# Accounting for Depreciation

Depreciation

Depreciation is systematic allocation the cost of a fixed asset over its useful life. It is a way of matching the cost of a fixed asset with the revenue (or other economic benefits) it generates over its useful life. Without depreciation accounting, the entire cost of a fixed asset will be recognized in the year of purchase. This will give a misleading view of the profitability of the entity. The observation may be explained by way of an example.

Types of depreciation

Common methods of depreciation are as follows:

1. Straight Line Depreciation

Straight line depreciation can be calculated using any of the following formulas:

 ● Depreciation per annum = ( Cost   −   Residual Value) Useful life
 ● Depreciation per annum = ( Cost   −   Residual Value )   x   Rate of depreciation

Where:

 ● Cost is the initial acquisition or construction costs related to the asset as well as any subsequent capital expenditure.
 ● Residual Value, also known as its scrap value, is the estimated proceeds expected from the disposal of an asset at the end of its useful life. The portion of an asset’s cost equal to residual value is not depreciated because it is expected to be recovered at the end of an asset’s useful life.
 ● Useful Life is the estimated time period that the asset is expected to be used starting from the date it is available for useup to the date of its disposal or termination of use. Useful life is normally expressed in units of years or months.
 ● Rate of depreciation is the percentage of useful life that is consumed in a single accounting period. Rate of depreciation can be calculated as follows:
 Rate of depreciation = 1 x 100% Useful Life
1. Reducing Balance Depreciation

Reducing Balance Method charges depreciation at a higher rate in the earlier years of an asset. The amount of depreciation reduces as the life of the asset progresses. Depreciation under reducing balance method may be calculated as follows:

Depreciation per annum = (Net Book Value – Residual Value) x Rate%

Where:

• Net Book Value is the asset’s net value at the start of an accounting period. It is calculated by deducting the accumulated (total) depreciation from the cost of the fixed asset.
• Residual Value is the estimated scrap value at the end of the useful life of the asset. As the residual value is expected to be recovered at the end of an asset’s useful life, there is no need to charge the portion of cost equaling the residual value.
• Rate of depreciation is defined according to the estimated pattern of an asset’s use over its life term.
1. Units of Activity Depreciation

Units of Production Depreciation Method, also known as Units of Activity and Units of Usage Method of Depreciation, calculates depreciation on the basis of expected output or usage.

For example, a machine may be depreciated on the basis of output produced during a period in proportion to its total expected production capacity. Therefore, useful life of an asset under Units of Production Method is stated in terms of production output or usage rather than years of service.

Depreciation per annum = (Cost – Residual Value) / Useful Life)

The Formula for calculation of depreciation under Units of Production Method is as follows:

 Stage of Completion % = Value of Work Certified as complete x 100 Total Expected Production or Usage

Where:

• Cost includes the initial and any subsequent capital expenditure.
• Residual Value is the estimated scrap value at the end of the useful life of the asset. Since residual value is expected to be recovered at the end of an asset’s useful life, there is no need to charge the portion of asset’s cost equaling the residual value.

Tax depreciation

Most income tax systems allow a tax deduction for recovery of the cost of assets used in a business or for the production of income. Such deductions are allowed for individuals and companies. Where the assets are consumed currently, the cost may be deducted currently as an expense or treated as part of cost of goods sold. The cost of assets not currently consumed generally must be deferred and recovered over time, such as through depreciation. Some systems permit full deduction of the cost, at least in part, in the year the assets are acquired. Other systems allow depreciation expense over some life using some depreciation method or percentage. Rules vary highly by country, and may vary within a country based on type of asset or type of taxpayer. Many systems that specify depreciation lives and methods for financial reporting require the same lives and methods be used for tax purposes. Most tax systems provide different rules for real property (buildings, etc.) and personal property (equipment, etc.).

Capital allowances

A common system is to allow a fixed percentage of the cost of depreciable assets to be deducted each year. This is often referred to as a capital allowance, as it is called in the United Kingdom. Deductions are permitted to individuals and businesses based on assets placed in service during or before the assessment year. Canada’s Capital Cost Allowance are fixed percentages of assets within a class or type of asset. Fixed percentage rates are specified by type of asset. The fixed percentage is multiplied by the tax basis of assets in service to determine the capital allowance deduction. The tax law or regulations of the country specifies these percentages. Capital allowance calculations may be based on the total set of assets, on sets or pools by year (vintage pools) or pools by classes of assets. Depreciation has got three methods only.

Tax lives and methods

Some systems specify lives based on classes of property defined by the tax authority. Canada Revenue Agency specifies numerous classes based on the type of property and how it is used. Under the United States depreciation system, the Internal Revenue Service publishes a detailed guide which includes a table of asset lives and the applicable conventions. The table also incorporates specified lives for certain commonly used assets (e.g., office furniture, computers, automobiles) which override the business use lives. U.S. tax depreciation is computed under the double declining balance method switching to straight line or the straight line method, at the option of the taxpayer.IRS tables specify percentages to apply to the basis of an asset for each year in which it is in service. Depreciation first becomes deductible when an asset is placed in service.

Many systems allow an additional deduction for a portion of the cost of depreciable assets acquired in the current tax year. The UK system provides a first year capital allowance of £50,000. In the United States, two such deductions are available. A deduction for the full cost of depreciable tangible personal property is allowed up to \$500,000 through 2013. This deduction is fully phased out for businesses acquiring over \$2,000,000 of such property during the year. In addition, additional first year depreciation of 50% of the cost of most other depreciable tangible personal property is allowed as a deduction.Some other systems have similar first year or accelerated allowances.

Real property

Many tax systems prescribe longer depreciable lives for buildings and land improvements. Such lives may vary by type of use. Many such systems, including the United States and Canada, permit depreciation for real property using only the straight line method, or a small fixed percentage of cost. Generally, no depreciation tax deduction is allowed for bare land. In the United States, residential rental buildings are depreciable over a 27.5 year or 40 year life, other buildings over a 39 or 40 year life, and land improvements over a 15 or 20 year life, all using the straight line method.

Averaging conventions

Depreciation calculations require a lot of record-keeping if done for each asset a business owns, especially if assets are added to after they are acquired, or partially disposed of. However, many tax systems permit all assets of a similar type acquired in the same year to be combined in a “pool”. Depreciation is then computed for all assets in the pool as a single calculation. These calculations must make assumptions about the date of acquisition. The United States system allows a taxpayer to use a half year convention for personal property or mid-month convention for real property. Under such a convention, all property of a particular type is considered to have been acquired at the midpoint of the acquisition period. One half of a full period’s depreciation is allowed in the acquisition period (and also in the final depreciation period if the life of the assets is a whole number of years). United States rules require a mid-quarter convention for per property if more than 40% of the acquisitions for the year are in the final quarter.

SOURCE

http://accountinginfo.com/study/dep/depreciation-01.htm

https://en.wikipedia.org/wiki/Depreciation

http://accounting-simplified.com/financial/fixed-assets/depreciation-methods/types.html