Depreciated Cost

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What is Depreciated Cost?

Depreciation is the loss of value of fixed assets as a result of their use, the passage of time, or obsolescence.

It is the accounting process of transforming the initial costs of fixed assets like plant and machinery, equipment, and other assets into expenses.

Depreciation is also a non-cash expenditure because it does not entail any actual cash outflow. As a result, depreciation as a cost is distinct from all other types of expenses. Depreciation is the process by which the value of a company's assets depreciates over time.

In the United States, accountants must calculate and report depreciation on financial statements using generally accepted accounting standards (GAAP).

GAAP (Generally Accepted Accounting Principles) is a system of standards that governs the specifics, complexity, and legality of commercial and corporate accounting.

Depreciation is defined as the systematic reduction in the reported value of a fixed asset until the asset's value is zero or inconsequential in accounting terms.

Buildings, furniture, office equipment, machinery, and other fixed assets are examples of the same. The sole exception is land, which cannot be depreciated since its value increases with time.

Revenues are recorded with their corresponding costs in the accounting period when the asset is in use; this is required under the matching principle. This helps to acquire a clearer view of the revenue generation transaction.

The value of a fixed asset minus all the depreciation recorded against it is called its depreciated cost. In a larger economic sense, this is the total amount of capital that is "used up" in a certain period.

It may be used to look for patterns in a company's capital investment and how aggressive its accounting techniques are, as measured by how precisely depreciation is calculated.

Key Takeaways

Depreciated cost is the value of a fixed asset after accounting for accumulated depreciation. It represents the original cost of the asset minus the total depreciation expense taken over the asset's useful life.
The depreciated cost reflects the current value of an asset on the balance sheet and provides a more accurate measure of its worth over time as it loses value due to wear and tear, obsolescence, or other factors.
Depreciated cost helps companies manage their assets by providing insights into when assets may need replacement or major repairs. It also aids in decision-making regarding the sale or disposal of assets.
Depreciation affects a company's taxable income since depreciation expense is deductible for tax purposes. The method of depreciation chosen can influence the timing and amount of tax deductions.

How Depreciated Cost Works

The depreciated cost technique of asset valuation is an accounting approach for determining the usable value of an item used by corporations and individuals. It's vital to remember that it does not equal market value.

The market value of an item is its price, which is determined by supply and demand in the market. The depreciated cost is the value of an asset after its useful life has ended, which is depreciated over time.

Because computing the depreciation cost continuously reduces an item's value, the depreciated cost technique always permits accounting records to represent an asset at its current value.

The formula is as follows:

Depreciated Cost = Purchase Price (or Cost Basis) − Cumulative Depreciation

For example, if a construction business can sell an inoperable crane for $5,000 in parts, the crane's depreciated cost or salvage value is $5,000. If the corporation paid $50,000 for the crane, the total amount depreciated during its useful life is $45,000.

Assume the crane has a 15-year useful life. The corporation now has all of the information it requires to compute depreciation for each year. Straight-line depreciation is the simplest way.

This indicates that the quantity of appreciation has no slope, whether it's a 30 percent depreciation when driving new automobiles off the lot or a higher depreciation when an item is nearing the point of needing substantial repairs.

Depreciation is the same every year when using this strategy. It's calculated by dividing total depreciation ($45,000) by the useful life (15 years), which comes to $3,000 each year.

Depreciated Cost = Original Cost - Accumulated Depreciation

Is depreciation a fixed cost or variable cost?

Depreciation is a fixed expense since it occurs at the same rate every period during the asset's useful life. Depreciation is not a variable expense because it does not change with the level of activity. There is, however, one exception.

If a company uses a usage-based depreciation technique, depreciation will be incurred more consistently with a variable cost.

Logging equipment, for example, is depreciated based on the number of hours it is utilized; therefore, depreciation costs will vary depending on the number of trees chopped.

These trees are later sold to produce money, the resulting depreciation might be considered a variable rather than a fixed cost.

However, because usage-based depreciation schemes are uncommon, depreciation cannot be considered a variable cost in most circumstances.

If depreciation is considered a fixed cost, it is factored into the numerator of the method for calculating a company's break-even sales, which is:

Total fixed expenses ÷ Contribution margin % = Break-even sales

Depreciation is used to lower the amount of the contribution margin percentage in the denominator of the calculation if it is deemed a variable expense, which may be claimed if usage-based depreciation is applied.

Firms' operating and overhead costs are known as fixed costs. These include items such as building, rent, utilities, labor, and insurance.

Methods to Calculate Depreciation Cost

When calculating depreciation, a corporation considers various elements. The technique of depreciation is one such element. As a result, organizations use multiple depreciation methodologies.

