Economic depreciation is defined as the wear and tear of an asset beyond its expected capacity or utility which means that suppose we have an asset and we expected the depreciation run to go for four years but it becomes obsolete and scrap in a span of only three years it is said to be economically depreciated.
Economic depreciation is generally termed as the process by which assets lose their market value due to some kind of influential factors which overall leads to the degradation of the market value of the asset. At times when the owners need to sell their assets, they prefer economic depreciation over accounting depreciation when they want to sell their assets at the market rate. Also, economic depreciation broadly impacts the sale price of any kind of asset which the owners want to sell in the market. It is very common among owners to keep a check and monitor the rate of economic deprecation pertaining to the asset one wishes to sell.
When it comes to accounting for business needs, accountants will never record economic depreciation in their books of accounts or financial statement for big capital assets. Instead, they prefer to use the book value of the particular asset for the main reporting needs. One of the keys areas where economic depreciation is considered for financial analysis is in the field of real estate. Economic depreciation can also serve as a need of forecasting methodology when the analyst wants to forecast how much of revenue the good or service will generate in the future.
Economic Depreciation vs Accounting Depreciation
The method of calculation of economic depreciation is much more complex than that of calculating the accounting depreciation. When it comes to accounting depreciation an asset suppose for example a non-tangible one is amortized based on a fixed schedule i.e. it is more time-based and this schedule we call in accounting term amortization schedule, whereas in cases of economic depreciation there is no fixed period or schedule involved. It gets amortized based on some influencing factor which affects its market value. The same goes for tangible assets too.
In accounting depreciation, the depreciation is calculated over a set period of time or schedule whereas in economic depreciation the value of asset gets depreciated quite before the set point of time due to some influencing factor that affects the market value of the asset.
The rate of economic depreciation is considered to be almost half of that of accounting depreciation. This difference between both results in the provision of a subsidy and also the replacement of capital at an earlier stage. Economic depreciation can be easily created on a model platform or accounted for by the creation of impairment charges. Economic depreciation is more based on the concept of capital investment
whereas accounting depreciation is driven tax laws or IRS rules which states that if a machine has a life of 5 years it will be depreciated at the same rate regardless of how much life more it could stay in service.