The provision for depreciation is an accounting and a taxation term. Most fixed assets such as plants, equipment and vehicles decline in value over time as they are used and as they age. The provision for depreciation accounts for this by lowering their value each year on financial statements and on tax returns for a set period of time.
Depreciation expense can play a very large role on a company’s balance sheet and income statements. The depreciation provision might be very large each year in industries that rely on heavy equipment, factories and other expensive capital investments. The depreciation charge on the income statement can be a large number that spreads the initial cost of the investment in property, plant and equipment out over several years. It can also play a significant role on a tax filing by lowering the amount of income that is taxable, therefore lowering the effective tax rate of a company.
The function of a depreciation provision is to make a company’s balance sheet more accurately reflect the current value of the investments it has made in fixed assets over time. For example, if a corporation invests $500 million into a new factory, that amount will appear on its balance sheet as a long term asst. However, if that number is not lowered each year over time to reflect aging, wear and tear, and obsolescence, then the balance sheet would be incorrectly too high as a measure of the company’s assets. The depreciation provision gradually lowers this book value over time to reflect its declining real value.
The most common type of depreciation provision is straight line. This is calculated in a simple way by dividing the value or cost of the asset at the beginning of its life, and then dividing that amount by the number of years it is expected to be useful. If there is a salvage or residual value at the end of its life, then this number is lowered from the initial value number before dividing by the years.
More accelerated types of depreciation schedules can also be used, such as the double-declining balance method (DDB) and the sum-of-years-digit method (SOYD). The DDB method causes much higher depreciation provisions in earlier years to reflect the fact that most assets are more valuable when they are new. The SOYD method is a compromise between DDB and straight-line, falling in between the two in terms of the annual provision amount.
Other methods include using the actual production volumes of an asset each year divided by the total years that it is expected to be productive. For example, the amount of oil coming out of an oil field asset divided by the total number of production years might be utilized to make a provision.
The primary consideration in deprecation provisions is that the accounting or tax rules governing depreciation might not reflect the real world fair value of an asset. Both accounting and tax depreciation provision calculations are estimates, and the real fair value of a fixed asset at a given point in time should be determined by a market transaction.
The most obvious benefit of a depreciation provision, especially for tax purposes, is that there is a cash value to the shield to income caused by the provision. For example, if a company has a tax rate of 35 percent and has a non-cash depreciation charge of $1,000 dollars per year for tax purposes, then this provision has a value of 35 percent of $1,000 each year or $350.