You're probably already familiar with the terms appreciation and depreciation as they relate to the value of currency, or to the value of investments like stocks, bonds, or real estate. But in the world of accounting, appreciation and depreciation mean something a little different. Appreciation is when the value of an asset increases, and depreciation is when the value of an asset decreases.
Before you read further, here's a quick refresher on what an accounting transaction is.
What Causes Appreciation and Depreciation?
Appreciation can happen when there are changes in supply and demand (lack of supply and/or increased demand) of a product or service, as well as inflation and changing interest rates. When there is increased supply and a decrease in demand, depreciation comes into play.
The increase or decrease in value of an asset can fluctuate greatly over time, sometimes even on a daily basis as in the case of stocks or commodities traded on the stock market. Other assets, referred to as long-term assets, will lose or gain value more slowly over time. Some examples of long-term assets would include land, real estate, and equipment.
While depreciation happens more often in accounting than appreciation, your company may see appreciation in assets like trademarks as your brand becomes more well known. However, since depreciation of assets is much more common, let's explore in greater detail how it's calculated for accounting purposes.
How is Depreciation Calculated?
Before getting into the two basic methods of calculating depreciation in accounting, let's take a look at a couple of key assumptions that come into play. The first assumption is the expected useful lifetime of an asset, which is just what it sounds like: the length of time you can expect an asset, such as a piece of equipment or a vehicle, to be useful to your company (i.e., generating revenue for your business). The second assumption related to depreciation is the salvage value of an asset: the estimated resale value the asset will hold at the end of its useful lifetime.
The two basic methods used to calculate depreciation are the straight line method of depreciation and the accelerated depreciation method. The more straightforward of the two is the straight line method of depreciation, where the difference between the cost of the asset and it's expected salvage value is divided by the number of years you expect to use the asset: depreciation expense = (cost of asset - salvage value) / number of years of useful life of asset.
By using the accelerated method of depreciation (such as the double declining balance method), you are able to make larger deductions in the value of an asset earlier on in its useful lifetime. (This method is generally used for income tax purposes.)
Appreciation, Depreciation, and Your Financial Statements
Generally speaking, the detailed calculations of the appreciation and depreciation of your company's assets will not be listed on your financial statements (i.e., your income statement, balance sheet, or cash flow statement). However, certain details about appreciation and depreciation of your assets may be noted in the footnotes of these statements, and could be something investors and other interested outside parties look at.
How you record the appreciation and depreciation of your company's assets does have an impact on your net income (aka your bottom line). Thus this information is important not only for investors, but also when it comes to forming an accurate picture of your company's financial health, both in the short- and long-term.
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