What is Depreciation?
The word Depreciation simply means a decline in price. Depreciation is the accounting process of allocating the cost of tangible assets to current expenses in a systematic and rational manner, in those periods expected to benefit from the use of the asset. It associates with a decline in the value of assets due to four main reasons:
- Physical wear and tear – due to continuous usage of assets
- Passage of time
- Exhaustion – the inability of the asset in providing service
- Obsolescence – assets become outdated
So nearly all fixed assets in business like plant and equipment, machinery, buildings, furniture and others depreciate due to these reasons during the useful life of the asset.
However, the depreciation of fixed assets is not seen as an expense like any other day to day expenses in business because depreciation is a non-cash expense. There is no loss of money from the business. We spent money to buy an asset and depreciation allocates the value of the asset over the years in which we use it.
Importance of Depreciation
- To get a true picture of the business
- To not overstate profits
- Shows gradual reduction in the value of assets
- To match benefits received from the assets to the cost incurred
- To know the current value of the fixed assets
- To comply with the legal requirements and taxes
- Indirectly retains cash in the business which helps to buy/replace old assets
How to calculate Depreciation?
Depreciation can be calculated on a monthly basis in two different ways:
- Straight-line method:
A common and simple method of depreciating an asset is the straight-line method which determines the estimated salvage value(scrap value) of an asset at the end of its life and then subtracts that value from its original cost(purchase price). The difference is divided by the number of years in the asset’s useful lifespan. The result obtained is the value that is lost over time during the asset’s productive use which is also the total depreciation amount.
- Declining balance method:
There are two variations in this:
The double-declining balance method and the 150% declining balance method. This method is more complicated than the straight-line method because the depreciation amount changes from year to year in these methods.
This method is often used if an asset is expected to have greater utility in its earlier years. With the declining balance method, management expenses depreciate at an accelerated rate rather than evenly over a particular number of years.
The formula for calculating depreciation by the declining balance method is:
Declining Balance Method = (Net Book Value – Residual Value)*Rate of Depreciation(in %)
Under the Double Declining Balance method, the depreciation is computed by the formula:
DDB = (2 / Useful life of asset)*(Cost – Accumulated Depreciation)
Which method to use?
The straight-line depreciation method is the easiest to use, which makes it ideal for small businesses that need to depreciate fixed assets.
On the other hand, the declining balance method provides a more accurate accounting of the value of an asset.
In short, the depreciation method to be used depends on the nature of assets and the preference of the company involved.