Depreciation of tangible assets is an accounting method used to allocate the cost of a physical asset over its useful life. This process reflects the gradual decrease in the asset's value due to factors like usage, wear and tear, or obsolescence. Tangible assets are physical items expected to last more than one year, such as machinery, vehicles, buildings, and equipment. Land, however, is generally not depreciated as it is considered to have an unlimited useful life.
Purpose of Depreciation
The primary purposes of depreciating tangible assets are:
- Matching Principle: To align the expense of an asset with the revenue it helps generate over its useful life. This provides a more accurate representation of a company's financial performance over time.
- Accurate Financial Reporting: It prevents large upfront expenses from distorting financial statements, offering a clearer view of a company's financial health and profitability.
- Tax Benefits: Depreciation is a tax-deductible expense, which can reduce a company's taxable income and, consequently, its tax liability.
- Asset Management: It assists businesses in tracking the declining value of their assets and planning for future replacements.
- Cost Allocation: Instead of expensing the entire cost of an asset in the year of purchase, depreciation systematically spreads this cost over the asset's productive years.
Methods of Depreciation
Several methods are used to calculate depreciation, each allocating the asset's cost differently over its useful life:
- Straight-Line Method: This is the simplest and most commonly used method. It allocates an equal amount of depreciation expense to each year of the asset's useful life.
- Formula: (Cost – Salvage Value) / Useful Life
- Declining Balance Method: This method, including the Double Declining Balance (DDB) variation, recognizes a higher depreciation expense in the early years of an asset's life and a lower expense in later years. This reflects the idea that assets are often more productive or lose more value in their initial years.
- Units of Production Method: This method depreciates an asset based on its actual usage or output rather than the passage of time. It is suitable for assets whose wear and tear are directly related to their activity level (e.g., machinery depreciated per unit produced or per hour of operation).
- Sum-of-the-Years' Digits Method: This is another accelerated depreciation method that results in a higher depreciation expense in the earlier years of an asset's life and a decreasing expense in subsequent years.