What is Depreciation? Class 11 Accounts – Commerce
Depreciation refers to a reduction in the value of any asset over time, due in particular to wear and tear or getting old.
In accounting terms, depreciation is outlined as the reduction or decreasing of the recorded value of a particular asset in a very systematic manner until the worth of the asset becomes zero or negligible.
Examples of some fixed assets are buildings, furniture, office equipment, machinery, etc. The land is the only exception that cannot be depreciated as the value of land appreciates with time.
Depreciation permits some of the value of a particular asset to the revenue generated by the fixed asset.
This is necessary because of the matching principle as revenues are recorded with their associated expenses within the accounting amount once the asset is in use.
This helps in obtaining a complete scenario of the revenue generation transaction.
An example of Depreciation – If any delivery truck is purchased by a company at a cost of Rs. 200,000 and the expected usage of the truck are 5 years, the business might depreciate the asset under depreciation expense as Rs. 40,000 every year for 5 years.
Features of Depreciation
i. It declines in the book value of the fixed assets.
ii. It includes the loss of value due to passing of time, usage or annihilation.
iii. It is a continuous process.
iv. It is an expired cost and hence must be deducted before calculating taxable profits.
Causes of Depreciation
These have been very clearly spelled out as part of the definition of depreciation in the Accounting Standard 6:
i. Wear and tear
ii. Expiring of legal rights
iv. Nonnatural factors
Factors Affecting the Amount of Depreciation
The determination of depreciation depends on three parameters, viz. cost, estimated useful life and probable salvage value.
How to calculate depreciation in small business?
Three main inputs are required to calculate depreciation:
i. Useful life– this is referred to the time over which an organization can consider the fixed asset to be productive. Beyond its useful life, a fixed asset is no longer cost-effective for continuing the operation of the asset.
ii. Salvage value– Post the useful life of any fixed asset, the company might consider selling it at a reduced amount. This is known as the salvage value of the asset.
iii. The cost of an asset– this includes shipping, taxes, and preparation/setup expenses.
These three methods commonly used to calculate depreciation. They are:
i. Unit of production method
ii. Straight-line method
iii. Double-declining balance method
Let’s take a look at each type of Depreciation method in detail.
Types of depreciation:
1) Unit of Production method
Unit of production method required the number of units used during production. This process includes two-steps, unlike the straight-line method. Here, equal expense rates are designated to each unit made. This assignment makes the tactic very useful in assembly for production lines. Hence, the calculation is predicated on the output capability of the asset rather than the number of years.
The steps are:
Step 1: Calculate depreciation per unit:
Per unit Depreciation = (Asset Value – Residual cost) / Usable life in units of production
Step 2: Calculate the total depreciation of actual units produced:
Total Depreciation Expense =
Per Unit Depreciation * Units Produced
So the total Depreciation expense is Rs. 800 which is accounted for. Once per unit depreciation is found out, it can be applied to future outputs as well.
2) Straight-line depreciation method
This is the easiest method of all. It involves easy allocation of an even rate of depreciation every year over the useful life of the asset. The formula for straight-line depreciation is:
Annual Depreciation expense = (Asset Value – Residual Cost) / Usable life of the asset
Example – Suppose a manufacturing company purchases machinery for Rs. 200,000 and the useful life of the machinery are 10 years and the residual value of the machinery is Rs. 20,000
Annual Depreciation expense = (200,000-40,000) / 10 = Rs. 16,000
Thus the company can take Rs. 16000 as the depreciation expense every year over the span of the next ten years as shown in the depreciation table below.
3) Double declining method
This is one of the common methods that a company uses to calculate/ determining for the expenses of a fixed asset. This can be referred to as an accelerated depreciation method. As the name explains, it is counted as an expense twice as much as the book value of the asset every year.
The formula is:
Depreciation = 2 * Straight-line depreciation percent * book cost at the beginning of the accounting period
Book value = Cost of the asset – accumulated depreciation
Accumulated depreciation is referred to as the total depreciation of the fixed asset accumulated up to a specified time.
Why should small businesses care to record depreciation?
As we know now that the meaning of depreciation is the methods used to calculate them, inputs required calculating them and also we saw examples of how to calculate them. Let’s figure out as to why the small businesses should care to record depreciation.
As we tend to understand already the purpose of depreciation is to match the cost of the fixed asset over its productive life to the revenues the business earns from it. It is very tough to directly link the value of the asset to revenues, hence, the cost is usually assigned to the number of years the asset is productive.
Over the productive life of the fixed asset, the value of the asset is moved from the balance sheet to income statement. Alternatively, it is just an allocating process as per the matching principle instead of a technique which concludes the fair market value of the fixed asset.
Accounting entry –
DEBIT depreciation expense account and CREDIT accumulated depreciation account.
If we do not utilize depreciation in accounting, then we have to include all assets to the expense once they are bought. This will, in turn, leads to huge losses in the following transaction span and high profitability in periods when the corresponding revenue is taken into account without an offset expense. Hence, companies that do not use the depreciation expense in their accounts will incur front-loaded expenses and highly variable financial results.
Depreciation is an important part of accounting records that helps corporations maintain their income statement and balance sheet properly with the profits rightly recorded. Using a smart business accounting software can assist you in recording the depreciation properly without making manual mistakes.
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