Depreciation: Definitions, 3 Methods of Depreciation,

Depreciation is an accounting method used to allocate the cost of a tangible or physical asset over its useful life. It represents how much of an asset’s value has been use and allows companies to earn revenue.From the assets they own by paying for them over a certain period. 

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Depreciation is define as the decrease in the actual value of an asset over a period. Because of use, wear and tear, or obsolescence. It is a non-cash business expense that is allocated and calculated over the period. That an asset is useful to your business.

“Depreciation refers to the process of estimating and recording the periodic charges to expense due to expiration of the usefulness of a capital asset”– Malchman and Slavin.

According to J.N. Carter, “Depreciation is the gradual and permanent decrease in the value of an asset from any cause,” 

J.R. Batiliboi defined depreciation as “Depreciation represents loss or diminution in the value of an asset consequent upon wear and tear, obsolescence, effluxion of time, or fall in the market value.”

The Institute of Chartered Accountants of England and Wales has described depreciation as “Depreciation represents that part of the cost of fixed asset to its owner which is not recoverable when the asset is finally put out of use by him. Provision against this loss of capital is an integral cost of conducting the business during the effective commercial life of the asset and is not dependent upon the amount of profit earned.”

 A.N. Agrawal said that “Depreciation is a permanent, continuing and gradual shrinkage in the value of a fixed asset.”


Importance of Depreciation in Accounting and Finance

Depreciation allows companies to recover the cost of an asset. When it was purchased and cover the total cost of an asset, and achieve the matching principle of accounting. Depreciation expense shows the use of assets.

 And allows businesses to spread costs over time rather than in a single year. So, by recording depreciation expenses. So companies can accurately reflect their financial position by reducing their net income and increasing their expenses.

  • Depreciation is a way of spreading an asset’s cost across its useful life, representing the asset’s fall in monetary value as a result of usage and wear and tear.
  • Depreciation is a non-cash expense. So it means that it does not command any cash. However, it still affects a company’s cash flow and profits. So that it reduces the asset’s value on the balance sheet.
  • It is an accounting technique that helps companies/business to measure the cost of an asset to its future value and determine which investments are the most cost-effective.
  • Depreciation helps companies understand how much an asset costs over time and calculates its profit, which is essential for determining the value of a company’s assets when securing a business loan.

  • It can affect a company’s tax liability, as it reduces the profits evenly and taxes payable each year.
  • Proper depreciation can help a company maximize the benefits of the expense and make the most of the tax benefit.
  • Depreciation is necessary for companies to accurately measure their net income over an accounting period, as it is an expense that must be accounted for.
  • It is used to record an asset’s current carrying value, which shows the asset’s market price and reflects the asset’s decrease in market value over time.
  • Depreciation can have an impact on a company’s cash flow, and as a non-cash item, all depreciation and amortization entries for the fiscal year must be adjusted to the cash flow statement.
  • Depreciation schedules can range from simple straight-line to accelerated or per-unit measures, and companies can use different depreciation methods to allocate the depreciation cost yearly.

  • It is deductible as a business expense in accordance with IRS rules, and businesses create accounting depreciation schedules with tax benefits in mind.
  • It can also be compared with amortization/decrease, which accounts for the change in value over time of intangible assets.

3 Methods of Depreciation

The three methods of depreciation are: 

  1. Straight-line method, 
  2. Written down value method, 
  3. Units of production method,

The three methods of depreciation are:  Straight-line method,  Written down value method,  Units of production method,

Straight-line depreciation is often chosen by default. Because it is the simplest depreciation method to apply. It involves calculating the asset’s cost, subtracting its projected value. And dividing the result by the number of years it will be useful. 

The written-down value method applies a constant rate of depreciation to the net book value of assets each year. The units of production method quantify an asset’s useful life in terms of the total number of units. It can produce over its lifetime. Other methods for calculating depreciation allowable under GAAP include double declining balance and sum-of-the-years’ digits.

