Depreciation Calculation, Formula, Meaning, and Methods

Depreciation meaning

What is depreciation in accounting?

The term depreciation in accounting refers to the method a company uses in the allocation of the cost of a tangible or physical asset over its life expectancy or useful life. It is a representation of the rate at which the value of an asset has been used. The act of depreciating assets helps companies to earn revenue from the asset while charging a portion of its cost each year of the asset’s use. The failure to account for can have a great effect on a company’s profits. Also, companies can depreciate long-term assets for both tax and accounting purposes. Depreciation ties the cost of using a physical asset over its useful life.

Fixed assets such as plants and machinery and other equipment are costly. Instead of realizing the entire cost of an asset in one year, companies use depreciation to spread out the cost and generate revenue from it. This gives companies the opportunity to write off the value of an asset over a period of time, notably its useful life. Companies may as well use it to account for declines over time in the carrying value, that is the difference between the asset’s original cost and the accumulated depreciation over the years.

Companies account for this on a regular basis for a company to be able to move the cost of the asset from the balance sheet to the income statement. In this case, a company records the purchase of an asset as a debit to increase an asset account on the balance sheet and a credit to reduce cash or increase accounts payable which are also in the balance sheet. No journal entry has an effect on the income statement where the account reports revenues and expenses.

Depreciation of fixed assets

At the end of an accounting period, an accountant accounts for depreciation for all capital assets that have not been totally depreciated. Here, the journal entry comprises a debit to depreciation expense which flows through the credit side of the income statement to accumulated depreciation which appears on the balance sheet.

As we have seen, firms and businesses can take advantage of depreciation for the purpose of both accounting and tax. By implication, they can take a tax reduction for an asset’s cost, reducing taxable income. Most times, the Internal Revenue Service (IRS) points out that it is compulsory for companies to spread the cost out over time when depreciating assets. There are also rules that apply for when companies can take a deduction. The IRS usually makes a publication of depreciation schedules showing in detail the number of years a company can depreciate an asset for tax purposes, on the basis of the different classes of assets.

Depreciation is therefore a non-cash charge since it is not a representation of an actual outflow of cash. It is possible that the company pays the entire cash outlay at the purchase of the asset. However, the incremental record of the expense is necessary for the purpose of the financial report. The reason is the fact that assets are beneficial to the company over a long period of time. Although these depreciation charges still amount to a reduction in a company’s earnings, it is helpful for tax purposes.

Under the Generally Accepted Accounting Principles (GAAP), the matching principle is an accrual accounting concept that dictates that the company must match expenses to the same period in which it generated the related revenue. Depreciation helps in tying the cost of an asset to its benefit of use over time. In essence, a company uses the asset each year from which it generates revenue. So, the company will also record the incremental/additional expense that has to do with the use of the asset.

What is depreciation in economics?

Depreciation in economics is a decrease in the economic value of an asset over a period of time resulting from influential economic factors. This form of depreciation basically has to do with real estate which is bound to lose its value for several reasons. These reasons can include the addition of unfavorable structures in close proximity to a property, the closure of roads, a decline in a neighborhood’s quality, and other negative factors.

Depreciation in economics varies from that of accounting in the sense that in accounting, a company charges expenses on an asset over a specific period of time on the basis of a set schedule.

As earlier stated, in economics, depreciation is a measure of the value that an asset loses as a result of influential factors thereby affecting its market value. The owners of assets tend to give closer consideration to economic depreciation than accounting depreciation if they look towards selling an asset at its market value. It is therefore important to the owners of assets that seek to sell their properties in the open market. This implies that economic depreciation has a great effect on an asset’s selling value in the market. Economic depreciation is usually not notated on financial statements in business accounting, for large capital assets since accountants make use of the book value as the primary method of reporting.

Many instances exist whereby economic depreciation is considered in financial analysis. Real estate, as mentioned above, is one of the most remarkable examples. However, analysts can also consider it in other situations also. This metric can also be a factor in forecasting future revenues for goods and services.

