If you own a business, you might be familiar with fixed assets. Plant machinery has a limited lifespan, probably 10 to 15 years or maybe more or less, depending on the kind of machine that you have. Companies need to keep account of these assets as they decrease in value over time. This particular decrease in the value of assets over time is called depreciation. How do you exactly calculate depreciation for an asset? Why is it useful to have depreciation calculated for your machinery? Please keep reading to learn more.
Did you know?
There are a lot of benefits of showing depreciation for a particular asset. Companies often show depreciation of assets differently using different depreciation methods to avail tax benefits.
What Is Depreciation?
Companies usually treat their assets and allocate their costs from the balance sheet to their financial statement. Investments in more significant classes, such as machines and other equipment, are expensive, and the companies deal with this high cost by distributing the cost over the years.
These companies or businesses can use depreciation. Companies often write off the value of such assets after some time by allocating the cost to match the revenue in the same reporting period. So, in a simple sense, depreciation is the distribution and allocation of the cost of an asset over some time. The value of an asset may decrease due to various reasons.
Also Read: Depreciation Under Income Tax Act
Types of Depreciation
There is more than one method or way that a business can use to depreciate its assets in its books. All the accounting treatments are different, but they serve the same purpose. Let us see what the various methods of depreciation are.
Some of the commonly known methods are –
- Declining balance depreciation
- Straight-line depreciation
- Units of production depreciation
- Sum of the year’s digit depreciation
Declining Balance Depreciation
It is a method that the companies commonly use to write off most of the asset's value earlier on in the years to minimise tax on it. It is most useful as an expense management tool, and more applicable on purchases that perform better in their earlier years.
Units of Production Depreciation
The unit of production method has to be one of the simplest methods to calculate depreciation. It works by analysing how much a particular asset or equipment is helping to yield. This method, however, requires constantly tracking the equipment or asset. It is also more applicable to high-value equipment and is used more by small scale businesses.
The Sum of the Year’s Digits Depreciation
Using this depreciation method, a company can allocate more cost of an asset earlier in the year and less of the cost at the end of the year or later on in that year. To calculate depreciation through this method, first, you need the SYD, and you can find this out by adding the digits in the asset's lifespan.
For example, a machine has a lifespan of 5 years. The SYD of it would be 1+2+3+4+5 = 15
Formula: Remaining Lifespan / SYD x Assets cost – Salvage value
Straight Line Depreciation
This method of depreciation has to be the easiest and simple. In this method, the value of an asset is said to decrease in equal intervals, and after a set amount of time, it reaches its salvage value.
Straight Line Depreciation Formula
You can calculate the depreciation using the straight-line method by
Annual Depreciation Expense = Cost of Asset – Salvage Value/Life of the Asset
Straight Line Depreciation Rate = Annual Depreciation Expense/Cost of Asset – Salvage Value of the Asset
Here is how you would show a journal entry of depreciation something like this in the account books.
Straight Line Method of Depreciation - Example
Let’s take a simple example to understand how the straight-line depreciation works –
Ajay blade works purchased a machine worth ₹1,00,000, and its lifespan is five years, with the salvage or scrap value of ₹20,000.
Let us calculate the total cost that you can depreciate from the asset. To do this simply remove the salvage value form the asset i.e., ₹1,00,000 - ₹20,000 = ₹80,000. Divide this by the total lifespan of the machine to find out the depreciation value each year.
80,000/5 = ₹16,000. The rate of depreciation would be 16000/80000 = 20%
Each following year the book value of that machine will reduce by ₹16,000 till five years are complete. And the remaining value of the machine after five years will be equal to its salvage value.
When Should Straight Line Depreciation Be Used?
It is most useful when there is a class of asset whose value decreases steadily over time and roughly at the same rate. It also comes with fewer errors so when in doubt use this method as it is very less complex compared to other methods of depreciation. Best suited for the short term, as the straight-line method does not call for the advancement in the technology or other factors due to which an asset might become obsolete sooner than expected.
Depreciation is a tool that most companies use for tax benefits. It is a fact that over time the value and the condition of an asset will decrease though there are some cases when an asset will increase in value, like building and land that also sometimes does not happen. Using different methods of depreciation, companies calculate appreciation for their asset, which also enables them to manage their financial condition better. We have discussed a few methods of appreciation along with the straight-line method of depreciation which is one of the easiest methods that one can use to calculate depreciation on their asset. There are several major methods of depreciation – the straight-line method, the sum of the year’s digits depreciation method, declining balance depreciation, and units of production depreciation are some of the most widely used methods of calculating depreciation.
The basic journal entry for depreciation is to debit the Depreciation Expense account (which appears in the income statement) and credit the Accumulated Depreciation account (which appears in the balance sheet as a contra account that reduces the number of fixed assets.)