciation
5. Under the units-of-production method, the useful life of the asset is expressed in terms of the total number of units expected to be produced.
Depreciation: This is the units-of-production method for calculating depreciation.