Depreciation: It may affect you more than you think

Depreciation

It may affect you more than you think

Before going any further, please accept my apology for dragging you into a subject that, for the most part, probably does not affect your day-to-day routine. But it does affect you in some manner.

What is this subject to which I am referring? Due to the title, you know that it's depreciation. This article will explain depreciation in general and demonstrate its relevance to you.

What is depreciation?
I will answer this by first posing two questions. Let's assume that you purchase a piece of machinery and plan to own it for 20 years. Is it likely that the machine's physical condition will deteriorate due to use or due to the elements in which it operates? Or will technology advance enough to render the machine obsolete at the end of or during the 20-year period? If the answer to either is yes, then the machine will have experienced depreciation.

While the "using up of the asset" is an expense to the business, understand two other characteristics of depreciation. It is an expense that does not directly affect cash nor does it imply that an organization is reserving cash.

Now that we know more about depreciation and what it represents, how can organizations quantify it or place a value on it?

How do we measure depreciation?
I would like to answer this question in two parts. The first part will examine measuring depreciation in a more general sense, while the second part will examine some of the specific rules that exist in two of the more common applications, tax and financial accounting.

Measuring or calculating depreciation in a general sense involves three ingredients - purchase price of the asset, length of ownership, and estimated asset value at the end of ownership.

Purchase price is what you actually pay for the asset plus any costs incurred to ready the asset for its intended use. For example, an aircraft's purchase price would include not only the price paid for the aircraft, but also the many associated costs such as sales tax, delivery costs, completion work, painting, and installation of optional equipment.

Length of ownership is really straightforward. This ingredient requires you to estimate the length of time that you plan to own and/or operate the asset. Estimating the length of ownership may be difficult on the day of purchase because it represents a guess about the future. What seemed like a sure seven-year ownership on the purchase date may change due to varying conditions. The current economic situation would be an example.

Estimating asset value at the end of ownership may be the ingredient with the least amount of certainty. Look at our current situation in aviation. Who would have predicted five years ago that aircraft market values would be what they are today? You should base an asset's residual value on the best available information at the time and recognize the value for what it really is, an estimate.

The three ingredients mix together to calculate the depreciable cost of the asset as follows.

(Purchase Price - Residual Value) / Length of Ownership = Depreciable Cost

Seems easy enough, if only our discussion could end here. Unfortunately, it can't. What we've calculated up to this point is the total amount of depreciation that we will take over the period of ownership. What we haven't determined is what portion of the total will be assigned to each year of ownership. Your organization has several choices.

Straight-line (See chart #1) and declining balance (accelerated) depreciation (See chart #2) are two of the most common. An example will illustrate each method. Let's assume that we purchased a $5,000,000 aircraft, plan to own it for five years, and estimate the resale value at $2,000,000.