Depreciation is a financial accounting term that refers to the allocation of the cost of a tangible asset over its useful life. It is a way for businesses to spread out the cost of an asset over the period it is being used rather than expensing the entire cost in the year it was purchased. Each method has its unique rules and calculations; the right one for your business will depend on your specific assets and financial goals.
Did You Know? Depreciation as an expense is different from all other conventional expenses.
Concept of Depreciation
Depreciation is the process of allocating the cost of a tangible asset over its useful life. There are several methods of calculating depreciation, including the straight-line method, the declining balance method, and the sum-of-the-years'-digits method.
For example, let's say a company in India purchases a new machine for ₹200,000. The useful life of the machine is 10 years, and the company estimates that the residual value (the value of the machine at the end of its useful life) will be ₹20,000. To calculate the annual depreciation expense, we use the following formula:
Depreciation expense = (Cost of the asset - Residual value) / Useful life of the asset
Plugging in the values from our example, we get:
Depreciation expense = (₹200,000 - ₹20,000) / 10 years = ₹18,000 per year
This means that the company will record an annual depreciation expense of ₹18,000 for the machine for each of the 10 years of its useful life. The expense will be recorded as a reduction in the company's net income on its income statement.
Need for Depreciation Expenses
In accounting, depreciation is the process of allocating the cost of a tangible asset over its useful life. This is necessary because the value of an asset typically decreases over time due to wear and tear, obsolescence, or other factors. Depreciation expenses are recorded on the income statement and are used to reduce the value of an asset on the balance sheet.
The purpose of depreciation is to more accurately match the expenses associated with using an asset with the revenue that the asset generates. Depreciation is a non-cash expense, meaning that it does not involve any actual cash outflows. Instead, it is a way of allocating the cost of an asset over its useful life and recognizing the loss in value on the company's financial statements.
Also Read: Brief on How To Book a Fixed Asset Depreciation Journal Entry
Why Should Depreciation Expenses Be Tracked?
Depreciation is a method of allocating the cost of a tangible asset over its useful life. Tracking depreciation expenses is important for a number of reasons:
- It provides a way to spread the cost of an asset over a period of time. This is in contrast to recording the entire cost as an expense in the year the asset is purchased. This can help smooth out the impact of large purchases on a company's financial statements.
- It helps a company accurately reflect the value of its assets on its balance sheet. As an asset depreciates, its value on the balance sheet is reduced by the amount of depreciation expense. This gives a more accurate picture of the company's overall financial position.
- It allows a business to more accurately reflect the cost of an asset over its useful life rather than expensing the entire cost in the year it was purchased. This can provide a more accurate picture of a business's financial performance.
- It can help a business manage its cash flow. By spreading the cost of an asset over its useful life, a business can avoid paying the entire cost upfront. This can be especially helpful for small businesses with limited cash.
- It is a required accounting practice. Indian Accounting Standard (Ind AS) and International Financial Reporting Standards (IFRS) require businesses to use some form of depreciation when accounting for the cost of tangible assets.
Factors Involved in the Depreciation Method
Here are some factors that can affect the choice of depreciation method:
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Useful Life of the Asset
The useful life of an asset refers to the period of time over which the asset is expected to be useful. The depreciation method should take into account the expected useful life of the asset.
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Residual Value of the Asset
The residual value of an asset refers to the estimated value of the asset at the end of its useful life. The depreciation method should take into account the residual value of the asset.
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Cost of the Asset
The cost of the asset is the amount paid to acquire the asset. The depreciation method should take into account the cost of the asset. For example, a method that depreciates the asset at a constant rate may not be appropriate if the cost of the asset varies significantly over its useful life.
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Tax Regulations
Tax regulations may require a specific depreciation method to be used for tax purposes. The company may choose to use the same method for financial reporting purposes to simplify the accounting process.
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Management Preferences
Management may have a preference for a particular depreciation method based on their experience, industry norms, or other factors.
Also Read: Straight Line Method of Depreciation - Straight Line Depreciation Formula
Types of Depreciation Method
Depreciation expense is a way for businesses to more accurately reflect the cost of an asset over its useful life, manage cash flow, and comply with accounting standards. There are several methods for calculating the depreciation of an asset.
The most common methods are
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Straight-line Method
The straight-line method is the most straightforward method, where the asset is depreciated at a constant rate each year over its useful life.
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Units-of-production Method
This method calculates depreciation based on the number of units of production that an asset generates over its useful life.
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Declining Balance Method
This method calculates depreciation at a higher rate in the earlier years of an asset's useful life and at a lower rate in the later years.
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Sum-of-the-years'-digits Method
This method calculates depreciation using a formula that takes into account the asset's useful life and the number of years it has been in use.
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Modified Accelerated Cost Recovery System (MACRS)
This is a complex method used for tax purposes in the United States that allow for accelerated depreciation of assets.
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Double Declining Balance Method
The method is similar to the declining balance method, but the rate of depreciation is doubled.
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Group Method
It is used to depreciate a group of assets as a single unit, rather than depreciating each asset individually. It is important to note that different methods may be more suitable for different types of assets and in different countries, as depreciation rules can vary.
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Activity Method
Such a depreciation method is used for intangible assets, such as patents and trademarks. It involves allocating the cost of the asset over its useful life based on the level of activity or use of the asset.
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Depletion
This is a method of depreciation used for natural resources, such as oil and gas reserves. It involves calculating the depletion expense based on the amount of the resource extracted or consumed.
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Amortisation
Amortisation is a method of depreciation used for intangible assets, such as copyrights and trademarks. It involves allocating the asset's cost over its useful life systematically and rationally.
It's important to note that the depreciation method can impact a business's financial statements and tax liability. It is important for a business to choose the depreciation method that best fits its specific needs and circumstances.
Also Read: Depreciation Rate as Per Companies Act | How to Use Depreciation Calculator
Conclusion
Depreciation is a method of allocating the cost of a tangible asset over its useful life. Businesses use depreciation to account for the decline in the value of an asset over time. There are several methods for calculating depreciation, including straight-line depreciation, declining balance depreciation, and sum-of-years digits depreciation. The choice of method depends on the type of asset, its useful life, and the company's accounting practices. In general, straight-line depreciation is the most commonly used method, as it is the simplest and easiest to understand. It involves dividing the cost of the asset by its useful life to determine the annual depreciation expense.
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