Assets appreciate and depreciate with time. However, it is common for one to wonder what it means for an asset to have appreciation vs depreciation?
Generally speaking, appreciation is an increase in the value of any kind of asset vs depreciation on the other hand is the opposite of appreciation and is the decrease in the value of assets with time. Now that you know the basics, let’s take an in-depth review of appreciation vs. depreciation.
What Is Appreciation?
Like we said earlier, appreciation refers to the rise in the value of an asset due to some factors in the market space. Assets that can readily be liquified into cash appreciate. Some examples of these assets include currencies, bonds, real estate, or stocks.
In the world of accounting, appreciation refers to an optimistic adjustment of the initial value of an asset placed in a company’s account book. So, when assets appreciate, it means that the assets have become more valuable with time and are capable of having a high ROA.
How Does Appreciation Work?
Appreciation will occur when there is a change in the demand and supply of a service or product. This change could result in inflation and lower interest rates.
Practically, when there is an increase in demand for a commodity and a decrease in its supply, we can expect the value of that commodity to appreciate. The rise and fall in assets value vary largely with time.
It may fluctuate daily but this only occurs with traded commodities in the stock market. Some other assets are not tradable commodities like long term assets, however long-term assets may gain or lose their value with time. Real estate and equipment are examples of assets that fall into this category.
Types of Appreciation
An increase in price means the asset is more profitable and valuable at the moment. Once it decreases, its value decreases as well.
There are two ways appreciation occurs:
Capital appreciation is the increase in profit a firm receives from an investment bought at the market price. Also, it is the difference between the buying and selling price of an investment.
Usually, capital appreciation is not subject to tax until the profit, also known as “capital gain”, is realized. Capital appreciation is not the only source of investment returns.
Other sources of investment returns are dividends and interest incomes. The blend of capital appreciation with interest returns or dividends is also known as the total return.
Not all investments are in efforts towards capital appreciation. Some example of capital gain investments include:
Example Of Capital Appreciation
Here’s an illustration of capital appreciation below. Assume an investor buys a stock at $20 and he gets an annual dividend yield of 10% from the stock which equates to $2.
The stock began to trade at $25 per share the following year but he has already received his dividend of $2. The investor still has a return of $5 which resulted from the capital appreciation of the stock as its price increased from $20 to $25 per share leading to a 50% increase return from the capital appreciation.
If the original dividend income and yield is $2 (that is 10%), the return from the capital appreciation added to the returns from dividends will sum up to a total return of $8 or 60%
Currency appreciation is the increase in the value of currencies. A currency appreciates in relation to another currency, and this, in turn, impacts the forex market.
A currency can appreciate for various reasons such as:
- Trade balance
- Interest rates
- Business cycles
- Government policies
Most countries use currency appreciation to increase their financial prospect. Usually, currencies are traded in pairs which makes the value of one currency increase in contrast to the other.
It is however important to note that currency appreciation differs from the security value of a currency. Naturally, a forex trader will trade currency pairs with the expectation of appreciation of the base currency to the counter currency.
This is in contrast to stocks whose appreciation is dependent on the market’s assessment of its value.
Example of Currency Appreciation
Here is an illustration to further understand currency appreciation. A basic currency quotation records two currencies as a rate.
For instance, EUR/USD = 136.02. The first currency is (EUR) the base currency and usually represents 1 single unit. The second is the amount of currency that is necessary to equal the base currency. It is often represented by a fraction that is 1/136.02.
This means that you’ll need 136.02 U.S dollars to get 1 Euro. If the rate of U.S dollars increases to 140, then 1 Euro can purchase 140 U.S dollars making the Euro appreciate.
Therefore, an increase or decrease of a currency depends on the appreciation or depreciation of the base currency. Since 1 Euro can now get more U.S dollars, we can say that the currency of the Euro has appreciated.
What Is Depreciation?
Depreciation is a decrease in the value of an asset. In accounting, depreciation is seen from two perspectives:
- A decrease in assets value with time
- And a decrease in the value of an asset as a result of wear and tear
Rather than knowing the total cost of the assets, depreciation allows the company to stretch out the cost of the asset to generate income from it.
Depreciation can be treated by allocating the initial cost of an asset to the periods in which the assets are used in the account statement. This is can also be known as depreciation with the matching principle.
What Causes Depreciation?