Economic depreciation vs accounting depreciation

To calculate economic depreciation is usually not as simple as in accounting depreciation. In accounting, the value of a tangible asset decreases over time on the basis of a set depreciation schedule. In economics, the decreases in the value of an asset are not necessarily uniform or scheduled, they are based on influential economic factors.

Oftentimes, economic depreciation can take place with real estate. In periods of economic depression or downturn or a general decline in the housing market, economic depreciation can amount to a market value decrease. The housing market environment has the ability to play a significant role in the valuation of real estate but also, unfavorable neighborhoods construction, neighborhood quality decline, road closures, etc. can affect individual valuations. Any type of negative economic factor can bring about depreciation as well as a lower appraisal value. The difference that exists in value from one appraisal to another can show the economic depreciation of a property.

Appraisals are key factors when it comes to understanding economic depreciation. They can take place on all types of assets and are usually the largest determinants of economic depreciation.

Also, financial analysts may consider economic depreciation in the course of forecasting future projections and cash flows. In these scenarios, economic depreciation will be on the basis of the reduction in the value of expected revenues from goods and services as a result of negative economic factors.

Causes of depreciation

Depreciation can be caused by the following factors;

  • Wear and tear
  • Perishability
  • Usage rights
  • Natural resource usage or depletion
  • Inefficiency/obsolescence
  • Destruction or damage
  • Passage of time
  • Poor maintenance

Wear and tear

Every asset is bound to break down overtime during the period of usage as parts wear out and need a replacement. In other words, it is the physical deterioration of an asset. As time goes on, the asset will wear away beyond repairs and at this point, replacements will be impossible. This is the most common cause for equipment used in production. Here, the asset/equipment has a manufacturer’s recommended life span that is usually on the basis of a certain number of units produced. For other assets such as buildings, it is possible to repair and upgrade them over long periods of time. In essence, the value of an asset decreases proportionately in the case of wear and tear.

Perishability

For some assets, their life span is extremely short. This is most applicable to inventory rather than fixed assets. It is another factor that causes an asset (non-fixed) to depreciate over time.

Usage rights

A fixed asset can also imply the right to make use of something such as a database or software for a specific period of time. In this case, the life span of an asset expires when the usage rights expire. With this, depreciation must attain its completion at the end of the usage period.

Natural resource usage or depletion

In a situation whereby an asset is a natural resource such as an oil or gas reservoir, the act of depleting the resource brings about depreciation. So, instead of referring to this as depreciation, we will refer to it as depletion. The pace of depletion is bound to change if a company subsequently alters the estimate of its reserves remaining.

Obsolescence

More efficient equipment will render some equipment obsolete. This brings about a reduction in the usability of the original equipment. In other words, obsolescence refers to the reduction of the value of assets due to the availability of up-to-date alternative assets. This comes about as a result of the emergence of new inventions and innovations. Although the asset is still in usable condition, users prefer the latest ones to it. This then brings about the loss of its value. An example is when users prefer the latest computers to the old ones.

Destruction or damage

Destruction or damage to an asset can cause the asset to depreciate. When this comes about, the company will need to write off or write down the asset/equipment to reflect its reduction in value and possibly shorter useful life/life expectancy. Another variation on the concept of depreciation is the impairment of assets where the carrying cost is higher than its market value. In the event of impairment, accountants charge the difference to expenses which amount to the reduction of the carrying amount of the asset. In essence, we can say that impairment and damage are factors that bring about depreciation because either of the events brings about a change in the amount of depreciation remaining to be recognized.

Furthermore, damage to an asset can be caused by fire accidents, natural disasters, etc. We can refer to these events as abnormal factors. In some cases, they may lead to a state of the asset being discarded.

Passage of time

There are certain assets that become potentially less useful with the passage of time whether the users use them or not.

Lack of maintenance

Naturally, good maintenance increases the life span of an asset. This also means that when the maintenance is poor, it increases the chances of depreciation.

