The concept and practice of depreciation and depletion play an integral part in a company's cash flow and profit or loss statements. Depreciation, according to investopedia is a method of allocating the cost of a tangible asset over its useful life. Depletion is very similar to depreciation with very subtle differences, the first one being what is depreciated verses depleted. All assets (except land) are depreciated but the assets with natural resources are depleted. The methods on how depreciation and depletion are calculated vary as well. Each will be visited in this essay.
Using depreciation, the time based usefulness of an asset of course varies depending on what the asset is. If it is a van for example, its usefulness might be seven years before the van needs replacing, but if it is a building we are talking about, its usefulness may be forty years.
The purpose of depreciation is to match the cost of a productive asset (that has a useful life of more than a year) to the revenues earned from using the asset. Since it is difficult to see a direct link to revenues, the asset’s cost is usually spread over the years in which the asset is used. Depreciation systematically allocates or moves the asset’s cost from the balance sheet to expense on the income statement over the asset’s useful life. In other words, depreciation is an allocation process; it is not a technique for determining the fair market value of the asset.
It is not only current assets that depreciation applies too, but also is applicable to fixed asset as well. Buildings for example lose their value too taking the time scale factor into account. If a building is purchased in 1970 as a newly built structure, its value will have definitely decreased in 2025 by the depreciation rate estimated.
There is one asset that is never depreciated. According to Accounting Tools website;
“Land is not depreciated, since it has an unlimited useful life. If land has a limited useful life, as is the case with a quarry, then it is acceptable to depreciate it over its useful life.” (Accounting Tools, 2010)
Land improvements or restoration are depreciated though over the period of which any resulting benefits are obtained. If a company purchases a parcel of land which includes a building, then separate the two assets and depreciate the building only.
There are four methods to calculate depreciation; straight-line method, declining balance, sum-of-the-years method and units of production. Each method takes into account two factors; useful life and savage value. Useful life is the time period over which the company expects that the asset will be productive. Past its useful life, it is no longer cost-effective to continue operating the asset, so it is expected that the company will dispose of it.
Salvage value is when a company eventually disposes of an asset, it may be able to sell it for some reduced amount, which is the salvage value. Depreciation is calculated based on the asset cost, less any estimated salvage value. http://www.assetaide.com/depreciation/calculation.html
Straight Line Depreciation Method
The straight line depreciation method divides the cost by the life.
Example: A desk is purchased for $487.65. The expected life is 5 years. Calculate the annual depreciation as follows:
487.65 / 5 = 97.53
Each year for 5 years $97.53 would be expensed.
Declining Balance Depreciation Method
The declining balance depreciation method uses the depreciable basis of an asset multiplied by a factor based on the life of the asset. The depreciable basis of the asset is the book value of the fixed asset -- cost less accumulated depreciation.
The factor is the percentage of the asset that would be depreciated each year under straight line depreciation times the accelerator. For example, an asset with a four year life would have 25% of the cost depreciated each year. Using double declining balance or 200%, which is the most...
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