We consider the definition of depreciation, the purpose of depreciation, and the types of depreciation in the following lines. Depreciation is a method used in accounting to account for the decline and decay of assets. Assets decay and decline in usefulness over time. The decay and decline in the use of assets over time reduce the monetary value of assets. The reduced monetary value of a given company’s assets should be reflected on that company’s balance sheet. Depreciation is the method used to represent the reduced monetary value brought about by the decay and decline in the use of assets over time.
What is Depreciation?
The word “depreciation” is directly derived from the Latin word “depretiare”. The Latin word depretiare is a compound verb constituted of the suffix de- and the word pretium “price”. Something is “de-priced” when it “depreciates”. To be “de-priced” means that an item or asset has lost monetary value. Depreciation happens when an item or asset loses monetary value. The reduction of monetary value due to decay and decline in usefulness is the most common type of depreciation, perhaps. Depreciation refers to the reduction in the estimates of the value of items due to decay and decline of usefulness over time, most commonly.
What is the Purpose of Depreciation?
The purpose of depreciation is to keep bookkeeping in line with the reality of the inexorable decay and decline of physical objects. The inexorable decay and decline of physical objects is a visible concomitant of the second law of thermodynamics. The second law of thermodynamics states that all organized physical systems are subject to entropy. “Entropy” is the decay of different kinds of energy into heat energy. All energy in the Universe tends to become heat energy unless subjected to a countervailing force. The law of entropy asserts that all complex modes of the organization tend to decay into simpler modes of organization. Thus, all assets decay and decline in usefulness over time. The practice of depreciation reflects the universal decay of the value of assets due to the inexorable decline of their usefulness.
How is Depreciation Calculated?
The following list lists the steps involved in calculating depreciation.
- First, determine the value of an item.
- Second, define a regular period of time or use.
- Third, choose a depreciation method.
- Fourth, estimate the amount that the item’s value declines within the given period of time or use.
- Fifth, reduce the value of the item by the specified amount with the passage of each given period of time or use.
- Finally, add the depreciated value of the item to the balance sheet.
What are the Types of Depreciation Methods?
The following table displays the types of depreciation methods.
|Straight-line||Reduces the value of assets at regular intervals||The simplest mode of depreciation|
|Declining balance||Reduces the value of assets at a greater rate at earlier periods compared with later periods||More accurately accounts for items that quickly obsolesce|
|Double declining balance||Reduces the value of assets twice as fast as with the declining balance method||Useful for companies that own assets that decline in value very quickly|
|Sum-of-the-year’s digits||Reduces the value of assets by a percentage obtained by adding together the number of years that an item is expected to be useful||A somewhat more complex accelerated depreciation method|
|Units of production||Reduces the value of assets in accordance with the frequency of their use in production||Useful for manufacturing companies whose machinery declines in value with production|
Straight-line depreciation is the most commonly used method of depreciation. Straight-line depreciation reduces the value of an asset by a determined amount with the passage of a determined period of time. Straight-line depreciation is a straightforward accounting approach. Straight-line depreciation does not take into account differing stages of the usefulness of an asset. Straight-line depreciation is inexpensive to use.
2. Declining Balance
A declining balance is an accelerated depreciation method. Accelerated depreciation methods decrease the value of assets more quickly than straight-line depreciation. Accelerated depreciation methods decrease the value of assets more quickly as assets age. Accelerated depreciation methods are useful for accounting for obsolescence. Assets that obsolesce quickly have their value more accurately represented by accelerated depreciation methods.
3. Double Declining Balance
Double declining balance is an accelerated depreciation method. Double declining balance doubles the rate at which the value of assets is decreased relative to the declining balance method. Assets that obsolesce very quickly will have their value better represented by the double declining balance method. Assets that obsolesce very quickly include items like computers. Computers obsolesce quickly due to advances in technology.
4. Sum-of-the-Years’ Digits
Sum-of-the-years’ digits is an accelerated depreciation method. Sum-of-the-years digits use an approach that differs from both the declining balance and double declining balance methods. Sum-of-the-years’ digits calculate depreciation by adding together the number of years for which an item is expected to be useful. Sum-of-the-years’ digits are useful for calculating the value of assets that obsolesce very quickly. Assets obsolesce very quickly for several reasons, including planned obsolescence, for example. Planned obsolescence involves intentionally producing items of low quality so that customers will be forced to buy replacements.
