Economic Depreciation

The progressive decrease in the market value of a commodity over time due to economic factors.

Economic Depreciation is the term used to describe the progressive decrease in the market value of a commodity over time due to economic factors.

Devaluation is the loss of an asset's worth due to economic alteration in its market value in significant ways.

When it comes to selling an asset, economic depreciation may be more important than accounting depreciation. 

Accountants typically employ book value as the main reporting approach, which pays little attention to corporate accounting. Several key financial studies can be used to examine its nature.

Because accountants typically use book value as a fairly dominant reporting technique for various purposes, economic depreciation focuses less on the financial statements of large capital assets in corporate accounting.

As a result, depreciation is referred to as "fixed capital consumption." When we calculate "net value" instead of "total value," we remove depreciation from the overall value of a variable.

How does Economic Depreciation work?

Depreciation is defined as the value loss of an asset fairly owing to factors that impact its market value in the economy. This is especially important when selling things in open markets.

Owners of assets tend to focus on economic depreciation rather than accounting depreciation when selling them.

The asset owner may pay attention to it because it has an impact on the asset's market sale value, which directly impacts the profitability of the asset owner when selling the asset. 

In financial studies, we think about it in a variety of conditions, which is extremely important. 

Although analysts may specifically utilize it in different scenarios. The real estate business is one of the most common examples in life. 

Economic depreciation mostly has a role in forecasting future earnings from goods and services. 

Because accountants typically use book value as the primary reporting method, depreciation does not appear in the financial statements of fairly large capital assets that businesses account for.

How is economic depreciation recorded in the system of national accounts?

Depreciation, for the most part, is the loss of absolute capital value in the economy, which results in a drop in revenue. 

When calculating the "net" value rather than the "total" value, depreciation is calculated by removing the total value of the variable. 

For example, depreciation is subtracted from the total gross domestic product (GDP)  to determine net GDP.


Various causes of economic depreciation are

1. Wear and tear

Over time, wear and tear mostly are unavoidable. 

Frequent use with certainty causes damage to goods that have been utilized for a long period. For example, after a period of use, a company's machinery and equipment may begin to fail, become slower, and is eventually scrapped, this is because of depreciation caused by machine wear and tear.

2. Obsolescence

Existing technologies generally have become obsolete due to rapid technological advancement and have been replaced by fairly more efficient alternatives. As a result, the value of obsolete technology or assets depreciates. 

Mobile maps, for example, are becoming increasingly capable of navigating, rendering standalone GPS devices obsolete.

3. Perishability

Raw materials and inventory have an expiration date implying they should be used within a specific amount of time or else their value will depreciate.

4. Expiration of rights

Intangible assets, such as the right to use software, patents, licenses, trademarks, and other actual intellectual property, are only valid for a limited time. Before the rights expire, intangible assets must be depreciated.

Amortization is the term for the depreciation of intangible assets. Intangible assets particularly are amortized over time, so when the rights expire, their value becomes zero.

How to calculate the economic depression and examples

There are two methods of measuring depreciation.

1. The value of the items produced by the asset

The depreciation of machinery or equipment can be calculated using the value of the items produced by the asset. 

For example, if a machine can produce 10 units of a good per day at $5 each, the total value of the goods produced is $50 at first. 

When the machine depreciates it can only produce 5 pieces of a good per day at $5 each. The total worth of the goods is $25 at this point. 

Here, Depreciation is $25.

2. By resale value 

The decrease in resale value, or the price at which you mostly sell an object to someone else, can also be used to determine depreciation. It is calculated by subtracting the asset's initial cost from its resale value subtly.

Let's say you paid $100 for some gadget and plan to sell it for $60 now.This shows the depreciation will be $(100 - 60) = $40.

Economic Depreciation  vs. Accounting Depreciation vs.Tax Depreciation

1. Economic depreciation

There is no specific duration or timetable for an asset value to drop, rather it's the impact of the influencing economic forces. 

As a result of the market value of some assets, the asset's worth may have depreciated ahead of schedule, which is quite significant. It can be estimated using an impairment charge or readily generated on a model platform.

It is more founded on the concept of capital investment than on the concept of depreciation. 

For example, it is common in real estate. It may result in a decrease in market value during a period of economic downturn or general deterioration in the real estate market. 

Assessment is one of them, and it is generally the key to understand economic depreciation. 

Valuations can be performed on a variety of assets and are often the most important factor in determining economic depreciation.

1. Accounting Depreciation

The value of a tangible asset falls over time according to a specified depreciation schedule in accounting depreciation.

As a result, it's much more time-based. 

Accounting depreciation is governed by tax law or IRS guidelines. If a machine has a five-year useful life, it will be depreciated at the same rate regardless of how long it is in use.

2. Tax Depreciation

Depreciation expense essentially reported on a taxpayer's tax return during a tax period is referred to as tax depreciation.

Depreciation is a tax deduction that allows a company or individual to claim a reduction in the value of a tangible asset within a defined territory. 

Individuals and businesses can reduce their taxable income by deducting depreciation, achieving the general goal of lowering corporate and individual taxes in a major way.

Valuing Assets

Economic depreciation is a risk that all sorts of assets face. To avoid losses as much as possible, companies and investors must study and track the repercussions in diverse ways. 

The impact on the market value of a company's tangible assets may not necessarily be a concern. On another hand, companies and investors are majorly concerned about the market impacts on highly liquid assets such as stocks, bonds, and money market accounts. 

Because depreciation has a higher impact on a company's overall performance, companies and investors pay special attention to it. Liquidity can also be a factor in determining economic depreciation for asset owners.

How does depreciation affect profits?

Depreciation costs may have a direct impact on a company's profit and income statement

The smaller a company's statutory profit, the greater the annual depreciation, which is quite significant. 

On the other hand, if a company's depreciation expenses are low in a given year, it represents a considerable huge profit. 

Depreciation is a non-cash expense that has little impact on a company's cash flow.

Key Takeaways

Causes of depreciation

  1. Wastage: The frequent use invariably damage goods that have been in use for a long time.

  2. Out-of-date notion: Existing technology generally becomes obsolete as a result of rapid technological advancement. For example, when the vehicle was introduced, the horse-drawn carriage was rendered outdated in comparison to the automobile.

  3. Perishability: The raw materials and inventory have a shelf life, they must be used before they expire. 

  4. A right that has passed its expiration date: Software rights, licenses, trademarks, and other forms of actual intellectual property are examples of intangible assets that have a finite lifespan. Intangible assets are required to be depreciated before the rights expire.

Depreciation can be calculated in two ways. 

  • The first factor is subtly determined by the asset's value as a project generator.

  • Resale value is the main topic of the second point.

There is a significant difference between economic and accounting depreciation.

 Knowing how to discern between the two types of depreciation is critical for business owners and investors.

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Reviewed and Edited by Parul Gupta | LinkedIn

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