In accounting parlance, depreciation is referred to as the reduction in the cost of a fixed asset in a sequential order, due to wear and tear till the asset becomes obsolete.
Machinery, vehicle, equipment, building are some examples of assets that are likely to experience wear and tear or obsolescence.
Also Check: What is Depreciation?
Meaning of Depreciation Expense
Depreciation expense refers to the expenses that are charged to fixed assets based on how much the assets get consumed during the accounting period according to the accounting policy of the business.
For accounting purposes, depreciation expense is not represented as a cash transaction, but it shows how much of an asset’s value the business has utilized over a period.
Here are certain factors that are essential to calculate depreciation
- Useful Life : It is that time till which the asset can function productively. Beyond this period, the asset will not be performing at its best and will not be cost-effective for the business.
- Salvage Value : Salvage value is the price of the asset at which it can be sold post the useful life of the asset.
- Cost of the asset : It includes taxes, setup, and shipping expenses.
There are three different methods of calculating depreciation expense, which are:
- Straight Line Method
- Declining balance method
- Unit Production method
Let us look into each of these methods to get well acquainted with the depreciation expenses that can occur.
Straight Line Method
It is the regarded as the most simplest method for calculating depreciation. It is also the most commonly used. In this method, the depreciation expense is determined by deducting the residual value from the actual cost of the asset and dividing it by the productive life of the asset.
Depreciation Expense = (Original Value – Residual Value) / Remaining Useful Life of the Asset.
We will understand this concept with an example.
Suppose a firm has purchased machinery worth Rs. 100000 with a useful life of 10 years and a residual value of 10000. Then the depreciation expenses can be calculated as
Depreciation Expense = (100000-10000) /10 = Rs.9000
Thus, Rs.9000 can be taken as the depreciation amount for the next ten years.
Declining Balance Method
The declining balance method is also known as the double-declining method. It acts on the premise that some assets are more productive during the first year and significantly show a reduction in performance over the course of years.
This method is also known as accelerated depreciation because assets tend to depreciate faster during the first year and progressively slow down in the subsequent years.
The formulae for calculating depreciation using this method is:
Double Declining Balance = 2 X Cost of the asset / Useful Life or Double Declining Balance = 2 X Book Value of the Asset / Useful Life
Book value = Cost of the asset – accumulated depreciation value of the asset.
Let us understand it through an example.
Suppose a firm has purchased machinery worth Rs. 100000 with a useful life of 4 years. Then the depreciation expenses can be calculated as
Double Declining Balance = 2 X 100000 / 4 = Rs. 50000 (For 1st year)
For 2nd year it will be
Double Declining Balance = (100000-50000) x 2 / 5 = Rs. 20000
Similarly, it can be calculated for the remaining years.
Unit Production Method
The Unit Production Method is a method of calculating depreciation of an asset in which an asset’s value is based on the number of units it produces than its useful life. This results in depreciation being calculated more for the period during which asset is most actively used.
The formula for calculating depreciation using this method is
Per unit Depreciation = (Asset cost – Residual value) / Useful life of the asset in terms of units of production
Total Depreciation Expense = Per Unit Depreciation value * Units Produced
Let us understand it through an example.
A company purchases a printer for Rs.10000 with a useful life of 100000 prints and a residual value of 5000. It prints 5000 copies. The Depreciation expense will be as follows.
Per unit Depreciation = (10000 – 5000) / 100000 = Rs 0.05
Total Depreciation Expense = 0.05 * 5000 = 250
This article serves as a guide to understand the concept of depreciation expenses in business; this concept is essential for students of Commerce to understand the decline in value of an asset over time in accounting terms. Stay tuned to BYJU’S for more such interesting concepts.