Depreciation

Depreciation is a noncash accounting method to represent the reduction in value of a tangible asset over time. It is a way to account for the diminishing value of capital funds invested in an asset.

Causes of Depreciation:

• Physical deterioration of an asset can reduce its performance, reliability, and productivity.
• Market conditions can affect the value of an asset, regardless of its physical condition.
• Technological advancements can make existing assets obsolete

Purpose:

• Book Depreciation: For internal financial reporting.
• Tax Depreciation: For calculating income taxes. It lowers income taxes because the annual depreciation amount is tax deductible.

Key Terms:

• Book Value (BV): Represents the original cost of an asset minus accumulated depreciation.
• Salvage Value (S): Estimated trade-in or market value at the end of an asset’s depreciable life. Salvage value may be positive, zero, or negative. aka also called residual value, break-up value, or used interchangeably with scrap value.  If the object’s value after being dismantled is considered it is often termed as scrap value. 
• First Cost (B): The initial cost or basis of the asset.
• Recovery Period (n): The expected useful life of an asset.
• Tangible Assets: Depreciation applies to physical assets such as equipment and buildings.
• Intangible Assets: Amortization is used for intangible assets like patents.

Depreciation Methods

Straight Line (SL):

• Can be utilized for book depreciation.
• Constant depreciation amount each year.

• apportions depreciation evenly across an asset’s useful life, making it ideal for assets with consistent utility patterns. The formula is:

  $$\text{<img decoding="async" class="equation\_image lazy" title="text{Annual Depreciation} = frac{text{Cost-Salvage Value}}{text{Useful Life}}" src="data:image/svg+xml,\%3Csvg\%20xmlns='http://www.w3.org/2000/svg'\%20viewBox='0\%200\%201\%201'\%3E\%3C/svg\%3E" data-src="https://canvas.instructure.com/equation\_images/\%255Ctext\%257BAnnual\%2520Depreciation\%257D\%2520\%253D\%2520\%255Cfrac\%257B\%255Ctext\%257BCost-Salvage\%2520Value\%257D\%257D\%257B\%255Ctext\%257BUseful\%2520Life\%257D\%257D?scale=1" alt="LaTeX: text{Annual Depreciation} = frac{text{Cost-Salvage Value}}{text{Useful Life}}" data-equation-content="text{Annual Depreciation} = frac{text{Cost-Salvage Value}}{text{Useful Life}}" data-ignore-a11y-check="">}$$

  For a $120,000 MRI machine with a $20,000 salvage value and 10-year lifespan:

  This method’s simplicity facilitates financial forecasting but may not reflect actual asset utilization patterns

Declining Balance (DB)

• Accelerated Depreciation Approach
• applies a fixed percentage to the asset’s decreasing book value,
• assets that lose value rapidly initially.
• The basic formula is:
  

 For a $30,000 digital press with 5-year life:

For a $30,000 digital press with 5-year life:

• Year 1: 30000*(1/5) = 6000

• Year 2: (30000-6000)*1/5$$

This approach benefits companies seeking larger tax deductions in early years

Double Declining Balance (DDB):

• This method suits technology assets prone to rapid obsolescence
• DDB doubles the depreciation rate of the declining balance method:
  

Using a $25,000 industrial robot with 5-year life:

Modified Accelerated Cost Recovery System (MACRS):

• Only approved tax depreciation system in the United States.
• Salvage value is always zero.
• Assumes assets are placed in service in the middle of the tax year (half year convention)

Sum-of-Years-Digits (SYD):

• This method bridges straight-line and accelerated approaches
• SYD creates a depreciation curve using the sum of an asset’s useful life years as the denominator:$$$$For a $50,000 vehicle with 5-year life and $5,000 salvage value:

• SYD = 15 (5+4+3+2+1)

• Year 1: (5/15) * 45,000 = 15,000
• Year 2: (4/15) * 45,000 = 12,000

Units-of-Production (UOP):

• Depreciation is based on asset usage rather than time. The depreciation is defined per unit of service rendered.
• This method ties depreciation to operational output, ideal for manufacturing equipment:
  $$\frac{}{}$$
  

For a $200,000 injection molding machine rated for 500,000 units:

• Per-unit depreciation = 200.000/500.000 = 0.40
  

• If Year 1 production = 80,000 units: Depreciation = 80,000 * 0.40 = 32,000
  

This matches expenses directly with revenue generation

Depletion

• Method to write off investment applicable to natural resources.
• Percentage and cost depletion.

Important Considerations

• Depreciation is not an actual cash flow.
• Depreciation affects cash flow by reducing income taxes.
• Switching between depreciation methods (e.g., DDB to SL) can maximize the present worth of total depreciation.
• Depreciation methods for tax purposes vary by country.

Industry-Specific Practices

• Transportation: Units-of-production for fleet vehicles based on mileage
• Technology: Double-declining balance for server infrastructure
• Construction: SYD for heavy machinery with predictable obsolescence curves
• Regulatory environments also shape practices— Eg: MACRS (Modified Accelerated Cost Recovery System) governs U.S. tax depreciation, requiring specific asset classification

Nepal’s tax system uses the reducing/declining balance method for calculating depreciation, based on the pool of assets. This means that depreciation is computed on the written down value of the assets. All assets with the same depreciation rate are aggregated into a common block or pool for computation.

• Pool of Assets: Assets with the same depreciation rate are grouped together.
• Depreciation Calculation: Depreciation is calculated using the declining balance method.
• Addition of Assets: In the year of purchase, full depreciation is available if the asset is added to the pool for more than six months during the financial year. Otherwise, depreciation is allowed at two-thirds or one-third of the normal rate if the addition is made for less than six or three months, respectively.
• Disposal of Assets: Amounts from the disposal of assets are reduced from the written down value of the relevant pool.
• Depreciation Rate: Depreciation is computed at varying rates as prescribed.

The Income Tax Act, 2058 categorizes depreciable properties into five categories (A to E) with specified rates.

In addition to normal depreciation, certain entities are allowed one-third additional depreciation of the rate prescribed on the assets falling under Blocks A, B, C, and D. These entities include those engaged in:

• Building public infrastructure to transfer to the Government of Nepal
• Power generation, transmission, or distribution of electricity
• Operating special industries under Section 11
• Operating roads, bridges, tunnels, ropeways, or sky bridges constructed by the entity.

Source https://ird.gov.np/public/pdf/379988550.pdf 

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