DEPRECIATION                              

         


   What is Depreciation?

 

v Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy.

 

v In accounting terms, depreciation is defined as the reduction of recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible.

 

v An example of fixed assets are buildings, furniture, office equipment, machinery etc.. A land is the only exception which cannot be depreciated as the value of land appreciates with time.

 

v Depreciation allows a portion of the cost of a fixed asset to the revenue generated by the fixed asset. This is mandatory under the matching principle as revenues are recorded with their associated expenses in the accounting period when the asset is in use. This helps in getting a complete picture of the revenue generation transaction.

 

v An example of Depreciation – If a delivery Van is purchased a company with a cost of Rs. 5,00,000 and the expected usage of the truck are 10 years, the business might depreciate the asset under depreciation expense as Rs. 50,000 every year for a period of 10 years.

 

v Depreciation represents how much of an asset's value has been used up. Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use. If not taken into account, it can greatly affect profits.


  Recording Depreciation


 

When an asset is purchased, it is recorded as a debit to increase an asset account, which then appears on the balance sheet, and a credit to reduce cash or increase accounts payable, which also appears on the balance sheet.

Neither side of this journal entry affects the income statement, where revenues and expenses are reported.

In order to move the cost of the asset from the balance sheet to the income statement, depreciation is taken on a regular basis.

 

At the end of an accounting period, an accountant will book depreciation for all capitalized assets that are not fully depreciated. The journal entry for this depreciation consists of a debit to depreciation expense, which flows through to the income statement, and a credit to accumulated depreciation, which is reported on the balance sheet. Accumulated depreciation is a contra asset account, meaning its natural balance is a credit that reduces the net asset value (NAV). Accumulated depreciation on any given asset is its cumulative depreciation up to a single point in its life.

 

Carrying value is the net of the asset account and accumulated depreciation. The salvage value is the carrying value that remains on the balance sheet after all depreciation has been taken until the asset is sold or otherwise disposed of. It is based on what a company expects to receive in exchange for the asset at the end of its useful life. As such, an asset’s estimated salvage value is an important component in the calculation of depreciation.

 

 Method of Depreciation

 


1.   Straight-Line : Depreciating assets using the straight-line method is typically the most basic way to record depreciation. It reports equal depreciation expense each year throughout the entire useful life until the entire asset is depreciated to its salvage value.

 

Example: A company buys a machine at a cost of Rs 5,000. The company decides on a salvage value of Rs 1,000 and a useful life of 5 years. Based on these assumptions, the depreciable amount is Rs 4,000 (Rs 5,000 cost – Rs 1,000 salvage value) and the annual depreciation using the straight-line method is: Rs 4,000 depreciable amount / 5 years, or Rs 800 per year. As a result, the depreciation rate is 20% (Rs 800/ Rs 4,000). The depreciation rate is used in both the declining balance and double-declining balance calculations.

 

2.   Declining Balance : The declining balance method is an accelerated depreciation method. This method depreciates the machine at its straight-line depreciation percentage times its remaining depreciable amount each year. Because an asset's carrying value is higher in earlier years, the same percentage causes a larger depreciation expense amount in earlier years, declining each year.

 

Example : Using the straight-line example above, the machine costs Rs 5,000, has a salvage value of Rs 1,000, a 5-year life, and is depreciated at 20% each year, so the expense is Rs 800 in the first year (Rs 4,000 depreciable amount * 20%), Rs 640 in the second year ((Rs 4,000 - $800) * 20%), and so on.

3.   Double Declining Balance (DDB) : The double-declining balance (DDB) method is another accelerated depreciation method. After taking the reciprocal of the useful life of the asset and doubling it, this rate is applied to the depreciable base, book value, for the remainder of the asset’s expected life.

 

Example : An asset with a useful life of 5 years would have a reciprocal value of 1/5 or 20%. Double the rate, or 40%, is applied to the asset's current book value for depreciation. Although the rate remains constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable base each period.

 

4.   Sum-of-the-Year's-Digits (SYD) : The sum-of-the-year’s-digits (SYD) method also allows for accelerated depreciation. To start, combine all the digits of the expected life of the asset.

 

Example : An asset with a 5 year life would have a base of the sum of the digits one through five, or 1+ 2 + 3 + 4 + 5 = 15. In the first depreciation year, 5/15 of the depreciable base would be depreciated. In the second year, only 4/15 of the depreciable base would be depreciated. This continues until year five depreciates the remaining 1/15 of the base.

 

5.   Units of Production : This method requires an estimate for the total units an asset will produce over its useful life. Depreciation expense is then calculated per year based on the number of units produced. This method also calculates depreciation expenses based on the depreciable amount.

The steps are:

 

Step 1: Calculate per unit depreciation:

 

Per unit Depreciation = (Asset cost – Residual value) / Useful life in units of production

 

Step 2: Calculate the total depreciation of actual units produced:

 

Total Depreciation Expense = Per Unit Depreciation * Units Produced

 

Example: XYZ company purchases a Machine for Rs. 40,000 with a useful life of 1,80,000 units and residual value of Rs. 4000. It produce 4000 units of product.

 

Step 1: Per unit Depreciation = (40,000-4000)/180,000 = Rs. 0.2

 

Step 2: Total Depreciation expense = Rs. 0.2 * 4000 units = Rs. 800

 

So the total Depreciation expense is Rs. 800 which is accounted. Once the per unit depreciation is found out, it can be applied to future output runs.