Methods to calculate depreciation

Depreciation Methods

Straight Line Depreciation Method
Diminishing Balance Method
The sum of Years’ Digits Method
Double Declining Balance Method
Sinking Fund Method
Annuity Method
Insurance Policy Method
Discounted Cash Flow Method
Use Based Method
Output Method
Working Hours Method
Mileage Method
Other Methods
Depletion Method
Revaluation Method
Group or Composite Method

As seen above, there are numerous methods for calculating depreciation, each different in terms of how it's calculated and the items considered in the calculation.

For simplicity of understanding, we will only discuss the four most commonly used methods of calculating depreciation.

Straight Line Depreciation Method

This is one of the most commonly used methods of computing depreciation. It is also known as the fixed-installment approach. In this method, the depreciation of each fixed asset is charged at the same rate in each accounting period.

This constant cost is charged until the asset is depreciated to zero or its salvage value at the end of its expected useful life.

As a result, this approach's name comes from a straight-line graph. After charting an equal amount of depreciation for each accounting period during the asset's useful life, this graph is produced.

The depreciation is determined by dividing the difference between the original cost and the book value of the fixed asset.

The following is the calculation for yearly depreciation using the straight line method:

Annual Depreciation Expense = (Asset Cost – Salvage Value) / Asset Useful Life

The asset's cost is either its acquisition price or its historical cost.
The worth of an asset after it has outlived its useful life is referred to as salvage value.
The number of years for which a firm projects to employ an asset is referred to as its useful life.

Diminishing Balance Method

This reducing balance approach is also known as the writing down value method or the declining balance method. Under this technique, a fixed percentage of depreciation is charged to the net balance of the fixed asset in each accounting period.

After subtracting cumulative depreciation, the net balance represents the worth of the asset that remains.

As a result, the depreciation rate is applied to the asset's decreasing balance.

This is the asset recorded in the books of accounts at the start of the accounting period. As a result, its book value is written down to decrease it to its residual value.

Every year, the amount of depreciation decreases as the asset's book value decreases. As a result, depreciation is charged at a greater rate in the early years of an asset compared to later stages.

As a result, the technique is predicated on the idea that higher depreciation should be charged in the asset's early years. This is because such years have minimal repair costs. The cost of repairs and upkeep rises as an asset enters the later phases of its useful life.

Depreciation Expense = (Book Value of Asset at Year's Start x Depreciation Rate) / 100

Sum of Years’ Digits Method

The Sum of Years' Digits Technique is another accelerated depreciation method. This strategy accelerates the recognition of depreciation. As a result, under this technique, the depreciable amount of an asset is charged as a fraction across many accounting periods.

This fraction is the ratio of an asset's remaining usable life in a certain time to the sum of the years' digits. As a result, this proportion implies that in the first year, the capital blocked or profit generated from the asset is the largest.

Therefore, as an asset approaches the end of its useful life, the benefit derived from it decreases. This is because no capital has been recovered until then; the largest amount of depreciation is given in the first year.

As a result, the last year should have the least amount of depreciation because most of the capital invested has been recovered.

Double Declining Balance Method

This approach combines the straight-line and declining balance techniques. Under this technique, depreciation is charged on the lower value of the fixed asset at the start of the year.

This is similar to the approach of declining balance. However, like the straight-line technique, a set rate of depreciation is used.

This depreciation rate is twice as high as the rate paid under the straight-line approach. As a result, when compared to the expected salvage value, this strategy results in an excessively depreciated asset at the end of its useful life.

As a result, firms use various techniques to solve such a problem. First, the amount of depreciation charged for the previous year is adjusted. This is done to bring the salvage value up to par with the expected salvage value.

Second, many corporations choose to modify the over-depreciated salvage value using the straight-line depreciation technique in the previous year.

The following is the formula:

Annual Depreciation Expense = 2 x (Cost of Asset – Salvage Value)/Useful Life of Asset Or Depreciation Expense = 2 x Cost of Asset x Depreciation Rate

Factors for Estimating Depreciation

A number of elements must be taken into account to determine the amount of depreciation to be charged in each accounting period.

These are some of them:

Cost of the Asset: The historical cost is another name for the asset's cost. It includes the fixed asset's acquisition price as well as any additional expenditures necessary to get the asset up and running. Freight and shipping, installation charges, commission, insurance, and so on are all included in these prices
Salvage Value: Salvage value is also known as scrap value or net residual value. It refers to an asset's anticipated net realizable value at the end of its useful life. The difference between the sale price and the costs required to dispose of an item determines this value.
Estimated Useful Life: The useful life of an asset is defined as its commercial or economic life. The physical life of an asset is no longer taken into account when determining its useful life. This is due to the fact that an asset may be in good physical shape after a few years, yet it may not be employed for production.
Method of Depreciation: You must develop an appropriate method for allocating the asset's cost over the asset's usage periods. In general, the method of depreciation to be utilized is determined by the predicted benefits derived from a certain item.

As a result, different strategies would be used for different sorts of assets in a business.

In practice, however, corporations do not consider service benefit patterns when deciding on a depreciation approach. In most cases, a single technique is used to depreciate all of the company's depreciable assets.