Outside some very exceptional cases, most tangible business purchases you’ll make are subject to depreciation. Plant assets like equipment and buildings encounter wear and tear as well as obsolescence, lowering their book value over time. For full transparency and legal compliance, these losses of value must be accounted for over the useful life of the assets on your business’s financial documents.
Because losses of value don’t usually happen in one go, it doesn’t make sense to add full depreciation costs immediately after acquiring assets. Instead, these costs must be spread out over the useful life of these acquisitions to better reflect their worth at a given point in time.
It can be difficult to account for the fair valuations for assets, especially if numbers aren’t your strong suit as an entrepreneur. Fortunately, you can learn more about and better mitigate your depreciation risks by hiring accountants Dunedin businesses depend on, like the trusted firm Target Accounting.
The Challenges of Depreciation
Accounting for these changes is not as straightforward as one might expect. For example, depreciation for a commercial stand mixer should probably be reckoned in a different way from that of a laptop, since the mixer is not as likely to be as affected by obsolescence.
In addition, depreciation does not always follow a linear curve where the loss of value remains constant from year to year. A new car, for instance, will usually depreciate heavily the moment it leaves the dealership and then experience slower depreciation in the subsequent years. An asset’s frequency of use, maintenance schedules, and overall build quality also factor heavily into how its real value declines over time.
Common Depreciation Methods
There are several methods to calculate depreciation, each suited to the different challenges we just described. The main types of depreciation include the following:
1. Straight-Line Depreciation
This is the simplest and most commonly used depreciation method. This involves evenly spreading the cost of the asset over its useful life. It’s commonly employed for assets that do not have dramatic differences in usefulness over their lifetimes, such as waiting room chairs or kitchenware.
This method is normally calculated as:
(Cost of Asset - Salvage Value) / Useful Life
Example: If a store display refrigerator costs NZD 10,000 and has a useful life of 10 years, and offers no salvage value, the annual depreciation expense would be NZD 1,000.
2. Double-Declining Balance Depreciation
This accelerated method depreciates assets faster in the earlier years of their useful life, reflecting the typical losses of saleability in regular use. It doubles the straight-line depreciation rate.
Double-Declining Balance is normally calculated as:
(2 x Straight-Line Depreciation Rate) x Book Value at the Beginning of Year
Example: For a NZD 10,000 construction site diesel power generator with a 10-year lifespan, the first-year depreciation would be NZD 2,000, the second year would be NZD 1,600, and so on.
3. Units of Production Depreciation
This method directly ties depreciation to the usage of the asset. Though it’s suited for any frequently used asset, the method is ideal for manufacturing equipment since wear and tear are usually directly related to production levels.
This depreciation method is normally calculated as follows:
(Cost of Asset - Salvage Value) / Total Estimated Units of Production x Units Produced in Period
Example: An offset printing press costing NZD 10,000 with a useful life of 100,000 cycles will depreciate NZD 0.10 per cycle. If the press is used 10,000 times in a year, the annual depreciation expense is NZD 1,000. The cost can be shifted if there is higher or lower usage in a given year.
4. Sum-of-the-Years’ Digits (SYD) Depreciation
Another accelerated depreciation method, the SYD approach, results in higher depreciation expenses in the early years of an asset's life and lower expenses as it ages.
The SYD method follows this formula:
(Remaining Life of Asset / Sum of the Years' Digits) x (Cost of Asset - Salvage Value)
Example: For an IT server costing NZD 10,000 with a 5-year lifespan, the sum of the years' digits is 15 (5+4+3+2+1). The first year's depreciation is (5/15) x NZD 10,000 = NZD 3,333.
The Impact of Depreciation on Financial Statements
However it’s calculated, depreciation will impact all of your main financial statements in the following ways:
Income statement. Depreciation is an expense. Therefore, it reduces both your taxable income and net income.
Balance sheet. A depreciating asset's book value decreases each year by however much the calculated depreciation expense is. Like any expense, this must be reflected on your balance sheet.
Cash flow statement. In typical practice, depreciation is a non-cash expense added back to net income in the operating activities section. This is done to indicate that, despite a drop in book value, no actual cash is leaving the business.
Choose the Right Depreciation Method, Every Time
As discussed above, selecting the ideal depreciation method for a given asset depends on the nature of the asset, your business's financial strategy, and external compliance considerations. You do have some leeway to choose, but there will always be a method that will best meet your unique business goals.
To mitigate your risks, get in touch with the right accounting team. Qualified experts who understand your business and the market it operates in can help you choose the best depreciation methods for any given asset. With the right help, you can further increase your business’s transparency, building your stakeholders’ confidence and keeping regulators satisfied.
Want advice on how to deal with in-depth financial issues like depreciation and the right choice of accounting software to use for it, as well as exhaustive business advisory services, HR services, or international client services? All of these are available from Target Accounting, so contact us today!