An accountancy term measuring the loss of value of an asset due to age, wear and tear, and obsolescence. Straight-line depreciation assumes that the asset loses value evenly over its life, by the same amount each year. Reducing balance depreciation assumes that an asset loses a constant proportion of its remaining value each year until it is finally scrapped, when the rest disappears.
Depreciation is a term used in accounting, economics and finance with reference to the fact that assets with finite lives lose value over time.
In accounting, depreciation is a term used to describe any method of attributing the cost of an asset across the useful life of the asset. Depreciation in accounting is often mistakenly seen as a basis for recognizing "wear and tear", obsolescence, or impairment on an asset, but these issues, where seen as significant enough to account for, are handled through an asset revaluation reserve.
In economics depreciation is the decrease in the economic value of the capital stock of a firm, nation or other entity, either through physical depreciation, obsolescence or changes in the demand for the services of the capital in question.
Depreciation is an average or expected view of the decline in value of an asset.
Recording depreciation
For historical cost purposes, assets are recorded on the balance sheet at their original cost; It is instead recorded in a contra asset account: an asset account with a normal credit balance, typically called "accumulated depreciation". Balancing an asset account with its corresponding accumulated depreciation account will result in the net book value.
Recording a depreciation expense will involve a credit to an accumulated depreciation account. The reason may be that the book value (accounted value) of the fixed asset has diverged from the market value.
Methods of depreciation
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.
Straight-line depreciation
Straight-line depreciation is the simplest and most often used technique, in which the company estimates the "salvage value" of the asset after the length of time over which it is depreciated, and assumes the drop in the asset's value is in equal, constant yearly increments over that amount of time. If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess depreciation would be considered as income by the tax office (capital gains).
Sinking fund method
A method of depreciation under which the depreciation expense is an amount of an Annuity so that the amount of the annuity at the end of the useful life would equal the Acquisition Cost of the asset. Theoretically, the depreciation charge should include interest on accumulated depreciation at the beginning of the period.
The depreciation for the first year equals the annual deposit needed for a sinking fund to accumulate at the given rate to an amount that equals the depreciation base.
Then for each consecutive year, the annual depreciation equals the annual sinking fund deposit plus the interest earned on the fund up to that year.
Declining-balance depreciation
As declining-balance method is a type of accelerated depreciation, because it recognizes a higher depreciation cost earlier in an asset's lifetime. This may be a more realistic reflection of an asset's actual resale value, as well as the expected benefit from the use of the asset: many assets are most useful when they are new.
In declining-balance depreciation, each period's depreciation is based on the previous year's net book value, the estimated useful life, and a factor. Each period we calculate depreciation:
For the double-declining balance method, using the vehicle example from above, we compute the depreciation after the first year:
We subtract $6800 from our previous year's net book value to obtain our new net book value: . For the second year, we use this new value to calculate depreciation. Since declining-balance depreciation doesn't always depreciate an asset fully by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This has the effect of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the asset's life.
Activity depreciation
Activity depreciation methods are not based on time, but on a level of activity.
Sum of years digits depreciation
Sum of Years Digits is a historical depreciation method that results in a more accelerated write off than straight line, but less than declining balance or later methods. N = Depreciable life of asset B = Cost basis S = Salvage value D(t) = Depreciation charge for year t
Example: If an asset costs $1000, has a depreciable life of 5 years and a salvage value of $90, compute its depreciation schedule.
| Year | D(t) | Sum of D(t) | Remaining Book Value |
| 1 | $303 | $303 | $697 |
| 2 | $242 | $546 | $454 |
| 3 | $182 | $728 | $272 |
| 4 | $121 | $849 | $151 |
| 5 | $61 | $910 | $90 |
The equation for year 1 would look like this:
Note: Most depreciation schedules round to the nearest dollar.
Units of Production depreciation
Units of Production depreciation is used in the U.S. in cases where MACRS is inappropriate, and the value to depreciate is based in the asset, such as a mine or natural resources. The method calculates the depreciation based on the units of the asset place in service as compared to the total units of the asset.
Units of time depreciation
Units of Time Depreciation is similar to units of production, and is used for depreciation equipment used in mine or natural resource exploration, or cases where the amount the asset is used is not linear year to year. In these jurisdictions accounting depreciation and tax depreciation are almost always significantly different numbers, as in many instances a form of "accelerated depreciation" can be used for tax purposes to lower net income (or, in some instances, a fixed asset may be allowed to be expensed for tax purposes;
Economics
In economics, the value of a capital asset is equal to the present value of the flow of services the asset will generate in future, appropriately adjusted for uncertainty.
National accounts
In national accounts, depreciation represents the decline in the aggregate capital stock arising from the use of capital in production, also referred to as consumption of fixed capital. Unlike depreciation in business accounting, depreciation in national accounts is, in principle, not a method of allocating the costs of past expenditures on fixed assets over subsequent accounting periods.
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