Depreciation formula 

The straight-line method is the most widely used method of depreciating assets; other methods and formulae are discussed below. The formula is expressed in the following format;

Annual depreciation = (Cost of asset – Salvage value) / years of useful life

Cost of asset

The cost of the asset also refers to its initial book value which includes taxes paid, shipping charges, etc.

The useful life

The useful life of the asset is the period of time for which the asset can function properly. When the asset lives beyond its useful life, then it is said to be cost-ineffective or unfit for usage or operation. For a few assets like computers, real estate, and other equipment, the use is defined by the respective revenue authority. For instance, computers are usually depreciated over five years while vehicles are depreciated over eight years.

Salvage value

The asset’s value after its useful life at which the company may sell it. it is also known as the scrap value or residual value.

Depreciation calculation and methods

There are various methods applied for calculating depreciation, these are:

  • Straight-line method
  • Reducing/declining balance or diminishing method
  • Double-declining balance (DDB) method
  • Sum of the years’ digit method
  • Unit of production method

Straight-line method

Using the straight-line method to depreciate assets is the most basic way of accounting for depreciation. This method provides a report showing an equal amount of depreciation expense each year throughout the entire useful lifespan of the asset until the entire asset is depreciated to its salvage value. In this case, the accountant will subtract the salvage value (scrap value) of the asset from its cost to determine the amount that can be depreciated. In other words, when you subtract the asset’s salvage/scrap value from its original cost, the remaining amount is the depreciable cost. Now, this depreciable cost becomes the total amount of depreciation that a company must expense in equal amounts over the asset’s estimated years of useful life.

After subtracting the cost from the scrap value, then we divide the remaining amount by the number of years in the asset’s lifespan. This is the simplest method of depreciating assets.

Formula

Calculating depreciation using the straight-line method is done by dividing the depreciable amount by the total number of years.

Dep. = (Cost – salvage value) / years of useful life

If for instance a company buys equipment at $5,000 and decides a salvage value of $1,000 and an estimated useful life of 5 years.

Example and Calculation

Using the formula above, the calculation will be like this;

Dep. = ($5,000 cost – $1,000) / 5 years

= $4,000 / 5 years

Dep. = 800

The annual depreciation is $800

Based on these assumptions, the depreciable amount is $4,000 ($5,000 cost – $1,000 salvage value).

To convert it to a percentage (depreciation rate), we will do this;

Dep. rate = ($800÷ $4,000) x 100

Dep. rate = 0.2 x 100

Therefore, the depreciation rate is 20%

Reducing/declining balance method

The declining balance method is also known as the diminishing method. It is an accelerated method of depreciation where the asset is depreciated at its straight-line depreciation percentage multiplied by its remaining depreciable amount each year. Because the carrying value of the asset is higher in earlier years, the same percentage brings about a larger depreciation expense amount proportionately in earlier years. In other words, this method recognizes the majority of the depreciation of assets earlier in its lifespan. The declining balance method is more complicated than the straight-line method. By implication, the amount of depreciation changes from year to year using either of the methods.

Also, accountants use this method to write off depreciation costs more quickly and minimize tax exposure. In this case, depreciating assets does not take place evenly over the years as it is in the straight-line method. Also, if a company expects its asset to have a greater utility in earlier years, then it makes use of this method. This method is helpful in creating a larger realization of gain at the sale of the asset. Some companies may also use this method which is an even more aggressive method of depreciation for early expense management.

To calculate depreciation using this method, we will depreciate the asset at its straight-line depreciation rate and multiply it by its depreciable amount each year. As explained above, the depreciable amount changes as each year passes because the factor is multiplied by the asset’s net book value of the previous period (usually a year). The value decreases over time because of the accumulated depreciation.

Formula

Dep. = Depreciation rate (straight-line) x Book Value at the beginning of the year

OR simply,

Dep. = CBV × DR

where,

CBV=current book value

DR=depreciation rate (%)

The two formulas mean the same thing.

