What is depreciation?

Depreciation is important to project managers because it has an effect on the overall justification of a project, equipment, and other capital assets that are used on projects and the profitability of projects to the company. Depreciation can make a difference between a project that is justified and one that is not. It can also influence the choice of equipment that is needed for a particular project.

Depreciation is an accounting method of deferring the expense of capital asset items so that the cost of an item is spread out over the useful life of the item rather than taking the full cost of the item in the year in which it is purchased.

There are two methods of depreciation: straight-line depreciation and accelerated depreciation. Straight-line depreciation spreads the cost of the asset evenly over its useful life while accelerated depreciation takes more of the cost of the asset earlier in its life rather than later.

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If we did not have depreciation methods to account for capital assets, it would be very difficult to make any sense out of a company's financial statements. Without depreciation methods, if a company purchased a large capital asset, it would have to recognize the cost of the asset in the year that it was purchased. Even though the asset had a life of several years, all of the cost associated with acquiring the asset would be recognized in the year it was purchased.

This recognition of all of the cost of the asset in the first year it is purchased would cause a company's financial statements to be irregular from year to year. Investors, seeing a reduction in profits, would not be able to tell whether the company had suffered a loss in business, which is bad, or simply purchased capital assets, which is generally good. For this reason we have depreciation.

Depreciation simply says that if we buy a capital asset that has a life of some years, we should distribute the cost of the asset over the years that are equal to its useful life rather than recognizing all of the cost in the first year of its life. This will also have an effect on the taxes the company pays.

For example, say a company purchased a machine for $100,000 and the machine had a useful life of ten years. Furthermore, the machine had a scrap value of $3,000. If we did not depreciate the machine, we would have to show an expense of $100,000 in the first year. This is an expense that occurs only once in ten years so once every ten years, the company's profits would be unusually low. For the other nine years there would be no machine expense, and the company would show an unusually high profit. A better way of accounting for this machine is to distribute the expense of the machine over the ten years of its life.

To use any of the depreciation methods, we need to know three things about the asset: the useful life of the asset, the original cost of the asset including delivery, installation, and start-up costs, and the scrap value of the asset at the end of its useful life. The depreciation expense is the amount of expense that is recorded each year during the life of the asset. This expense is the amount by which before-tax profit is reduced.

Perhaps a little accounting is in order to explain what is going on here. When a capital asset is purchased, the company pays for the asset with cash. The transaction reduces the company's cash assets by the amount of the purchase and increases the company's equipment assets by the same amount. There is no change in the company's total assets; there has been a trade between the two accounts. Each year the depreciation amount for the year is calculated, and the depreciation expense reduces the net profit before taxes by the same amount. At the same time, the asset account for the equipment is reduced by the same amount.

For the following examples we will use the same asset. The asset has a purchased cost of $39,000. The purchased cost of the asset includes shipping, installation, and start-up. Installation and start-up include the initial tooling that the equipment needs to make it function. It has a useful life of eight years and a scrap value of $3,000.

Straight-line depreciation

Straight-line depreciation is the simplest method of depreciation. We start with the purchase price of the asset. From this we subtract the scrap value and divide the remaining value by the number of years of useful life.

In Figure 4-9 it can be seen that the depreciation taken each year is the same, $4,500. Each year the accumulated depreciation increases by $4,500, and the book value of the equipment is reduced by the same $4,500. The $4,500 of depreciation is taken each year until the scrap value is reached. From this point on, if the asset is still owned by the company, depreciation expense is no longer taken. If the asset were sold before the end of its useful life, the difference between the selling price and the remaining depreciation would be taken as depreciation expense in that year.

Year	Depreciation	Accum. dep.	Book value
1	4,500	4,500	34,500
2	4,500	9,000	30,000
3	4,500	13,500	25,500
4	4,500	18,000	21,000
5	4,500	22,500	16,500
6	4,500	27,000	12,000
7	4,500	31,500	7,500
8	4,500	36,000	3,000
Annual depreciation is 36,000/8 = 4,500

Figure 4-9: STRAIGHT-LINE DEPRECIATION

Suppose the asset were sold at the end of year four for $20,000. At the end of year four, the remaining book value is $21,000. We would take the $1,000 of depreciation expense and clear the asset from our books. If the same asset were sold for $25,000, we would show a profit of $4,000. A depreciation expense of $21,000 would be taken, $25,000 would be added to the cash account, and $4,000 would be added to the equity account as profit on the machine.

