In accounting, depreciation refers to the decrease in the value of a fixed asset in a systemized method until the value of the specified asset becomes nil. A fixed asset could be furniture, machinery, office equipment, buildings, etc. Land, however, does not fall under that, since a land’s worth increases with time. Since fixed assets seem to lose their value over time, some methods of depreciation distribute the majority of the cost of an asset in the beginning years of the asset’s existence and it decreases gradually in the later years.
To understand the theory of depreciation, simply think like this: An asset is expensive with several years of functioning therefore its costs should also be spread out over time until it’s not useful anymore.
What Is Depreciation
Important Terms to Understand Depreciation
Salvage Value
If an asset is no longer required, it can be traded at the termination of their useful life. Salvage value, which is also known as residual value, refers to the selling price of an asset at the end of their lifespan. This value is deducted from the cost of the asset before depreciating.
Depreciable Cost
The depreciable cost refers to the value that stands after the salvage value is subtracted from the actual cost of the asset.
Depreciation Period
Depreciation period refers to the total number of years that would take an asset to depreciate. In other words, it’s the useful lifespan of an asset.
Accumulated Depreciation
Accumulated depreciation refers to the cumulative depreciation of an asset up to any specific point in its lifespan. Accumulated depreciation is only possible on capitalized assets (assets that have a lifespan exceeding one year).
Accelerated Depreciation
Accelerated depreciation refers to any form of depreciation used for finance or accounting purposes that permits larger deductions in the earlier years of the total life of an asset. This provides a true picture of actual depreciation because an asset is heavily used during the earlier years when it is the most efficient.
Be sure to check out: Straight Line Depreciation
Five Methods to Calculate
1. Straight-line Method
The simplest way to calculate it is through the straight-line method. It requires an even rate of it for every single year of the asset throughout its useful life. It portrays that the asset is depreciating at an equal amount, each year.
Step 1: Subtract the Residual Value from the Asset Cost
Step 2: Divide the result by the total number of years of the asset’s useful life
The remaining value is the Annual Depreciation Expense.
2. Unit of Production Method
As the name suggests, this method requires each unit produced to be allocated with uniform expense rates. Since the result shows output capability, this method of calculation is ideal for production lines.
Step 1: Subtract the Residual Value from the Asset Cost
Step 2: Divide the result by Useful life of the units of production
Step 3: Multiply the outcome by total units of production
The remaining value is the Depreciation Expense.
3. Declining Balance Method
If you want to measure the depreciation of an asset in its early years, the declining balance method is the right one to opt for.
To calculate it, multiply the Current Book Value (CBV) and its rate. CBV refers to the net value of the asset at the beginning of an accounting period, which could be calculated by subtracting the accumulated depreciation from the cost of the asset.
4. Double-declining Balance Method
It is a form of accelerated depreciation where the expense is counted twice compared to the net asset value.
Step 1: Multiple the Straight-line depreciation % to the Book Value
Step 2: Multiply the result by 2
The remaining value is Depreciation.
5. Sum-of-years Digits Method
Another form of accelerated depreciation is calculated by the Sum-of-years Digits method.
Step 1: Add the cumulative number of years of the asset’s useful lifespan up to the total number of years it is expected to last. For example, if an asset’s expected lifespan is 5 years, the sum of the year’s digits would amount to 5+4+3+2+1.
Step 2: Divide the Remaining Useful life of the asset by the sum-of-years digits.
Step 3: Multiply the result with the Depreciable Cost.
The remaining value is the Depreciation Expense.
Two Accounting Principles That Depreciation Calculation Depend On
Cost Principle
According to the cost principle, the depreciation expense that is mentioned on the income statement and the asset amount that is included in the balance sheet should be established on the original cost of the asset (not the current market value). Besides, the recorded amount should not be altered based on inflation or any increase in the market value at any point in time.
For example, when a retailer buys inventory from a supplier, the cash price (that was paid by the retailer) is recorded. Therefore, the cost is equivalent to the total amount paid in the transaction.
Matching Principle
According to the matching principle, expenses should be reported on the income statement over the life of the asset. By doing so, a portion of the asset’s cost is matched with each period during which an asset is being used. Because of this, liability is formed in the balance sheet at the end of the accounting period.
For example, an XYZ appliance store has sold kitchen appliances for 20 years in Town A. The store purchases an appliance from a wholesaler at $600 and sells it to a restaurant for $900. The price of $600 should be matched with the revenue of $900 by XYZ appliance store at the end of the period.
By now you must be familiar with the important terms of depreciation and the various methods it can be calculated in. To sum it up, it is the process by which the value of an asset is reduced over a period of time till it’s value becomes zero or negligible.
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