Calculation and examples

When we use the straight-line example above, the cost of the machine is $5,000, its salvage value is $1,000, and its life expectancy is 5 years. The depreciation rate is 20% for each year while the expense is $800 for the first year.

For the second year;

Dep. = ($4,000 – $800) x 20% or 0.2

= $3200 x 20%

Dep = $640

So, we can apply the same principle to the subsequent years. With this, it is easy to notice that with each year, the balance keeps decreasing.

Double declining balance (DDB) method

This is another accelerated method of depreciation. In this case, you take the asset’s useful life’s reciprocal and multiply it by two, that is doubling it. Here, accountants apply the figure to the depreciable base, book value, for the remainder of the asset’s life expectancy. For example, if an asset that has a useful life of five years will have a reciprocal of 1/5 or 20 percent, to double the rate, we would apply 40 percent to the current book value of the asset for depreciation. Although the rate remains unchanged or constant, the currency value will decrease over time. This is because we multiply the rate by a smaller depreciable base for each period.

Formula

Using the double-declining balance method, we will calculate the depreciation using the declining balance method and multiply it by two. We can simplify it in the formula below;

Dep. = 2(SLDP×BV)

where,

SLDP = Straight-line depreciation percent

BV = Book value at the beginning of the period

Now let use the declining balance calculation for the second year above. Note that the same principle applies to subsequent years.

Example and Calculation 

Using the formula above;

Dep. = 2 (20% x $4,000 – $800)

= 2 (20% x $3200)

=  2 ($640)

Dep. = $ 1,280

Sum-of-the-year’s-digits (SYD)

The SYD method also makes provision for accelerated depreciation. So to begin this method, we would combine all the digits of the expected years of the useful life of the asset. This method provides for a depreciation rate that accelerates more than the straight-line method but accelerates less than the declining balance method. We separate the annual depreciation into fractions using the number of years of the useful life of the asset. These assets may include machinery, furniture, building, vehicles, equipment, and electronics. Also, the SYD method is more appropriate than the straight-line method if an asset depreciates faster or possesses greater production capacity during its earlier years.

For instance, if an asset has a five-year life expectancy, it would have a base of the sum digits from one through five, that is 5 + 4 + 3 + 2 + 1 = 15. In the first year, we would depreciate 5/15 of the depreciable base. In the second year, we would depreciate 4/15 of the depreciable base. This process will continue down to the fifth year where we would depreciate the remaining 1/5 of the base.

Formula

To begin the sum-of-the-year digit method, we would combine all the digits of the expected years of the useful life of the asset. Under this method, the following formula is used;

Dep. = (Remaining useful life of the asset/sum of the year) x depreciable cost

In the first three methods above, we used one question, let us consider the following example;

Example and Calculation

A company purchased a machine at the cost of $250,000 with a scrap value of $25,000. The expected useful life of the asset is 5 years.

To carry out the calculation using this method, we would prepare a table (schedule) showing the depreciation expense for each year;

Table showing the depreciation expense for each year
Year
Dep. base ($)
Machine’s remaining life
Dep. fraction
Display of calculation
Dep. expense ($)
Cost of machine
Calculating the book value
Book value ($)
1
225,000
5
5/15
(5/15) x 225,000
75,000
250,000
250,000 – 75,000
175,000
2
225,000
4
4/15
(4/15) x 225,000
60,000
250,000
250000 − 60,000
115,000
3
225,000
3
3/15
(3/15) x 225,000
45,000
250,000
250000 − 45,000
70,000
4
225,000
2
2/15
(2/15) x 225,000
30,000
250,000
250000 − 30,000
40,000
5
225,000
1
1/15
(1/15) x 225,000
15,000
250,000
250000 − 15,000
25,000
15
225,000

As seen in the table above, the depreciation base came about after subtracting the depreciation expense from the initial cost of the asset, which is 250,000 – 25,000 =225,000. Secondly, we summed the year digits, 1+2+3+4+5 = 15, we displayed the machine’s remaining life, starting from year 5 as seen in the third column above. From there, we calculated the depreciation expense using each year digit divided by the sum of the year digit multiplied by the depreciation base. Lastly, we subtracted the depreciation expense for each year from the initial cost of the asset (250,000), arriving at the book value for each year.

