What is the Concept of Depreciation in Accounting?

What is Depreciation?

Depreciation is the process of rationally and systematically allocating to expend the cost of a plant asset over its useful life.

A firm typically owns a variety of long-lived assets, such as buildings, equipment, and vehicles. The period of service is known as the asset’s useful life. Since a building is expected to be of service for many years, on the date it is acquired, it is recorded as an asset rather than an expense.

To follow the expenses recognition principle, companies allocate a portion of this cost as an expense for the useful life of each period of the asset.

Example of Depreciation

Let’s assume you want to buy a Machine for your company. You spend $300,000 to buy it. We usually call that an investment in fixed assets. You could also call it capital expenditures.

Let’s assume that the machine has a useful economic life of 10 years and has no residual value. If you use straight-line depreciation, you book $30,000 per year in depreciation. The value of the asset on the balance sheet goes down by $30,000 per year, and in the income statement, you charge this $30,000 as an expense.

Features of Depreciation

The important features of depreciation are as follows:

  1. Depreciation is a revenue expenditure.
  2. The depreciation that occurs on fixed assets is not visible. So depreciation is an invisible cost.
  3. Depreciation is a non-cash expense. Unlike other expenses, depreciation does not cost any cash.
  4. Depreciation is not the actual cost. This is a kind of estimated cost.
  5. Depreciation is not charged on any current or short-term asset. Depreciation is usually imposed on fixed assets.
  6. Depreciation is charged on considering three elements i.e. Cost price of assets, Estimated Life of assets, and Salvage Value.

Importance of Charging Depreciation

The importance of charging depreciation is as follows

  1. Determination of Actual Profit or Loss
  2. Determination of Actual Financial Position
  3. Replacement of fixed assets
  4. Maintenance of capital
  5. Ascertainment of the actual cost of production
  6. For Dividend payments
  7. Determination of accurate value of assets
  8. Reduction of tax liabilities

What is the Reason for Charging Depreciation?

The reasons for depreciation can be divided into two parts.

  1. Internal Reasons
  2. External Reasons

1. Internal Reason:

  • The continued use of various types of fixed assets, such as buildings, machinery, etc., results in a reduction in its efficiency and value. This is one of the reasons for depreciation.
  • Depletion occurs as a result of the continuous extraction of resources from mines.
  • Wealth has a certain lifespan. As time passes, its production capacity gradually decreases. As a result, they are no longer useful. Time erosion is one of the reasons for depreciation.
  • Depreciation also occurs as a result of deterioration.

2. External Reason:

  • There are some properties that become worthless as a result of evolution over time or after a certain period of time. For example, patents, leases, etc.
  • New discoveries in science have led to the arrival of many new resources. As a result, many old assets, despite their efficiency, seem useless and have to be depreciated.
  • One of the reasons for depreciation is the depreciation of property due to accidents. For Example, Floods, earthquakes, etc.

Some Important Note about Depreciation

  • Depreciation is a cost-allocation process. It is not a valuation process of the assets. That is, the depreciation allocates the cost of an asset to the periods it is being used in.
  • Depreciation does not attempt to report the true change in the asset value.
  • The depreciation concept follows the going concern assumption. The going concern assumption states that for the foreseeable future, the company will continue to operate. If a company does not use an assumption of a going concern, then assets of the plant should be stated at their fair value. There is no need to depreciate those assets in that case.

Factors to be considered in Computing Depreciation

Three factors affect the computation of depreciation, which are as follows:

Cost: all necessary expenses to acquire the asset and make it ready for the intended use.

Useful life: an estimate of lifespan based on the need for repair, service life, and vulnerability to obsolescence. Useful life may express itself in terms of time, activity units (such as machine hours), or output units.

Salvage value: an estimate of the value of the asset at the end of its useful life. This value may be based on the value of the asset as scrap or the expected value of the trade-in.

Depreciation Methods

In general, depreciation is calculated using one of the following methods:

  1. Straight-line Method
  2. Units-of-activity Method
  3. Declining-balance Method

1. Straight-line Method

In the straight-line method, companies charge the same amount of depreciation on the useful life of the asset for every year. It is only determined by the passing of time.

In order to calculate depreciation costs in line with the straight-line method, companies need to determine depreciable costs.

Depreciable cost = (Asset Cost-Salvage value)

Annual Depreciation Expense= Depreciable cost/Useful Life

When a business uses an annual straight-line rate, the percentage rate is applied to the depreciable cost of the asset.

Annual Depreciation Rate= 100%/Useful Life

Annual Depreciation Expense= Depreciable Cost x Annual Depreciation Rate

How to Calculate Depreciation under Straight-line Method

For Example:

Cost of Delivery Van      $22,000

Expected Salvage Value  $2,000

Estimated Useful Life in Years  5 Years

Here,

Depreciable Cost         

= Cost- Salvage Value    

= ($22,000- $ 2,000)

= $ 20,000

Annual Depreciation   

= Depreciable Cost / Useful Life        

= $20,000/5

= $4,000

Alternatively,

Annual Depreciation Rate

= 100%/ 5 Years

=20%

Annual Depreciation Expense

= Depreciable Cost x Annual Depreciation Rate

= $20,000 x 20%

=$4,000

Calculation of Annual Depreciation:

YearDepreciable CostXDepreciation Rate=Annual
Depreciation
Expense
Accumulated DepreciationBook Value
(Cost-Acc. Dep)
202020,000X20%=4,0004,00018,000
202120,000X20%=4,0008,00014,000
202220,000X20%=4,00012,00010,000
202320,000X20%=4,00016,0006,000
202420,000X20%=4,00020,0002,000

Note that the depreciation expense of $4,000 is the same each year.