There are numerous reasons why assets lose value over time. A few of those reasons are:
Short Life Span: Some assets have a short life span. This means that after a while they become less relevant. The condition applies more to inventories than fixed assets.
Depletion: If an asset is used for a while, it begins to wear out gradually and will need replacement. Depletion is more common with production equipment which usually has a recommended life span by the manufacturer. Other assets like constructions can be fixed up and upgraded so they can last for a longer time.
Obsolescence or Ineffectiveness: When a piece of equipment gets old and outdated, it can become obsolete. The result is that it will be replaced by new and effective equipment, thereby reducing the usability of the initial equipment.
How To Record Depreciation
The record of depreciation is kept on an the income statement and it’s done regularly. You can record depreciation by debiting depreciation expenses and crediting accumulated depreciation.
By the end of an accounting period, an accountant books the depreciation for assets that did not depreciate. This entry for depreciation includes a debit depreciation expense which goes through the income statement.
Then, a credit accumulated account that indicates an accumulated balance of depreciation is recorded on a balance sheet. An accumulated depreciation account is a contra asset account. This means that its normal balance is a credit that decreases the net asset value (NAV).
Here is an illustration below with a table showing the analysis of the residual value of a cargo van:
|Cargo Van – Initial Cost||$80,000||$80,000||$80,000|
|Cargo Van – residual value||$62,000||$57,000||$50,000|
A residual value (carrying value) is the total of the assets cost and accumulated depreciation. It is what is left on the balance sheet account after all depreciation has been recorded and until the van is sold or disposed of.
Also at the end of the useful life of an asset, the residual value is what the company would want to receive. Therefore, to record depreciation, the carrying value of an asset is important.
How To Calculate Depreciation
Further than recording depreciation, you’ll also need to understand how to calculate it. Let’s look at the different ways you can calculate depreciation.
Straight Line Method
The straight-line method is the easier and more common way to calculate depreciation. This method lets you deduct the same amount of depreciation each year over the useful life of the property. Here, you depreciate the asset to realize its salvage value.
Annual depreciation = Depreciation factor × (1/Lifespan) × remaining book value.
To calculate depreciation using the straight-line method, take the following steps:
- Find the asset’s cost
- Calculate the total depreciable amount (asset’s salvage value – asset’s cost)
- Determine the lifespan of the asset
- Then to get the annual depreciation, you divide the total of steps 1&2 by step 3.
The declining balance is used to record the larger part of an asset’s depreciation expenses during the early years of its life, and smaller depreciation expenses in its later years. It comes in handy for products that become obsolete rapidly.
Depreciation = SLDP × BV
SLDP = Straight-line depreciation percent
BV = Book value
This method has two variations. They are:
- The double-declining method
- The 150% declining method
Double Declining Balance
This method, can also be referred to as the reducing balance method. It is one of the two regular methods businesses use to account for the cost of a long-lived asset.
Depreciation = 2 × SLDP × BV
SLDP = straight-line depreciation percent
BV = Book value.
The double-declining balance is a type of declining balance. This method uses twice the normal depreciation rate, as opposed to straight-line depreciation which uses the same amount of depreciation for an asset’s life each year.
Units of Production
This is a depreciation method that enables you to determine the value of an asset based on its usage. The method is suitable for manufacturers whose machineries vary with clients demand because it corresponds to the cost and income.
Unit of production reflects the depletion of assets more precisely. To calculate the unit of production depreciation expense, you’ll need to divide the cost per unit rate of the asset by the total number of units the equipment produces throughout its useful life. Then, multiply by its unit produced during the year.
Depreciation Expense = (Cost basis of assets – salvage value) /Estimated total unit produced during the estimated useful life.
What Is The Key Difference Between Appreciation and Depreciation?
The major difference between appreciation and depreciation is that appreciation refers to an increase in the useful life of an asset while depreciation refers to a decrease in the life of an asset.
Useful life is the length of time your assets have before it depreciates. For an asset to be depreciable, it must have a determinable useful life. However, assets such as real estate, stocks, and land are not depreciated. This is because they do not wear out, get used up or become obsolete.
Having an understanding of how assets appreciate and depreciate is a vital tool for business owners and investors. With this knowledge, you’ll know what assets appreciate or depreciate, what assets may never depreciate, and what assets you need to own for a period to avoid money loss.
However, if you have this knowledge but still aren’t certain about what to do, we recommend consulting a skilled financial advisor. In the end, you and your financial advisor will be able to make the decisions best fit for yourself.