Companies cannot expense assets in one accounting period. This requirement comes from accounting standards. However, it does not imply companies must not include those costs as a part of their profit calculation. At the same time, companies must abide by the matching principle in accounting. This principle requires companies to match expenses to the revenues they help generate.
Considering the above factors, companies must only expense portions of fixed assets. For this purpose, companies use a method known as depreciation. For intangible assets, it includes amortization. Before depreciating an asset, companies must calculate its depreciable value. This value may differ from the asset’s cost. Before discussing depreciable value, it is crucial to understand depreciation and its methods.
What is Depreciation?
Depreciation is a process companies use to expense the cost of a fixed asset over its useful life. In accounting, an asset is any resource that can provide financial gains. Similarly, companies must either control or own this resource to classify it under assets. However, companies cannot use depreciation for every item falling under assets. Instead, this process only occurs to fixed assets.
Fixed assets are resources used by companies to help generate revenues. These assets do not constitute a part of the goods purchased or sold for operations. Instead, fixed assets support the primary activities carried out by companies as a part of their activities. For example, these assets may include machinery, vehicles, plant, building, etc. Similarly, fixed assets last longer than 12 months.
Depreciation takes an asset’s cost and spreads it over a specific period. This period constitutes the asset’s useful life, as estimated by the company. However, this life differs from its actual expected lifetime. Usually, the term “useful life” only represents the period for which a company can benefit from the asset. This asset may last longer than that period. However, it will not be a part of operations after that.
Depreciation can also represent the accumulated depreciation for assets in the balance sheet. This amount comes by depreciating assets for their time underuse. In accounting, depreciation represents an expense and reduces the profits reported in the income statement.
What are the types of Depreciation?
Companies can calculate the depreciation of an asset under various methods. These methods constitute the types of depreciation as well. Usually, companies use a straight-line or declining balance method to depreciate assets. However, other types may also apply to some assets. Companies must decide the best approach to use for each asset class.
The types of depreciation include the following.
Straight-line method
The straight-line method for depreciation divides its depreciable value over its useful life. This method is the most straightforward and results in a fixed depreciation amount. However, it may have its flaws due to this feature. The straight-line depreciation method assumes companies consume assets at the same rate each year. The formula to calculate depreciation under this method is as follows.
Depreciation = Asset’s depreciable value / Useful life
In some cases, companies can also assign a percentage to calculate straight-line depreciation. This percentage reflects the asset’s useful life.
Declining method
The declining method of depreciation takes a different approach to the straight-line method. This method assumes companies consume an asset more in the initial years than later. Usually, it results in higher depreciation amounts initially. Later, these amounts decrease based on the asset’s carrying value. The formula for the declining method of depreciation is as follows.
Depreciation = Asset’s carrying value x Depreciation rate
In the first year, the asset’s carrying value will equal its depreciable value.
Double-declining method
The double-declining method of depreciation is similar to the declining-balance approach. However, it uses accelerated depreciation at a double rate than the latter. This method depreciates assets at a faster pace compared to the declining method. Usually, companies use a similar approach to calculate depreciation in this method. The formula may look as follows.
Depreciation = Asset’s carrying value x Depreciation rate x 2
The asset’s carrying value in the first year equals its depreciable value.
Sum-of-the-year’s-digit (SYD) method
The sum-of-the-year’s-digit depreciation method also allows companies to use accelerated depreciation. This method combines all the digits of the asset’s expected life. For example, an asset with a 3-year life expectancy will have an SYD of 6 (1 + 2 + 3). Based on that, it allocates the depreciation for each year. This method produces higher depreciation in the initial years than the later ones.
Unit of production method
The units of production method allow companies to depreciate assets based on their production rate. It is more appropriate for companies with a life expectancy based on their production capacity. Usually, companies estimate that capacity and use it as a base to calculate depreciation. This method also requires the asset’s depreciable value to depreciate it.
What is Depreciable Value? Explained.
As mentioned above, all depreciation methods require depreciable value. It is an essential part of the calculation process for depreciation. Usually, this value comes from two items. The depreciable value is the difference between an asset’s cost and its salvage value. Companies can calculate it by subtracting the former amount from the latter.
The depreciable value requires the asset’s cost as the primary element. This cost comes from the criteria set by IAS 16 to establish the amount. Usually, it includes the item’s acquisition price and any installation or delivery expenses incurred. This cost is also the amount on the balance sheet to report the asset’s value. Sometimes, the asset’s cost may be its depreciable value as well.
Similarly, depreciable costs consider the salvage value of the underlying asset. This value is also called the scrape value. It represents the estimated value of the asset after its useful life. However, the item must have a resale value for the salvage value to apply. If a company cannot sell an asset after its useful life, it will not have a scrap value.
The depreciable value represents an asset’s cost after subtracting its salve value. It is the amount companies must use to calculate the depreciation on assets. Removing the salvage value is crucial to depreciating an asset. Therefore, companies calculate the depreciable value for the asset.
How to calculate Depreciable Value?
As mentioned above, the depreciable value of an asset is its cost minus any salvage value. Usually, this cost comes from the financial statements or the notes to those statements. On the other hand, the salvage value is an estimated amount. Companies can use their historical data to calculate this amount. Once they have these values, they can use the depreciable value formula below.
Depreciable value = Asset’s cost (acquisition cost or fair value) – Asset’s salvage value
If an asset does not have any salvage value, its cost will constitute its depreciable value. For companies using the fair value method to evaluate assets, its fair value will be a part of this calculation.
Example
A company, ABC Co., acquires machinery for $200,000. The company expects to use this item for the upcoming five years. After that period, ABC Co. estimates the machinery to have a salvage value of $15,000. Before calculating the depreciation for the item, ABC Co. must determine its depreciable value.
ABC Co. uses the following formula for depreciable value.
Depreciable value = Asset’s cost (acquisition cost or fair value) – Asset’s salvage value
Depreciable value = $200,000 – $15,000
Depreciable value = $185,000
Conclusion
Depreciation is a method companies use to allocate an asset’s cost over its useful life. There are several types of depreciation. However, all of these require companies to calculate the asset’s depreciable value. This value represents its cost minus its salvage value. Primarily, depreciable value determines how much of the asset’s value a company can depreciate.
