In accounting terms, depreciation is systematically deducting a fixed asset’s documented costs until the asset’s value comes down to zero or becomes negligible. Fixed assets include furniture, equipment, and machinery. Depreciation involves reducing an asset’s cost over an extended period rather than over the time period of a year.
Did you know? Depreciation is used on income statements. It is noted down as a kind of expense, and fixed assets like land cannot be depreciated.
Meaning of Depreciation
First, let us understand the depreciation definition. The word "depreciation" refers to a loss or reduction in an asset's worth as a result of damage, expiry, the passage of time, or a steady decline in market price. One can define depreciation as the loss of price due to normal wear and tear or another type of material degradation. The process of revising financial asset statements is another meaning of depreciation.
Depreciation is the term used to describe the accountant's practice of decreasing the value of assets or other resources as they become old in the accounting records. Depreciation is a cost or damage that comes with using equipment, automobiles, instruments, and other capital assets during production. Accountants do it by determining the amount the owner has to deduct from the price of an item annually and comparing it to the net profit for the same year.
How to Calculate Depreciation?
There are three methods that anyone can use to determine depreciation.
- A straight-line approach
- Unit of production method
- The method of double-declining balance
Calculating depreciation requires three key inputs:
Useful Life: The useful life of a fixed asset is the time frame during which the company deems it to be profitable. The asset isn't any more cost-effective to operate when its usable life passes off.
Salvage Value: After the permanent asset's useful life is through, the organisation might think about selling it for less money. This is what they refer to as the item's salvage value.
The Asset Cost: It considers shipment, taxation, installation, and preparation costs.
Let us discuss each type of depreciation method below.
Types of Depreciation
The following are the types of depreciation:
Straight-Line Depreciation Method
The most convenient approach is the straight-line depreciation method. It entails the straightforward distribution of equal annual depreciation rates of the asset's useful life. You can calculate straight-line depreciation as follows:
(Asset Cost - Remaining Value) / Useful life of the asset is the annual depreciation expense.
Unit of Production Method
In contrast to the straight-line approach, this involves two steps. Each unit generated in this case is given an equal expenditure rate. The procedure is extremely helpful in assembling manufacturing lines due to this task. As a result, instead of using the number of years, the estimate depends on the asset's productive capacity.
- First, determine the per-unit depreciation: Per unit depreciation is equal to (asset cost minus residual value) to useful life in production units.
- Second, determine the overall depreciation for total units of production. The Total Depreciation Expense equal Per Unit Depreciation multiplied by Units Produced.
Depreciation Expense = Per Unit Depreciation x Units Produced.
Double Declining Method
This is among the two popular ways a business accounts for the costs associated with a fixed asset. It is a form of accelerated depreciation. As the name implies, it annually counts expenses at twofold the asset's market price.
Depreciation is equal to two times the straight-line depreciation rate multiplied by the initial book value of the accounting period.
Cost of the asset minus total depreciation equals book value.
Depreciation= 2 x Straight line depreciation rate x Initial book value where, (book value = cost of assets - total depreciation).
Also Read: What is Double Entry System of Accounting
Causes of Depreciation
Let us look into some of the causes of depreciation
Wear and Tear
Due to use-related wear and tear, certain assets visibly degrade. A resource deteriorates when one uses it for production. An item will experience increasing wear and tear as its owner uses it more frequently. Mobility, stress, abrasion, eroding, and other factors can all result in the physical degradation of an item. For example, structures, equipment, furniture, cars, or plants. The basic but main reasons for depreciation include wear and tear.
Lapse of Time
Some resources that one purchases for a specific period, such as rental property, trademarks, copyrights, etc., become obsolete after time crosses off, losing all of their worth. Because of this, their expense is written off along with their lawful lifetime.
Older equipment owners discard as newer, better models become available. Therefore, discoveries, changes in tastes and styles, the state of the market, governmental regulations, etc., are the reasons why the worth of an item is discarded. However, this isn't true depreciation, nor is it the reason for depreciation. New machinery completes the same task faster and more affordable than an existing model, and current equipment may therefore become obsolete.
Some resources are wasteful in nature, for example, miners, oil wells, and crushers. It's the decline in the worth of natural reserves brought on by the yearly extraction of resources. Thus, these resources are referred to as squandering resources. The withdrawal of its materials physically exhausts the mining company or oil barrel.
Over time, idle machines lose more of their usefulness. Some machines that are subject to weather conditions might depreciate more from being idle than from use.
A vehicle's life will automatically increase with proper maintenance, and more depreciation value results from a lack of maintenance.
The market rate may change for some assets, such as deposits in gilt-edged bonds. The asset in question may lose its value whenever rates decline. Accidents can occasionally result in a decrease in the price of assets.
The Need for Depreciation
The following reasons are why we need to calculate depreciation.
To Ascertain the True Working Outcome
Assets are a crucial tool for generating income. Huge sums of money are spent on purchasing assets that are damaged during the income-generating process. As a result, the earlier mentioned reasons cause assets to lose long-term value. If assets lose value, one must consider the depreciation to determine the genuine working outcome. Depreciation is an operational cost of a tangible asset, and as such, one should also consider this account when determining the actual profit made annually. Depreciation's primary purpose is to determine genuine income. If you ignore depreciation, the loss incurred concerning capital assets will also be disregarded.
To Ascertain True Value of an Asset
The purpose of financial statements is to provide an accurate picture of a company's financial situation. A balance sheet won't accurately reflect a company's financial situation while no depreciation is taken into account, and it reports assets are always at their initial price.
To Retain Funds for Replacement
Once their service life expires, the company's assets must be replaced. It is never possible to estimate an asset's usable life. But in other circumstances, a machine frequently becomes obsolete even before it breaks down due to quick technological changes. It results in a constant loss of valuation. When someone uses the asset consistently, eventually, one has to replace it when it does not work. Thus, it will be extremely difficult to obtain money to substitute the asset throughout its lifespan if they do not charge degradation against the profits. If they replace the equipment, it may severely limit assets. As a result, it's important to plan and raise money to replace these assets when they're needed.
To Reduce Tax Liability
Depreciation is an expenditure that is eligible for a tax deduction. As a result, authorities deduct it from profit under the current tax legislation. As a result, the company owner can take advantage by adding depreciation to his earnings and lowering his tax obligation.
To Present True Position
The company uses a financial report to analyse its financial condition. The financial report must reflect the fixed assets at their actual worth. When a company lists assets in the financial statements without depreciation, their worth is inflated, and the financial statement will not accurately represent the company's financial situation. Therefore one must remove the depreciation from the item to represent the genuine financial condition, and later one can show the asset in the financial statements at its lower amount.
Depreciation is a crucial component of an accounting system that aids businesses in maintaining accurate profit statistics on their financial statement. Using successful company depreciation software, you may avoid human errors and accurately record the devaluation.
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