Answered March 26 2020
When companies discuss depreciation, they are usually looking at one of two things. Depreciation can refer to the actual decrease in the value of a particular asset. For example, a new machine used on a production line will decrease in value year after year as it is used by the organization. Depreciation can also refer to the allocation of the original price of a particular asset over many years in an accounting system.`
Depreciation is important because businesses can use this system to spread out the investments of long-term assets over the course of many years for accounting and tax benefits. As the value of an asset decreases over the years due to wear and tear, the amount shown on an accounting balance sheet will affect annual income.
Capital expenditures refer to the money that a business will spend to buy equipment, assets, or services that it expects to use for more than one year. These expenditures might include machines that operate in a facility or on a production line, physical expansions or renovations to a building, trucks or other vehicles used to ship items to customers, or hardware investments including computers and technology systems.
Capital expenditures may be brand-new equipment or assets, but may also include goods or services that help lengthen the productive life of an existing piece of machinery. These expenditures appear in an accounting system on a balance sheet, as well as on a company’s cash flow-statement. Once the piece of equipment or asset starts to operate, it is usually depreciated over time, allowing businesses to spread the cost of the equipment over its expected life.
Besides capital expenditures, businesses also incur operating expenditures. Operating expenditures are the smaller expenses that need to be incurred simply to run a business on a daily basis. For example, operating expenditures may include things like building rent, utility bills, wages and salaries, taxes, or travel expenses. Operating expenditures usually make up the majority of the company’s ongoing spending.
Capital expenditures differ from operating expenditures in several ways. Since capital expenditures are those purchases that will be used over several years, the cost of those expenses are also spread out over the same amount of time for accounting and tax purposes. On the other hand, operating expenditures are smaller and tend to be incurred in a single accounting period. They are usually purchased and used in the same time frame, so companies place them in a separate budget category.
While operating expenditures are tax-deductible during the year they are incurred, capital expenditures are not. Businesses may be able to use these two accounting categories to their advantage if they have particular challenges. For example, an organization that is struggling with cash flow may choose to rent a large piece of equipment instead of purchasing it. By doing so, that company can deduct the leasing cost in the current tax year.
Just about any major piece of tangible property as well as some intangible property can be depreciated over time. Examples of tangible property may include buildings, production machinery, computer and technology systems, transportation vehicles, and furniture. According to the Internal Revenue Service, businesses may also depreciate particular intangible assets like copyrights, computer software, and patents.
Any smaller expenses that are incurred and used in a single accounting period cannot be depreciated. Instead these expenses are considered operating expenditures and can be taxed deducted in the same fiscal year when they were incurred. Typical expenses that cannot be depreciated include things like office supplies, rent and utilities, taxes, and labor expenses.
Other fixed assets that are not eligible for depreciation are those things that do not lose their value over time. For example, the land that your company owns is a fixed asset, but it does not get “used up” over time. Instead, it holds value the entire time your business owns it. Other non-depreciable assets include cash, investments, leased and personal property, and things like artwork.
The bottom line: Any asset that your business owns, is used to produce income, loses its value over time and has a lifespan of more than one year, can be depreciated.
Four standard types of calculations are used to determine depreciation expenses. The most common methods are straight-line depreciation, double declining balance depreciation, units of production depreciation, and sum of years digits depreciation.
All depreciation calculations have the same overall goal, which is to assign the cost of a fixed asset over its entire lifespan. Depreciation allows a company to spread out the original purchase price over time, which better reflects how that particular asset is “used up.”
Straight line depreciation shows how an asset’s value decreases over time. It’s a straightforward accounting calculation that assumes a uniform rate of reduction in value. Graphically, this method is represented by drawing a line from the asset’s purchase price down to its value at the end of its useful life. The formula for straight-line depreciation is: Depreciation Expense = (Cost – Salvage Value) / Useful Life.
Straight line depreciation is the simplest and most convenient way to describe the devaluation of an asset. With straightforward requirements, it is a versatile method that is applicable to most businesses and industries.