5. Units of Production
Units of production are an entirely distinct method of depreciation. Units of production are calculated by determining the number of products that a machine produces over a period of time. The amount of products that a machine produces is the standard according to which the value of the machine is reduced. The units of production method employ a standard that does not involve temporal considerations. The units of production method are useful for companies involved in manufacturing.
Why do Assets Depreciate over Time?
The Second Law of Thermodynamics states that all energy tends inexorably to become heat energy, a process known as “entropy”. The tendency of energy to become heat energy is for all energy to be reduced to its simplest form. The tendency for all energy to be reduced to its simplest form is a tendency for all systems to lose complexity. Entropy is the process of depreciation to which all material things are subject. Assets decay in value as they age because they are subject to entropy.
What Types of Assets are Depreciable?
All material things are subject to decay. Only some types of assets are subject to accounting depreciation, however. The following is a list of assets that are subject to accounting depreciation.
- Assets Held Longer than a Year. Assets that a company owns for longer than a year are subject to accounting depreciation.
- Assets whose Value Depreciates at a Rate that is Useful to Measure. Most kinds of assets lose value at a rate that is useful to measure. Some kinds of assets lose value at a rate that is not useful to measure.
- Industrial Machinery. Industrial machinery loses value at a rate that is useful to measure. The loss of value in industrial machinery can best be measured using the units of the production method of depreciation.
- Electronics. Electronics lose value at a rate that is useful to measure. The loss of value in electronics can best be measured by depreciation methods that account for obsolescence, such as the double declining balance method.
- Livestock. Livestock loses value at a rate that is useful to measure. The loss of value in livestock can be measured using the straight-line method of depreciation.
- Office Furniture. Office furniture loses value at a rate that is useful to measure. The loss of value in office furniture can be measured using the straight-line method of depreciation.
What Assets are Exempt from Depreciation?
All material things are subject to decay. Only some types of assets are subject to accounting depreciation, however. The following is a list of assets that are not subject to accounting depreciation.
- Land. The decay to which land is subject occurs over too long a span to be considered in accounting.
- Buildings. The decay to which buildings are subject occurs over too long a span to be considered in accounting.
- Cash. Currency is the basis of accounting valuations. Cash cannot be depreciated since it itself is the unit by which depreciation is calculated.
- Current Assets. Current assets are assets that companies have owned for less than a year. The decay to which current assets are subject occurs over too short of a span to be considered in accounting.
What are the Causes of Depreciation?
The following is a list of the causes of depreciation.
- Entropy. All material things are subject to decay over time.
- Obsolescence. Advances in technology reduce the value of older models.
- Planned Obsolescence. Items are made to a low standard. The low standard to which items are made results in quick failure. Quick failure necessitates the purchase of new units.
What are the Factors Affecting Depreciation?
The following is a list of the factors affecting depreciation.
- Time. The passage of time reduces the value of assets.
- Technological advances. The advent of new technological developments reduces the value of older models.
- Accidents. Assets may be destroyed in sudden catastrophes, reducing their value to nothing.
How can Depreciation be Reduced?
Depreciation is a law of nature. There exist ways to reduce the rate at which assets depreciate, however. The following is a list of ways to reduce the rate at which assets depreciate.
- First, you can use a different depreciation method. Be careful to avoid fraud when changing depreciation methods.
- Second, you can buy better quality assets that decrease in value more slowly.
- Third, pay attention to the salvage value of your assets. The salvage value of assets may be evaluated differently at different times. Increase the value of your assets on your balance sheet when their salvage value is increased.
Is Depreciation Viewed as an Expense?
Yes, depreciation is viewed as an expense. When companies buy assets, the value of the assets bought comes to be included on the balance sheet. Depreciation is a method of calculating the loss in value of the assets that a company has bought. Depreciation is a method of “expensing”, i.e. moving the value of the asset from the company’s possession into the expenses column of the balance sheet. The transfer of an asset’s value to the expenses column reduces the amount of tax that companies owe.