Units of production depreciation method

The units of production method require an estimate for the total units that an asset will produce over its useful life. Here, we calculate the depreciation expense per year on the basis of the number of units produced. This method as well also calculates depreciation expenses on the basis of the depreciable amount. This method assigns an equal rate of expense to each unit produced. This, in turn, makes it most useful for assembly or production lines. The formula has to do with the use of historical costs, that is the asset’s price based on its nominal and original cost when a company acquires it and estimated salvage/scrap value. This method is then the determinant of the expense for the accounting period times the number of units produced.

Formula

Analysts oftentimes use the unit of production method in mining operations’

Dep. expense (unit) = (Fair value – residual value) / useful life (in units)

Annual depreciation = Dep. expense (unit) x units produced

There may be an interchange in the phrases (salvage value, residual value, and scrap value). Note that they all mean the same thing.

Calculation and Example

A company purchased a machine worth $100,000 with a scrap value of $5,000 and the units of production are 95,000.

Let us now calculate the depreciation using the formula;

Dep. expense (unit) = (Fair value – residual value) / useful life (in units)

= ($100,000 – $5,000) / 95,000

= $95,000 / 95,000

Dep. = $1.

Accumulated depreciation

Another name for accumulated depreciation is cumulative depreciation. It is a representation of the total amount of depreciation of an asset to a given point. In other words, it is the total amount of the asset’s depreciation over its useful life. When you add up all the depreciation expenses for a capital asset over an ownership course, then the summation is the accumulated depreciation. An asset’s carrying value on the balance sheet is the difference between its purchase price and the accumulated depreciation. A business would buy and hold an asset on the balance sheet until the salvage value correlates with the carrying value.

Accumulated depreciation is applicable to all capitalized assets, these are assets that provide value for more than one year. Accounting rules dictate that one has to match the expenses and sales in the period it incurred them. We can therefore say that depreciation profers a solution for this matching problem for capitalized assets. A fraction of the asset’s cost in the year of purchase and for the remaining useful life of the asset is considered a depreciation expense.

In essence, after calculating depreciation using the methods mentioned above (straight-line, declining balance, SYD, DDB, and units of production), the summation represents the accumulated depreciation.

It is the accumulated depreciation that a company uses in calculating the book value of its asset. A company carries this amount on its balance sheet. The netbook value is the figure remaining after subtracting accumulated depreciation from the cost of an asset.

Depreciation expense

Depreciation expense refers to the portion of the fixed asset that is considered as consumed in the current period. Companies charge this to expense with the intention of gradually reducing the carrying amount of the fixed assets as their value decreases over time. However, this is a non-cash expense which means that there is no cash outflow associated with it.

When a company makes an entry to the depreciation expense account, then the offsetting credit goes to the accumulated depreciation account which is a contra asset account that offsets the fixed asset account. In the course of the fiscal year of the entity, the balance in the depreciation expense account increases. This is then flushed out and set to zero as part of the end of the year closing process. In the next fiscal year, accountants use the account again to store depreciation charges.

We can apply the same concept to intangible assets where the associated expense account. This concept is known as amortization.

When a long-term asset is purchased, it should be then the company should capitalize it instead of expending it within the accounting period of the asset’s purchase. For instance, if the asset will be economically useful and yield returns beyond that initial accounting period, expensing it immediately would lead to an overstatement of the expense in that period and understatement in all future periods. For a company to avoid doing so, there is a need to use this depreciation to better match the expense of a long-term asset to the periods in offers value or to the revenue it generates.

