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Depreciation: Meaning, Types and Advantages

  • Hrithik Saini
  • Mar 24, 2022
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Depreciation is sometimes misinterpreted as a phrase for anything just losing value or as a tax computation. Depreciation is a crucial component of your company's tax returns, but it's a complicated topic. Continue reading to find out what depreciation is, how it's evaluated, and how it might affect the business.


What is Depreciation?


Depreciation is the loss of asset value owing to routine maintenance. Every asset is susceptible to wear and tear as a result of normal use as well as the changes that come. The asset's cost is spread out over time and accounted for as an expenditure.


It is used on long-term commodities that provide long-term advantages. For instance, plant and machinery, automobiles, computers, furnishings, and structures. Depreciation is not paid on land since it is not susceptible to wear and tear, but it is levied on buildings.


Depreciation must be seen as a cost to be effective in budgetary control. For example, if a driver lends his automobile to a tourist, he must keep in mind that the vehicle has a limited usable life and will need to be replaced after a few years.


To do so, he must evaluate the cost of the automobile, its life, and its resale value after its useful life, as well as other costs, while estimating the entire cost.


According to the income tax statute and the corporation's act, depreciation is also permitted as a cost. Although the method of computation differs between the two actions, this discrepancy results in the formation of a deferred tax asset or liability.


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What assets are eligible for depreciation?


The categories of assets that could be depreciated for taxation purposes are governed by IRS regulations. An asset must have accumulated depreciation, according to the IRS. The assets must be:


  • Owned by yourself.


  • Utilized in your business or to generate revenue


  • Have a predetermined lifespan


  • Be expected to endure longer than a year.


Automobiles, residences, stationery or furniture, electronics and other telecommunications, manufacturing equipment, as well as certain intellectual properties, such as trademarks, copyrights, and computer programmes, are all examples of depreciation charges.


Also Read | Introduction to EBITDA



Types of Depreciation

There are 4 types of depreciation. Striaght-Line, Double-Declining, Sum-of-Years Digit and Units-of-Production Depreciations.

Types of Depreciation

Accounting employs a variety of depreciation strategies. The following are the four basic categories of depreciation.


  1. Straight-Line Depreciation



Annual Depreciation Expense = (Asset Cost – Residual Value)Useful Life of Asset


This is the most elementary and basic technique of depreciation. It divides the value of an item evenly over several years, implying that you pay the same amount for each year of the asset's useful life.


Small firms with rudimentary financial reporting or enterprises where the owner compiles and submits the tax return might consider straight-line depreciation.


Straight-line depreciation always has the advantage of being simple to use, resulting in minimal mistakes, and allowing business owners to expense the same proportion every bookkeeping period.


However, because the valuable life estimate is mostly based on guessing or assumption, its simplicity might be a disadvantage. It also ignores the asset's rapid depreciation in the short term, as well as the possibility that maintenance expenses would rise as the asset ages.


  1. Double-Declining Depreciation



Depreciation = [2 X Straight-(Line Depreciation %  X  Book Value)]

Book Value = [ Asset Cost - Accumulated Depreciation]


This strategy, also known as falling balance depreciation, includes writing off a larger portion of an asset's value immediately after purchase and a smaller portion over time. 


This is an excellent alternative for firms who wish to recoup a higher percentage of the asset's worth right away rather than waiting a fixed amount of months, such as small enterprises with high startup expenses and a need for cash.


The double-declining balance approach has the benefit of permitting larger depreciation charges in the early years, which can assist in offsetting rising operational costs as an asset age. It can also help optimize itemized deductions by increasing overall discretionary accruals in the early years.


Also Read | Opportunity Cost


  1. Sum-of-Years Digit Depreciation



Depreciation Expense = (Remaining Life)(Sum-of-Years Digit) X [Cost - Salvage Value]


Since it is an annual depreciation computation, sum of the years' digits (SYD) depreciation is comparable to the dual approach. Rather than lowering the book value, SYD estimates a proportionate percentage depending on the asset's lifetime of the product.


Businesses who wish to recover additional value immediately but with a more economic equality than they would obtain with the double-declining strategy may benefit from SYD. 


The fundamental benefit of the SYD approach is that accelerated depreciation decreases taxable income and taxes owed during the asset's early years of life. The primary disadvantage of SYD is that it is significantly more difficult to compute than the other approaches.


  1. Units-of-Production Depreciation



Depreciation Expense = (No. of Units Produced)(Life-in-Number Units) X [Cost - Salvage Value]


This is a straightforward method of depreciating the value of an item based on how often it is utilized. The term "units of production" can apply to anything that the machinery produces.


This strategy is appropriate for companies that want to depreciate equipment that produces a quantified and universally recognised output throughout its useful life. Make sure you have a system in place to analyze your equipment usage and anticipate writing off a different amount each year.


The essential advantage of the sets of productivity depreciation techniques is that, depending on your tracking system, it provides you with a highly accurate image of your depreciation rate based on real statistics.


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Why is it important for small businesses to keep track of depreciation?


So now we know what depreciation is, what techniques are used to compute it, what inputs are needed to calculate it, and we've seen instances of how to calculate it. Let's look at why small businesses need to keep track of depreciation.


The goal of depreciation, as we all understand, is to balance the expenditure of a depreciation expense during its useful life to the income generated by the asset. Because it is difficult to relate an asset's cost to its income, the cost is often allocated to a great many years the asset is profitable.



Advantages For Charging Depreciation


  1.  Depreciation is a tax-deductible cost, thus it's necessary to think about it if you want to save money on taxes.


  1. Under the Companies Act of 2013, it is obligatory to calculate depreciation in the financial statement.


  1. If it is not taken into account, expenditure in the best interests of fixed assets is not taken into account, and the profit may appear to be very high, especially in businesses that require a lot of equipment and machinery. This may also result in a high redistribution of revenues to shareholders, resulting in a lack of finances when the company wants to rebuild an asset.



What effect does depreciation have on Tax Liability?


By recording the reduction in the value of company assets, depreciation lowers the taxes your company must pay through deductions. Depreciation affects the revenues on which company taxes are calculated, lowering the amount of money owed to the IRS by your company. Your taxable income is reduced by the amount of depreciation expenditure.



How does Depreciation affect Asset Sale Prices?


Machines & techniques are tangible facilities that assist in the performance of numerous functions that are required for the development of a product or the completion of labor. 


To give you an example: Vehicles assist in the movement of goods and people, whereas packaging equipment in industrial settings assists in the packaging of finished items. Computers and cellphones aid in the completion of numerous activities as well as communication. 


All of these actual or tangible items are referred to as assets in general since they offer value to the goods they deal with. The worth of these assets is determined by the resources and labor that went into their creation.


Anyone who needs the services provided by these facilities can purchase and utilize them. The asset's worth depreciates over time as it is used up, worn out, and completely destroyed. As a result, the equipment or asset's value decreases year after year. 


Annually, the equipment's sales price is determined by this decline in value. Depreciation is shown on the balance sheet of a firm since it comprises the values of all equipment and assets. It is sometimes advantageous to the asset or business owner to reduce his tax expenditures during accounting.


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Managing Cash Requirements with Depreciation


The estimate may help you prepare for and optimize your company's business funding requirements, which is an even sometimes advantage of properly reporting depreciation in your financial information. This is extremely useful if you wish to buy future assets with cash rather than taking out a loan.


You can draw some conclusions about it when the firm will need to acquire new technology since you took the effort to evaluate the productive life of the component for depreciation reasons. 


The sooner you start saving for that purchase — maybe by putting money aside each month in a high-interest savings account — the quicker it is to replace the apparatus when it breaks down.

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