A typical straight-line depreciation graph would look like the following:
The double-declining balance method is another example of an accelerated depreciation method. For this method, the rate of depreciation is assumed to be twice the rate of the straight line method. While the name suggests “doubling” the straight line depreciation rate, the declining balance can actually be tweaked to suit the asset. Values for declining balances can be taken as 1.5x or even 2.5x the straight line depreciation rate, if required. The formula for double-declining balance depreciation is Periodic Depreciation Expense = Beginning Book Value x Rate of Depreciation.
Double-declining balance depreciation considers the fact that new assets are usually significantly more productive in their early years. Many assets will lose more of their value during their first few years of operation than later down the road. By using the double-declining balance depreciation method, companies can keep the larger expenses on the books during the first several years.
How does straight line depreciation compare with other methods?
Units of production assumes depreciation to be directly linked to the amount of time that the asset is being used. By quantifying the number of units produced, it estimates the utilization hours required to make the units. The length of operating time is then used to calculate the devaluation of an asset. The formula for units of production depreciation is Periodic Depreciation Expense = Beginning Book Value x Rate of Depreciation.
This method is regarded as the most accurate representation of devaluation, as it more closely reflects the actual wear and tear that assets go through. However, the increased accuracy comes with a price. When using the units of production method, more resources are needed to collect enough data over long periods of time. Because of additional efforts required for this method, it is typically used for higher-value equipment.
Remember how the straight line method assumes a constant rate of depreciation? The sum-of-years-digits method deviates from this by accelerating the depreciation rate, instead of assuming it to be constant. In other words, this method expects an asset to have higher depreciation rates within the first years of its useful life. The rate of devaluation then decreases over time until it reaches the end of its useful life. The depreciation formula for the sum-of-the-years-digits method is:
This method of accelerating the depreciation is applicable to assets that are expected to deteriorate more quickly than others. It can be a more realistic representation for assets that significantly reduce production capacities over time.
Depreciation is an accounting method, and accounting is not the first thing you might associate with maintenance. Maintenance teams are more commonly regarded as hands-on experts in keeping equipment in tip-top form. What isn’t obvious, is how data from maintenance activities can be used for bookkeeping.
Maintenance workers can update and add entries to the computerized maintenance management software (CMMS) as part of their day-to-day work. This information is useful for the finance department, as it provides an accurate breakdown of costs to maintain an asset. You can draw a complete picture of the financial worth of an asset when coupling it with enterprise asset management (EAM) software that tracks asset values.
Working between two software systems sounds simple in principle. However, when accounting for every asset in the plant, calculating financials can get tedious. Some CMMS providers solve this issue by having a depreciation tracking functionality. This essentially puts all the asset-related information in one place, so you can easily make more sense of it.
Take, for example, any new or existing equipment that you have in your plant. Your CMMS can track an asset’s value and anticipate depreciation over its useful life. If you’re using the straight line depreciation method, you can set expectations on how the total devaluation of an asset will be distributed over time and recorded in the depreciation schedule. At any point in an asset’s useful life, its projected depreciation can give you hints on whether it is more financially beneficial to repair the asset or to replace it altogether.
Decreased equipment failure. By tracking the wear and tear on your machinery and equipment, you’ll be able to better monitor asset conditions. The integrated system can help you project when you may need to not only perform maintenance but consider asset replacement. In the long run, this should reduce the amount of unexpected equipment failure. Here’s how:
By using depreciation in accordance with your maintenance system, you’ll be able to accurately report on the value of your assets in each year that you’re using them.
Understanding asset depreciation is an important part of running any business. Remember that asset depreciation applies to capital expenditures, or to those pieces of equipment or machinery that will be used over the course of several years to generate income for your organization.
Four types of depreciation systems are commonly available within accounting. Depending on your particular business and the assets you are depreciating, you want to choose the method that most accurately reflects the rate of use and deterioration of your assets. Asset depreciation is designed to help companies spread out the purchase price of a more expensive piece of equipment throughout the years of its life cycle.
Although depreciation is typically tied closely with accounting systems, maintenance professionals must understand how data collected throughout a CMMS can work together with the accounting components. By integrating both maintenance and accounting data into an overall system, companies will have powerful tools to help draw an extremely accurate picture of the value of its assets over time, as well as the costs of maintaining and replacing them at the end of their life.
This story was updated and expanded in March 2020.
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