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 common, would mean that depreciation expense in the first year would be twice that or 50%. So to calculate the depreciation expense each year the depreciable basis would be multiplied by 50%.Example: A copy machine is purchased for $3,217.
89. The expected life is 4 years. Using double declining balance the depreciation would be calculated as follows: factor = 2 * (1/4) = 0. 50 Year Depreciable Basis Depreciation Calculation Depreciation Expense Accumulated Depreciation 1 3,217.
89 3,217. 89 * 0. 5 1,608. 95 1,608. 94 2 1,608. 94 1,608.
94 * 0. 5 804. 47 2,413. 41 3 804. 48 804.
48 * 0. 5 402. 24 2,815. 65 4 402. 24 402. 24 * 0.
5 201. 12 3,016. 77 Sum of the Years Digits The first step is to sum the digits or numbers starting with the life and going back to one.For example, an asset with a life of 5 would have a sum of digits as follows: 5+ 4+ 3 +2 + 1 = 15 To find the percentage for each year divide the year's digit by the sum. In the example above the percentage would be calculated as follows: Year 1 5 / 15 = 33.
34% Year 2 4 / 15 = 26. 67% Year 3 3 / 15 = 20 % Year 4 2 / 15 = 13. 33 % Year 5 1/ 15 = 6. 67% Example: A conference table is purchase for 1,467. 89.
The expected life is 5 years. Since this is a 5 year asset the yearly factors have been calculated above. Year Depreciation Calculation Depreciation Expense 1 1,467. 89 * 33. 34 % 489. 40 2 1,467.
89 * 26. 7 % 391. 49 3 1,467. 89 * 20 % 293. 58 4 1,467.
89 * 13. 33 % 195. 67 5 1,467. 89 * 6. 67 % 97. 91 Units of Production Depreciation To calculate units of production depreciation, follow these steps: Estimate the total number of units of production that are likely to result from the use of the asset.
Divide the total capitalized asset cost, less any salvage value, by the total estimated production to arrive at the depreciation cost per unit of production. Derive the total depreciation for the period by multiplying the number of units of actual production during the period by the depreciation cost per unit.ABC Company builds an oil derrick at a cost of $350,000. ABC expects to use the derrick in the extraction of 1,000,000 barrels of oil, which results in an anticipated depreciation rate of $0.
35 per barrel. During the first month, 23,500 barrels of oil are extracted. Under this method, the resulting depreciation expense is: = (cost per unit of production) x (number of units of production) = ($0. 35 per barrel) x (23,500 barrels) = $8,225 depreciation expense Not all assets can be depreciated, some need use depletion as a method of calculating the charge for the assets.Depletion actually calculates the annual usage of natural resources, such as mines, orchards and quarries, just to name a few.
In order to compute depletion, a depletion base needs to be establish first, which is the amount of the depletable asset. The depletion base should include the following elements: “Acquisition costs—The cost to obtain the property rights through purchase or lease, royalty payments to the property owner, Exploration costs—Typically, these costs are expenses as incurred; however in certain circumstances in the oil and gas industry, they may be capitalized,Development costs—Intangible development costs such as drilling costs, tunnels, shafts, and wells, Restoration costs—The costs of restoring the property to its natural state after extraction of the natural resources has been completed. ” (Accounting Tools, 2010) There are two methods of calculating depletion, percentage and cost. “To figure percentage depletion, you multiply a certain percentage, specified for each mineral, by your gross income from the property during the tax year. Cost depletion is an accounting method by which costs of natural resources are allocated to depletion over the period that make up the life of the asset.
Cost depletion is computed by (1) estimating the total quantity of mineral or other resources acquired and (2) assigning a proportionate amount of the total resource cost to the quantity extracted in the period. For example, Big Texas Oil, Co. discovers a large reserve of oil. The company has estimated the oil well will produce 200,000 barrels of oil. The company invests $100,000 to extract the oil, and they extract 10,000 barrels the first year.
Therefore, the depletion deduction is $5,000 ($100,000 X 10,000/200,000). ” (Accounting Tools, 2010)
