Depreciation is a calculation of wearing out, consumption, or other loss of value of a depreciable asset arising from use, effluxion of time, or antiquation through technology and market changes. Depreciation is allocated for charging a good proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Depreciation involves the amortization of assets whose useful life is pre-planned.
In accounting, depreciation is referred to as reducing the original cost of a fixed asset in a prescribed manner until the asset’s value becomes nil. For example, if a transport company buys a truck for Rs. 200,000, and its useful life is five years, then the business will depreciate the asset under depreciation expense as Rs. 40,000 each year for 5 years.
The main elements while calculating depreciation :
- Useful life – Period when the business considers the assets to be productive. After the asset is utilized for the period of useful life, the asset is no longer cost-effective to continue the operation of the asset.
- Salvage value – The residual cost can be recovered by selling the asset after its useful life.
- Cost of the asset – This includes the entire cost of the asset that a company pays to purchase, including expenses on tax, shipping, etc.
- Depreciation Rate – This is a percentage charged as depreciation on the fixed asset.
VARIOUS METHODS OF DEPRECIATION:
i) Straight-Line Method: This is often the easiest depreciation method. In this method, the asset’s value depreciates with the same amount every year until it reaches nil. Suppose if an asset has a useful life of 10 years, its value will depreciate by 10% each year. The formula for calculating depreciation under this method is as follows:
Straight Line Method = (Cost of Asset – Salvage Value) / Useful Life
ii) Unit of Production Method: In this method, depreciation is computed by measuring the asset’s work rather than the number of years it serves. Here, equal expense rates are allocated to each production unit. To calculate the units of production depreciation, first, we need to calculate per-unit depreciation with the following formula:
Per Unit Depreciation = (Cost of an Asset– Salvage Value) / Useful Life in Units of Production
Hence, total depreciation based on the actual units produced will be calculated by the following formula:
Total Depreciation = Per Unit Depreciation x Units Produced
iii) Double-Declining Balance Method: Double-declining depreciation is an enhanced form of depreciation, wherein a higher percentage of value is lost in the early stages of the asset’s useful life. This method is useful when resources are consumed faster in the first few years. The formula for calculating depreciation under this method is given below:
Depreciation = 2 x Straight Line Depreciation Rate x Book Value at the Beginning of the Year
Depreciation accounting is essential as it helps in providing an accurate picture of the organization’s profitability. Depreciation helps ascertain how much value assets have lost over the years. If we don’t factor it into the revenue of the Company, it could mean that costs are being underestimated. In addition, depreciation plays a crucial role in tax. If companies do not account for depreciation in their books, they will pay more tax.