Accelerated depreciation is used because it effectively reduces taxes on the company. Although the total amount of depreciation expense taken is the same as it is in straight-line depreciation, with the accelerated depreciation method, the depreciation taken in the earlier years is significantly greater than it is in the later years. Since larger amounts of depreciation mean that the depreciation expense is larger, the net profit before taxes is going to be smaller. The taxes are figured on the net profit before taxes, so the taxes will be lower as well. Now the total amount of tax the company pays over the years is going to be the same regardless of the depreciation method, but some of the taxes will be deferred to a later time. Since the money we pay someone (the IRS in this example) later in time has less value, we will profit from accelerated depreciation.

This may all seem a bit strange, but it is a win-win situation all around. Companies like to accelerate their depreciation because it reduces their taxes in the early years of the equipment's life. The government likes this too because it encourages the company to sell the equipment before the end of its useful life and buy a new piece of equipment. The new piece of equipment not only makes the company more profitable and pays the government more taxes, it also makes profit for the equipment manufacturer, who in turn pays taxes on that money to the government as well.

Sum of the years' digits

This is an accelerated depreciation method (see Figure 4-10). The depreciation for each year is calculated by first taking the digit of each year of the equipment's useful life and adding them together.

Year	Factor	Deprec.	Accum.	Book value
1	8/36	8,000	8,000	31,000
2	7/36	7,000	15,000	24,000
3	6/36	6,000	21,000	18,000
4	5/36	5,000	26,000	13,000
5	4/36	4,000	30,000	9,000
6	3/36	3,000	33,000	6,000
7	2/36	2,000	35,000	4,000
8	1/36	1,000	36,000	3,000
Sum of years' digits = 1+2+3+4+5+6+7+8 = 36

Figure 4-10: SUM OF THE YEARS' DIGITS

In our example the equipment has a useful life of eight years, so we add 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 = 36. The first year we take 8/36 of the allowable depreciation; in the second year we take 7/36 of the allowable depreciation; in the third year we take 6/36 of the allowable depreciation, and so on. Adding the numerator of the fractions we get 36/36. That is, we have taken all of the allowable depreciation.

Notice that in the sum of the years' digits depreciation method, we are still taking $36,000 depreciation just as we did using the straight-line method. Notice too that we still have $3,000 of scrap value. The only difference is that we have taken larger amounts of depreciation in the earlier years than we did in the later years.

Double declining balances

This is another accelerated depreciation method. The first thing we do in this method is calculate the percentage of depreciation that would apply if we were using straight-line depreciation. In our example of straight-line depreciation we were taking straight-line depreciation over a period of eight years. That would be 12.5 percent each year. So, the double declining balances percentage is 25 percent. The depreciation expense for each year is taken by multiplying the remaining book value of the asset by 25 percent.

As can be seen in Figure 4-11, we start with a remaining book value of $39,000. This can be thought of as the remaining book value at the end of year zero, the time we purchased the asset. Multiplying $39,000 by 25 percent gives us the first year's depreciation of $9,750. This $9,750 is subtracted from $39,000 to give us $29,250, which is the book value at the end of year one. $29,250 is multiplied by 25 percent to get the next year's depreciation expense of $7,310.

Year	Deprec.	Accum.	Book value
1	9,750	9,750	29,250
2	7,310	17,060	21,940
3	5,490	22,550	16,450
4	4,110	26,660	12,340
5	3,090	29,750	9,250
6	2,310	32,060	6,940
7	1,970	33,800	4,970
8	1,970	35,100	3,000

Figure 4-11: DOUBLE DECLINING BALANCES

The calculation is continued until the last two years of the asset's life. For the last two years the scrap value is subtracted from the remaining book value and the difference is divided by two and used as the depreciation expense for both years.

The calculations for depreciation may seem a bit strange for engineers who are used to having things depend on natural laws of physics and other logical causes. Some accounting rules—including depreciation methods—are not subject to the laws of nature but are subject to "generally accepted accounting practices". These are the rules of accounting that are agreed to by committees of qualified accountants. As long as everyone follows the same rules and the calculations for things like depreciation are carried out consistently, businesspeople, the IRS, and investors can all be confident that everyone is performing the same calculations in the same way.