Handling the Depreciation Expense

A depreciation expense is used by businesses to record the shrinking value of their assets, such as a plant, equipment and furniture. This item or entry can be found in the company’s income statement, which, in turn, formally reports the financial performance of the business over a specified accounting period. This type of expense is important because it helps in showing a more accurate picture of the company’s profitability.

No actual cash is paid out when reporting depreciation. Rather, it simply distributes the acquisition price of an asset over a period representing its useful life. This type of expense reflects the loss in asset value as brought about by the passage of time, obsolescence and the typical process of wear and tear among objects. Ultimately, this expense will write off the value of the assets at the end of their useful lives.

Implications on Financial Reporting and Stockholders

Being a non-cash item, depreciation expense is added back into the reported net income to compute for the company’s actual cash inflow. Most companies would also use different approaches in computing depreciation for their books and for tax reporting purposes. Some businesses use accelerated depreciation for taxation purposes. Doing so results in a lower taxable income, meaning the company will have lower taxes during the first few years of possessing the assets. However, there are other companies that prefer lower depreciation during their start-up years in order to reflect higher net incomes, which would mean higher profits for stockholders.

Common Methods of Computing Depreciation Expense

Under generally accepted accounting principles (GAAP), there are many ways in which this type of expense can be computed and handled in the books and financial statements. Below are some of the most common methods.

1. Straight Line Method

This is the simplest and most common method used when computing depreciation. You simply need to know the acquisition cost, salvage value and expected useful life of the asset. To compute, deduct the salvage value from the cost of the asset. Then, divide the resulting amount by the number of years representing the asset’s useful life. The figure that you arrive at will be the expense amount to be applied annually.

2. Double Declining Balance

This is an example of an accelerated depreciation method by which bigger chunks of the asset’s value are written off during the first few years. The depreciation expense will become smaller as the asset nears the end of its useful life. Under this method, simply compute for the depreciation rate using the straight line method. Then, double the percentage that you arrived at or multiply it by 200 percent. The doubled rate will be applied to the asset’s net book value at the start of every year. When using the double declining balance method, you will have a different depreciation amount every year as the asset’s net book value changes.

3. Sum of the Years' Digits

This is another type of an accelerated depreciation method. The expense for the year will be arrived at by multiplying the depreciable amount by a fraction in which the numerator represents the number of years left in the asset’s useful life, and the denominator is the sum of the years' digits. To compute for the sum of the years' digits, simply list down the years of the asset’s useful life, starting with year 1 and continuing with year 2, year 3 and so on. Then, total all the numbers or years to arrive at the figure you will use as denominator. If an asset had 4 useful years, you would add 1, 2, 3 and 4 and then use the sum, 10, as your denominator.

Always remember that the fraction or factor to be used for a given period should have a numerator that corresponds to the asset’s remaining number of years for that particular period. Thus, you will have a bigger numerator during the first few years of possessing the asset.

4. Unit of Production

For this method, you need to know the number of units that are expected to be produced by using the asset. The first step requires the computation of the depreciation rate on a per-unit basis. Take the acquisition cost of the asset, deduct the salvage value and then divide the resulting amount by the estimated number of units to be produced. In the second and last step, multiply the actual number of units produced by the rate that you have computed in step one. The resulting amount will be the depreciation expense for the year.



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