In practice the straight-line method is predominant. Such large firms use the straight line method. It is easy to apply and matches expenses with income when the use of the asset is reasonably uniform throughout the lifetime of service.

2. Units-of-Activity Method:

Under the unit-of-activity method, the useful life is expressed in terms of the total units of production or use expected from the asset, rather than in terms of the time period.

The unit-of-activity method is ideally suited for manufacturing machinery. Manufacturing companies can measure production in production units or in machine hours.

This method can also be used for assets such as delivery equipment (miles are driven) and aircraft (hours in use). The unit-of-activity method is generally not suitable for buildings or furniture because the depreciation of these assets is more a function of time than of use.

In order to calculate depreciation expense in line with the units of activity method, companies need to determine the depreciable cost and depreciable cost per unit.

Depreciable Cost = (Asset Cost-Salvage value)

Depreciable Cost per Unit= Depreciable Cost/total units of activity

How to Calculate Depreciation under Units-of-Activity Method

For Example:

Cost of Delivery Van                  $22,000

Expected Salvage Value              $ 2,000

Estimated Useful Life in Miles   100k Miles

Units of Activity during the Year 16K Miles

Here,

Depreciable Cost          

= Cost- Salvage Value    

= ($22,000- $ 2,000)

= $20,000

Depreciable Cost per Unit

= Depreciable Cost/Total units of activity

= $20,000/ 100000 miles

= $0.20

Annual Depreciation Expense

= Units of Activity during the Year x Depreciable Cost per Unit

= 16,000 x $0.20

= $3,200

Calculation of Annual Depreciation:

YearUnit of ActivityXDepreciation Cost/Unit=Annual
Depreciation
Expense
Accumulated DepreciationBook Value
(Cost-Acc. Dep)
202016,000X0.20=3,2003,20018,800
202120,000X0.20=4,0007,20014,800
202225,000X0.20=5,00012,200 9,800
202318,000X0.20=3,60015,800 6,200
202421,000X0.20=4,20020,000 2,000

The units-of-activity method is not nearly as popular as the straight-line method primarily because businesses often find it difficult to reasonably estimate total activity.

But this method is used by some very large companies. If an asset’s productivity varies significantly from one period to another, the method of units-of-activity results in the best matching of expenses with revenues.

3. Declining Balance Method

The method of declining-balance yields a decreasing annual depreciation expense over the useful life of the asset. The method is named so because the periodic depreciation is based on the asset’s decreasing book value (cost less accumulated depreciation).

Annual Depreciation Expense = Book value at the beginning of the year x declining-balance depreciation rate.

The declining-balance method, unlike the other methods of depreciation, does not use depreciable costs in computing the annual depreciation expense. That is, when determining the amount to which the declining-balance rate is applied, it ignores salvage value.

How to calculate Depreciation under Declining Balance Method

For Example:

Cost of Furniture                    $22,000

Expected Salvage Value          $ 2,000

Estimated Useful Life in Years  5 Years

Here,

Annual Depreciation Rate

= 100%/ 5 Years

=20%

A common declining-balance rate is double the straight-line rate. The method is often called the double-declining-balance method.

Depreciation Rate will be

= (2 X the straight-line rate of 20%)

= 40%

The computation of the first year’s depreciation on the delivery Van = 22,000X 40% = 8,800 The depreciation schedule under this method is as follows.

Calculation of Annual Depreciation:

YearBook Value
Beginning of the Year
XDepreciation Rate=Annual
Depreciation
Expense
Accumulated DepreciationBook Value
(Cost-Acc. Dep)
202022,000X40%=8,8008,80013,200
202113,200X40%=5,28014,0807,920
20227,920X40%=3,16817,2484,752
20234,752X40%=1,90119,1492,851
20242,851X40%= 85120,0002,000

*Computation of $1,140 ($2,851* 40%) is adjusted to $851 in order for book value to equal salvage Value.

In the early years, the declining-balance method generates higher depreciation expenses than in the later years. It is considered an accelerated-depreciation method. The declining-balance method is compatible with the principle of expense recognition.

In the early years, it matches the higher depreciation expense with the greater benefits received in these years. In later years, when the asset’s contribution to revenue is less, it also recognizes lower depreciation expense.

Due to obsolescence, some assets lose usefulness quickly. The declining-balance method provides the most suitable depreciation amount in these cases.

Journal Entry for Recording Depreciation

The entry to record depreciation every year would be

DateParticularsL.F.Debit
(Amount)
Credit
(Amount)
2020Depreciation Expense***
Dec. 31 Accumulated Depreciation***
(To record annual depreciation on Delivery Van)

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