Accumulated depreciation vs depreciation expense

Both have to do with the wearing out of an asset and help to state its actual value. However, there are significant differences.

Accumulated depreciation is the total amount of the asset’s depreciation over its useful life. On the other hand, a depreciation expense is the amount of depreciation a company records on the balance sheet of a company for a single accounting period. This implies that if one is to add up all the depreciation expenses for an asset over the course of ownership, the summation will then represent its accumulated depreciation.

The major difference that exists between the two concepts is that one appears as an expense in the income statement and profit and loss account while the other is a contra asset reported on the balance sheet.

Under the standard principles of accounting, accumulated depreciation is a contra asset that should appear in the balance sheet of a company. Analysts use it to forecast the lifetime of an asset or to keep track of depreciation over the years. On the other hand, the regular depreciation expenses have to be debited from income statements.

Tax depreciation

Tax depreciation is the expense a taxpayer claims on a tax return in order to compensate for the loss incurred in the value of tangible assets used in activities that are income-generating. Just like accounting depreciation, tax depreciation charges depreciation expenses over multiple periods. Also, the tax values of depreciable assets decrease gradually over their years of useful life.

Depreciation expenses are treated as tax deductions by tax authorities. This implies that taxpayers can claim depreciation expenses for tangible assets that are taxable to reduce their taxable income and the tax amount owing.

Tax rules with regard to depreciation can vary across different tax jurisdictions. The case is similar for assets that are eligible for a claim of tax depreciation expense, it may vary across countries as well. There are several criteria for tax authorities to consider assets eligible for depreciation claims that are present in various jurisdictions. The criteria include;

  • The taxpayer owns the asset
  • The asset is meant for income-generating activities
  • A determinable useful life of the asset
  • The useful life should exceed one year

A taxpayer owns the asset

A taxpayer only has the right to claim tax depreciation for those assets that belong to him.

The asset is meant for income-generating activities

Only assets that are employed in income-generating activities or businesses are eligible for the claim of tax depreciation. This implies that any asset that is mainly for personal use is not eligible for this claim.

The asset has a determinable useful life

Also, for an asset to be eligible for a depreciation claim, it must have a useful life that one can reasonably estimate. In other words, there should be a provision for a reasonable estimate for the number of years in which the asset will be actively functioning until the time it ceases to produce economic value or becomes obsolete.

The useful life exceeds one year

Another important criterion that an asset should meet for the claim of tax depreciation is that it should be a long-term asset. In other words, the useful life should be more than one year.

Amortization

Amortization refers to an accounting technique that analysts and companies use to lower a loan or an intangible asset’s loan over a set period of time. In other words, it is the process of writing down the value of either an intangible asset or a loan. Pertaining to loans, amortization pays attention to spreading out the payment of loans over time. Applicable to a physical asset, amortization is the same as depreciation. Lenders such as financial institutions make use of amortization to present a loan repayment schedule on the basis of a specific maturity date. Amortizing intangible assets over time helps to tie the cost of an asset to the revenues which the asset generates according to the matching principle of Generally Accepted Accounting Principles (GAAP).

In essence, the term, amortization makes reference to two situations. First, in the process of debt payoff through regular principal and interest payments over a specified period of time. It usually payments in installments in this situation.

The second situation is that amortization makes reference to the spreading out of capital expenses in relation to intangible assets over a specific period of time. This is usually over the useful life of the asset for accounting and tax purposes.

Amortization vs depreciation

Both amortization and depreciation are similar in the case of a reduction in the cost of an asset. They are both non-cash expenses which implies that the company suffers no cash reductions when these expenses are recorded.

The two terms, however, differ in the sense that depreciation makes reference to physical assets or property while amortization essentially involves depreciating intangible assets such as intellectual property or interest on the loan over time.