Straight-line Method

The Straight-line method is the most simple and easy-to-use method for calculating depreciation. It is also the most commonly use method. The Straight-line method calculates depreciation by dividing the cost of an asset by its useful life. The result is the amount of depreciation that is recorded each year.

For example, if a company spends $30,000 on a car with a 5-year useful life, the annual depreciation expense is $6,000 ($30,000 divided by 5 years).

This sum is recorded on the company’s income statement each year until the asset reaches the end of its useful life.

  • The straight line method allows assets to be completely depreciated over time.
  • The calculation method is simple and easy to understand, reducing miscommunication.
  • It is suited for small firms with a limited number of assets and machinery.
  • Total depreciation knowledge can be obtained by multiplying yearly depreciation with the number of years the asset has been used.
  • This method is suitable for assets with a lower value associated with them, making calculation faster and easier.
  • It is suitable for firms with a mixture of old and new assets, achieving a balance of maintenance costs.

Written Down Value Method:

The Written down value method, also known as the reducing balance method. Calculates depreciation based on the net book value of an asset. Net book value is the original cost of the asset minus the accumulated depreciation.

The Written down value method is often use for assets. That lose their value quickly or have a shorter useful life. The depreciation expense is higher in the earlier years of the asset’s life and decreases over time.

For example, if a business purchases a machine for $50,000 with a useful life of 4 years and a salvage value of $10,000, the net book value of the machine at the end of year 1 would be $37,500 ($50,000 – $12,500 in accumulated depreciation). 

The depreciation expense for year 1 would be $12,500 (25% of the net book value). The net book value at the end of year 2 would be $22,500 ($50,000 – $27,500 in accumulated depreciation). And the depreciation expense for year 2 would be $9,375 (25% of $37,500).

  • Written down value method helps you determine the depreciated value of your asset, which is crucial for determining the price at which it should be sold. 
  • You may ensure that you’ll be receiving an appropriate price for your asset by assessing its depreciated value and avoid selling it for less than it’s valuable.
  • This method applies a higher amount of depreciation in the initial years of your asset’s useful life. 
  • This makes sense, as assets are generally used more frequently in their earlier years, and thus experience more wear and tear. 
  • By applying higher depreciation during this time, you can more accurately reflect the true value of your asset over time.

  • It is an excellent choice for anyone looking to capture the depreciation of their assets accurately. 
  • It is based on logical assumptions about how assets depreciate over time and can assist you in making informed decisions about when to sell your assets.

Units of Production Method

The Units of production method calculates depreciation based on the number of units an asset produces or the number of hours it is use. This method is often use for assets. That are use in production or manufacturing processes.

For example, if a business purchases a machine for $100,000. That is expected to produce 100,000 units over its useful life of 5 years. The depreciation expense would be $1 per unit. If the machine produces 10,000 units in year 1. The depreciation expense for year 1 would be $10,000 (10,000 units x $1 per unit).

Key Points

  • Depreciation is required by many tax systems for items likely to produce future benefits
  • Assets that represent a commitment of resources over several periods, such as property and capital equipment, are often subject to depreciation
  • Depreciation reduces the net income of activity by accounting for costs associated with assets used over many periods
  • The straight-line method is the simplest and most commonly used method of depreciation
  • The straight-line method reduces the book value of an asset by the same amount each period by dividing the total value of the asset, less its salvage value, by the number of periods in its useful life
  • The declining balance method provides for a higher depreciation expense in the first year of an asset’s life and gradually decreases expenses in next years.

  • Annual depreciation expense under the declining balance method is found by multiplying the book value of the asset each year by a fixed rate
  • Activity depreciation methods are not based on time, but on a level of activity, such as miles driven or cycle count for machines
  • It is important to estimate the useful life of an asset for depreciation in time units. And to calculate the corresponding depreciation rate to extinguish the value of the asset from the books when the estimated useful life ends
  • Choosing the right depreciation method depends on the asset and the needs of the business

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