Accounting for Depreciation

Concept of Depreciation

Most plant and equipment assets wear out or become obsolete over the years. Similarly, although land is not depreciated (because it does not wear out), improvements to land, such a paving or fences, are depreciated because these improvements wear out or become obsolete over time. The portion of assets "used up" (wear out) each year is referred to as depreciation.

Depreciation is the way to calculate the reduction in value of any fixed assets due to use, wear, tear and obsolescence. It is the method to calculate deduction in price of any fixed assets due to wear and tear that reduces the monetary value of the assets.

Nature of Depreciable Assets

The depreciable assets can be found by reviewing the following characteristics of the assets listed as bellows:

Ability to use more than one accounting period
Having a limited useful life
Use for production of goods or services
Use for rent, etc.
Large investment requirement
Capital Expenditure in Nature, etc.

Factors Affecting Depreciation Expenses

Depreciation for each assets is usually calculated separately and is based on four factors:

Asset's Costs: It is the cost of an assets that include acquisition cost, installation cost and commission cost. It is also known as net cash outlay.
Asset's Estimated Life: It is the life of an assets that is estimated by various factors such as contract, law, physical deterioration etc.
Asset's Salvage Value: It is the value that is expected to get after completing the useful life of an assets. It is also referred to as residual or scrap value of an assets.
Method of Depreciation: It is way to calculate or determine the annual depreciation expenses to deduct from its original price of an assets over its useful life.
Legal Provision: It is a law of the country or particular body of concerned industry that is determined the minimum rate for depreciation expenses on an assets.
Repair and Renew: It is way to meet expected useful life of an assets by repairing and renewing the assets condition over the period.

Terms related with Depreciation

Depletion: It refers to the process of estimating and recording the periodic charge to operations owing to the exhaustion of natural resource such as oil, coal, or standing timber. The main difference between depletion and depreciation is that the former is concerned with utilization of a bundle of economic resources, but the later relates to the usages of an assets.
Obsolescence: It refers to a state of an existing assets becoming out of date on account of the availability of a better model due to improvements in technology or changes in demand pattern. Obsolescence is the output of events external to the assets, which significantly reduces the net economic value of the physical output, provided by it.
Amortization: It is often used as a general term to write off intangible assets such as patents, copyrights, franchises, leasehold minus which have entitlement to use for a specific period of time. The procedure for amortization or period write off, of a portion of the cost of intangible assets is the same as for recording depreciation of fixed assets.

Need for Depreciation

The following reasons that need to depreciation are listed as follows:

Matching of costs and revenues
Consideration of tax
Fair-financial position
Recording the true impact of an expenses
Compliance with law

Methods of Depreciation

There are following methods are used to depreciation based on asset's nature and company's policy are listed as follows:

Straight Line Method: Under this method, the same amount is deducted from its value every year over its useful life. It can be calculated as:
Annual Depreciation Expenses = (Cost of Assets - Salvage Value)/ Useful Life
Diminishing Balance Method: Under this method, a fixed percentage on the book value of assets is charge every year. It can be calculated as:
Annual Depreciation Expenses = Net Value of Assets * Depreciation Rate in %
Declining Balance Methods: Under this method, the asset is depreciated at higher rate in the initial year than in the subsequent years. It can be calculated as:
Annual Depreciation Expenses = (Cost of Assets - Salvage Value)* Depreciation Rate in %
Production Units Method: Under this method, the depreciation is charged based on unit produced during the year. It can calculated as:
Annual Depreciation Expenses = Depreciable Value * (Units Produced During the Year / Total Estimated No. of Units Over Its Useful Life)
Where, Depreciable Value = Cost of Assets - Salvage Value
Sum of the years' digit method: Under this method, the depreciation is charged based on useful life and digit of each year to find the annual depreciation rate. It can be expressed as:
Annual Depreciation Expenses = Latest Ending Year/ Sum of Years' Digit up to Its Useful Life
Example: An assets having 5 year useful life, the depreciation rate will be:
- Total digits up to useful life = 1+2+3+4+5 = 15
- Annual Depreciation Rate

Note 1: The percentage of all the above years should add up to 100%

Note 2: Under Double Declining Balance depreciation method, the value of assets is depreciated at twice the rate it is done in straight line depreciation method. It can be calculated as:

Annual Depreciation Expenses = 2*Cost of Assets * Depreciation Rate in %

Note 3: Depreciation Rate in % = 1/Useful Life *100

Conclusion

The portion of assets "used up" (wear out) each year is referred to as depreciation. Depreciation for each assets is usually calculated separately and is based on four factors include cost, useful, residual value and depreciation method. It is the method to calculate deduction in price of any fixed assets due to wear and tear that reduces the monetary value of the assets. Basically, there are two most depreciation methods widely used which are straight line and diminishing balance method.

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