Advantages of depreciation

The act of depreciating assets is advantageous in the following areas;

  • Matching cost
  • Cost/expense recovery
  • Company’s asset valuation
  • Tax deduction

Matching cost

One significant advantage of depreciation is that it helps companies to express the measure of the cost required in a reasonable manner which results from the use of the asset during an accounting period. This is to properly match expenses incurred in the use of the asset with revenue the asset generates in a specific period of time in accordance with the reference for business. Without properly charging the purchase cost of an asset to depreciation expense, companies are bound to understate or overstate the total expenses and as well misstate revenues thereby reporting financial information that is misleading.

Cost/expense recovery

Making use of depreciation expense paves a pathway for recovering the purchase cost of an asset. This is because it is a non-cash expense against revenue which allows companies to set aside part of their income for asset replacements in the future. Without depreciating assets, a company is bound to inappropriately use part of the income for other purposes.

Company’s asset valuation

The use of depreciation expense helps companies to provide a correct report for assets at their net book value. Companies can correct the value of their assets which helps them to reflect the wear and tear the asset may have based on the number of its useful years. Initially, companies record the original costs of fixed assets. The value of an asset, however, decreases over time as a result of usage that is bound to cause wear and tear. With this, it is necessary for companies to adjust the value of their asset to their net remaining value. Therefore, the net book value of an asset is its original cost minus its accumulated depreciation.

Tax deduction

Depreciation is helpful to companies in terms of generating tax savings. The rules of tax allow companies to use depreciation expense as a tax deduction against revenue and this enables them to arrive at the taxable income. The taxable income decreases as the depreciation expense become higher and proportionately, a company will be able to increase its tax savings. There are times that companies make use of accelerated depreciation to charge higher depreciation expenses in specific periods when they expect to generate higher revenue in order to reduce taxable income thereby achieving tax savings.

Limitations of depreciation

Despite the advantages of depreciation, it has the following limitations;

  • The problem of lower future deduction
  • Quicker deductions than usual
  • Difficulty in accurately ascertaining the depreciation rate

The problem of lower future deduction

The lower deduction of an asset can pose challenges for businesses that are still growing. The declining balance does not provide for tax deductions with higher forthcoming upfront deductions at the expense of lower deductions in the future. This implies that accelerating deductions will provide for fewer options to reduce taxes in the future because the company will be in a higher tax bracket.

Quicker deductions than usual

Depreciating assets provides room for companies to deduct expenses quicker than the assets will actually wear out. This can bring about a distortion in business decisions with regard to what, when, and how to invest.

Difficulty in accurately ascertaining the depreciation rate

The estimated life span of an asset is highly dependent upon many factors such as its maintenance and handling. The length of the time of operation and the quality of the asset’s parts are other determinants. These factors and many others do not always reflect in the depreciation rate. This can therefore complicate the calculation.

Currency depreciation

Currency depreciation refers to the fall in a currency’s value in terms of its exchange rate against other currencies. This implies that the value of a currency falls in a floating exchange rate system. It can occur as a result of factors such as economic fundamentals, political instability, variations in interest rate, or risk aversion on part of investors. It is therefore important to note that depreciation does is not applicable to a company’s assets (tangible ad intangible) alone, it is also applicable to a country’s economy. So in all cases, it has to do with a decrease in value.

Economies that have weak economic fundamentals such as chronic deficits in their current accounts and high rates of inflation have depreciating currencies in general terms. If a currency depreciation is orderly and gradual, it can improve the export competitiveness of a country and as well improve its trade deficit as time goes on. On the other hand, if an extremely steep currency depreciation occurs, it will scare foreign investors away because they will fear that the currency may further fall. In turn, this makes them pull portfolio investments out of the country thereby putting further downward pressure on the currency. Easy monetary policy and high inflation are two major factors that bring about currency depreciation.

In a floating exchange rate system, the value of a currency can go up or down if the demand for it increases or decreases than its supply does. This can take place in the short run in an unpredictable manner for various reasons. These reasons include the balance of trade, speculation, and other factors present in the international capital market. For instance, a sudden increase in the purchase of foreign goods can bring about a sudden increase in the demand for foreign currency necessary to pay for those goods. This will certainly bring about depreciation in the local currency.

