Depreciation is a non-cash expense (in other words, an accounting entry) charged to the profit and loss account which reduces the value of an asset over time. Many types of assets naturally depreciate as they age. This is generally due to one of two reasons:
- Wear and Tear: Over use, many assets naturally diminish in value as their usefulness or product lifespan reduces. For example, a car will decrease in value as its mileage increases, or as wear on its tires accumulates.
- Obsolescence: Other assets may depreciate due to becoming less relevant, often because new and better models are released. This is often the case in fast-moving industries such as technology, where computing power has increased exponentially. While mobile phones were once considered a luxury purchase, standard mobile phones are so cheap as to be easily affordable to anyone. In the advent of smartphones, traditional mobiles are next to obsolescent.
Depreciation is an accounting entry used to indicate how much of an asset’s value has been used up. Depending on the asset class, there is often specific legislation about how and when the deduction may be taken based on reasonable estimates about how long it will last.
Some of the methods used to calculate depreciation are:
Straight line depreciation method
Depreciation = (cost – residual value)/useful life
For example, if a piece of machinery is purchased at a price of £100,000 with an expected lifespan of 5 years and a resale value of £20,000 at the end of those 5 years, you would apply depreciation over the same period until that asset is wiped off the balance sheet up to its residual (or resale) value. Every accounting year, the company will expense (100,000-20,000)/5 = £16,000 from that asset.
Declining balance depreciation method
Depreciation = (cost – Residual Value) * percentage rate
It is common to use multiples of 2 and 1.5 to work out the rate of deprecation. What this means is you divide 1 by the useful life of the asset to get a percentage (1/5=20%) and times it by the multiple (ie. 1.5 * 20% = 30%) to find the depreciation rate. You can also use the formula: rate = (salvage/cost) ^ (1/useful life) -1 to work out a depreciation rate, which fully depletes an asset to its residual value in the final year.
To work out each year’s depreciation, take the cost or value of the asset, in our case £100,000. Now apply a depreciation rate, lets say we use 30%. To work out the depreciation in year 1, take 30% of £100,000. This works out to £30,000
Next, minus the first year’s deprecation of £30,000 from our £100,000 to get £70,000. Apply the same depreciation rate of 30% to £70,000 to work out depreciation in year 2. This is works out to £21,000
Follow the same process for each year until you reach the end of the assets working life where you would wipe the remaining balance to leave just the residual value of the asset.
Year 1: 100,000*0.3 = £30,000
Year 2: 70,000*0.3 = £21,000
Year 3: 49,000*0.3 = £14,700
Year 4: 34,300*0.3 = £10,290
Year 5: 24,010*0.3 =
£7,203 BUT £7,203 is more than the £4,010 needed to depreciate the asset to its residual value of £20,000 so for year five, we depreciate the asset by just £4,010.
This method means that more of the asset’s value is wiped off at the start of its useful life. This can be useful to act as a tax shield, if a business is expected to make a higher profit at the start of its useful life than towards the end.
Currency, equipment, and real estate are all examples of assets that can depreciate or lose value very quickly. During the infamous hyperinflation of 1920s Germany, Reichsmark banknotes had depreciated so rapidly that they were used as wallpaper. During housing crises, real estate owners may also experience swift depreciation, which can quickly decimate their net value. The rush to sell in these instances may often precipitate a crash.
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