What Is Depreciation?

What is Depreciation?

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

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.

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.

An example of Depreciation – If a delivery truck is purchased a company with a cost of Rs. 100,000 and the expected usage of the truck are 5 years, the business might depreciate the asset under depreciation expense as Rs. 20,000 every year for a period of 5 years.

How to calculate depreciation in small business?

There three methods commonly used to calculate depreciation. They are:

1. Straight line method
2. Unit of production method
3. Double-declining balance method

Three main inputs are required to calculate depreciation:

1. Useful life – this is the time period over which the organisation considers the fixed asset to be productive. Beyond its useful life, the fixed asset is no longer cost-effective to continue the operation of the asset.

2. Salvage value – Post the useful life of the fixed asset, the                 company may consider selling it at a reduced amount.This is known as the salvage value of the asset.

The cost of the asset – this includes taxes, shipping, and preparation/setup expenses.

Unit of production method needs the number of units used during production. Let’s take a look at each type of Depreciation method in detail.

1) Straight-line depreciation method

This is the simplest method of all. It involves simple allocation of an even rate of depreciation every year over the useful life of the asset. The formula for straight line depreciation is:

Annual Depreciation expense = (Asset cost – Residual Value) / Useful life of the asset

Example – Suppose a manufacturing company purchases a machinery for Rs. 100,000 and the useful life of the machinery are 10 years and the residual value of the machinery is Rs. 20,000

Annual Depreciation expense = (100,000-20,000) / 10 = Rs. 8,000

Thus the company can take Rs. 8000 as the depreciation expense every year over the next   ten years as shown in depreciation table below.

 Year Original cost – Residual value Depreciation expense 1 Rs. 80000 Rs. 8000 2 Rs. 80000 Rs. 8000 3 Rs. 80000 Rs. 8000 4 Rs. 80000 Rs. 8000 5 Rs. 80000 Rs. 8000 6 Rs. 80000 Rs. 8000 7 Rs. 80000 Rs. 8000 8 Rs. 80000 Rs. 8000 9 Rs. 80000 Rs. 8000 10 Rs. 80000 Rs. 8000

2) Unit of Production method

This is a two-step process, unlike straight line method. Here, equal expense rates are assigned to each unit produced. This assignment makes the method very useful in assembly for production lines. Hence, the calculation is based on output capability of the asset rather than the number of years.

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: ABC company purchases a printing press to print flyers for Rs. 40,000 with a useful life of 1,80,000 units and residual value of Rs. 4000. It prints 4000 flyers.

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

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

3) Double declining method

This is one of the two regular techniques an organization uses to represent the costs of a fixed resource. This is a quickened deterioration strategy. As the name proposes, it considers cost twice much as the book estimation of the advantage each year.

The equation is:

Deterioration = 2 * Straight line devaluation percent * book an incentive toward the start of the bookkeeping time frame

Book esteem = Cost of the advantage – gathered devaluation

Amassed deterioration is the all out devaluation of the repaired resource aggregated to a predefined time.

Model: On April 1, 2012, organization X bought a gear for Rs. 100,000. This is required to have 5 helpful life years. The rescue esteem is Rs. 14,000. Organization X considers deterioration cost for the closest entire month. Figure the deterioration costs for 2012, 2013, 2014 utilizing a declining balance technique.

Useful life = 5

Straight line depreciation percent = 1/5 = 0.2 or 20% per year

Depreciation rate = 20% * 2 = 40% per year

Depreciation for the year 2012 = Rs. 100,000 * 40% * 9/12 = Rs. 30,000

Depreciation for the year 2013 = (Rs. 100,000-Rs. 30,000) * 40% * 12/12 = Rs. 28,000

Depreciation for the year 2014 = (Rs. 100,000 – Rs. 30,000 – Rs. 28,000)  * 40% * 9/12 = Rs. 16,800

Depreciation table is shown below:

 Year Book value at the beginning Depreciation rate Depreciation Expense Book value at the end of the year 2012 Rs. 100,000 40% Rs. 30,000 * (1) Rs. 70,000 2013 Rs. 70,000 40% Rs. 28,000 * (2) Rs. 42,000 2014 Rs. 42,000 40% Rs. 16,800 * (3) Rs. 25,200 2015 Rs. 25,200 40% Rs. 10,080 * (4) Rs. 15,120 2016 Rs. 15,120 40% Rs. 1,120 * (5) Rs. 14,000

Depreciation for 2016 is Rs. 1,120 to keep the book value same as salvage value.

Rs. 15,120 – Rs. 14,000 = Rs. 1,120 (At this point the depreciation should stop).

Why should small businesses care to record depreciation?

So now we know the importance of deterioration, the strategies used to figure them, inputs required to ascertain them and furthermore we saw instances of how to compute them. How about we discover with respect to why the private companies should mind to record devaluation.

As we definitely know the motivation behind deterioration is to coordinate the expense of the fixed resource over its beneficial life to the incomes the business gains from the benefit. It is extremely hard to legitimately connect the expense of the resource for incomes, thus, the expense is normally appointed to the quantity of years the benefit is gainful.

Over the valuable existence of the fixed resource, the expense is moved from monetary record to salary articulation. On the other hand, it is only a distribution procedure according to coordinating rule rather than a strategy which decides the honest evaluation of the fixed resource.

Accounting entry – DEBIT depreciation expense account and CREDIT accumulated depreciation account.

On the off chance that we don’t utilize deterioration in bookkeeping, at that point we need to charge all advantages for cost once they are purchased. This will bring about immense misfortunes in the accompanying exchange time frame and in high benefit in periods when the relating income is considered without a counterbalance cost. Consequently, organizations which don’t utilize the deterioration cost in their records will bring about front-stacked costs and exceptionally factor budgetary outcomes.

Final Notes

Deterioration is a significant piece of bookkeeping records which assists organizations with keeping up their pay proclamation and asset report appropriately with the correct benefits recorded. Utilizing a decent business bookkeeping programming can assist you with recording the deterioration accurately without committing manual errors.

You can attempt Profit Books. It is a basic bookkeeping programming which gives you a chance to make proficient solicitations, track costs and compute charges with no bookkeeping information.

Tayyab Shah

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