Speculative movements of funds can also bring about depreciation or appreciation of a currency. This usually occurs when there is a belief that there is an undervaluation or overvaluation of a currency, anticipating correction. So these movements bring about a change in the value of a currency. A lower or higher rate of home inflation has a tendency of bringing about a long run of currency appreciation or depreciation, on average than the inflation in other countries, according to the principle of long-run purchasing power parity.

Economic effects

When the currency of a country depreciates, it becomes more difficult to buy foreign goods because they become more expensive in the domestic market. Also, the price of domestic that foreigners pay for will rise up thereby decreasing the foreign demand for domestic products. The reverse will be the case when the currency appreciates in relation to foreign currencies. This will rather make foreign goods become cheaper in the domestic market thereby bringing about downward pressure on domestic prices. By implication, currency depreciation brings about a fall in the purchasing power of a country’s currency as it can longer buy a specific quantity of foreign goods at a particular price as it used to be.

Also, when a country’s currency depreciates, the balance of trade of a country tends to increase by bringing about an improvement in the competitiveness of domestic goods in foreign markets. On the other hand, foreign goods become less competitive in the domestic market because they become more expensive. Balance of trade is the difference between a country’s exports and imports. This implies that in an economy whose currency depreciates, its goods become cheap in the foreign market while foreign goods become more expensive in the domestic market. The effect is clear that while other countries enjoy the benefits of getting local goods at a cheaper rate, the country enjoys fewer benefits as its affordability of foreign goods decreases rapidly.

This, in effect, brings about a foreign exchange loss in a local currency, unlike appreciation that brings about foreign exchange gain. If a country’s currency appreciates, the value of financial instruments dominated in that currency will increase. This also means that when a country’s currency depreciates, there will be a fall in the value of financial instruments dominated in that currency. This can have an adverse impact on debt instruments.

In order to be able to predict either depreciation or appreciation of a currency, traders make use of an economic calendar. The calendar includes economic releases that help in determining the economy’s strengths and weaknesses. So, if a trader is only aware of the growth in the country’s GDP whose currency he trades declined in comparison with the forecast, then he can predict or expect the domestic currency’s fall.

These terms are common when we talk about the central bank monetary policy. Because the central bank is a single authority that issues money, its policies have a great impact on the domestic currency. A domestic currency will appreciate if the central bank decides to raise the interest rate or becomes optimistic while issuing comments on the country’s economy. If the central bank does otherwise, then the domestic currency will depreciate. That is, the domestic currency depreciates if the bank decides to cut the interest rate or signals problems for the economy

Appreciation

In general terms, appreciation is a situation whereby the value of an asset increases over time. Different factors can bring about appreciation such as changes in inflation and interest rates and an increase in demand or weakening supply. The term means the opposite of depreciation where a value decreases over time.

Appreciation, in general terms, is an increase in the value of an asset over time. The increase can occur for a number of reasons, including increased demand or weakening supply, or as a result of changes in inflation or interest rates. This is the opposite of depreciation, which is a decrease in value over time.

So the term appreciation is usable in reference to an increase in any category of assets such as stocks, bonds, currency, or real estate. The appreciation of an asset does not necessarily imply a realization of an increase on part of the owner. If one revalues his assets at a higher price on the financial statements, then he is bound to realize an increase.

Appreciation can also take place in terms of a country’s currency, that is currency appreciation. A country’s currency value can either appreciate or depreciate over time in relation to foreign currencies.

Appreciation vs depreciation

In accounting, appreciation is an increase in the value of a company’s assets held in accounting books.  Depreciation on the other hand typically implies a loss in an asset’s economic value due to usage.

Appreciation is less frequent because such assets as trademarks and patents may experience an upward shift in value due to an increase in brand recognition. Depreciation on the other hand is more frequent as it takes place periodically usually a year.