What is depreciation and how is it calculated?
Every material thing wears off after a certain period. The value doesn’t stay the same with time, whether it is a car or a piece of heavy machinery. The application of depreciation causes a decrease in this value. Depreciation helps in finding the fair value of an item to be added to the balance sheet of a company. This article will look into the meaning of depreciation, cause of deprecation, types of depreciation, and how it is different from amortization.
What is depreciation?
Depreciation is applied to all the physical or tangible long-term assets bought for the business over its useful life. The useful value of an asset is calculated based on the time frame it can be used. For example, machinery is typically useful for 10-15 years.
Each year, a certain percentage or amount is written down from the acquisition cost of an asset. In simple terms, depreciation means deducting the value of an asset that has already been used. A company must account for depreciation on assets at least annually.
Example of depreciation
Suppose the total value of a machine is Rs. 9,00,000. If the depreciation rate is 10%, annually Rs. 90,000 will be deducted from its useful life.
The depreciation cost is applied to an asset until the value becomes zero. Based on the types of assets, different depreciation methods are used. It is crucial to note that depreciation holds value from accounting as well as taxation purposes.
What is the cause of depreciation?
With time, the quality and usefulness of an asset reduce, and it becomes less valuable and less productive. It is necessary to mention this amount as a depreciation cost in the balance sheet to showcase the value lost over a certain period. That is the leading cause we apply depreciation to assets. However, it is a non-cash expense and thus has no impact on the cash flow statement.
What are the types of depreciation?
Before understanding types of depreciation, a basic understanding of these terms is a must.
- Salvage value of an asset: The amount at which a company is ready to sell its assets–the reduced price, is known as the salvage value.
- Useful life: It is the period till which an asset is considered appropriate to use and is cost-effective.
- The cost of an asset: It is the additional cost that a company pays to acquire an asset, such as shipping, taxes, etc.
Now let’s see how depreciation is calculated using these four methods.
1. Straight-Line method
This is one of the simplest and most popular types of depreciation. As per the straight-line method, the same amount is dedicated as depreciation from the asset’s total cost each year.
The depreciation formula for this method is:
Depreciation = Total Cost – Salvage Value of Asset / Useful Life of Asset
2. Double Declining Balance method
This method is used to write down a significant sum of depreciation in the initial years compared to the last few years of the life cycle of an asset. The reason to depreciate an asset using this method is the fact that in the initial years, when an asset is new, it is the most predictive and cost-efficient. Also, the most value lost occurs in the first few years of buying an asset. For using the double-declining balance method, the depreciation percentage is considered 2X compared to the straight-line method.
The depreciation formula for this method is:
Depreciation = Initial Book Value of an Asset X Depreciation Rate
3. Unit of Production method
This is a method that calculates depreciation based on the production output. It considers the total expected output units or the hours invested for production over the useful life of an asset. A specific rate is allotted to each production unit in this method. The unit of production depreciation method is used chiefly at larger assembly or production facilities.
The depreciation formula for this method is:
Depreciation = Total Number of Units Produced / Useful Life in Number of Units X (Total Cost – Salvage Value of Asset)
4. Sum of the Years Digits method
Like the double-declining method, the sum of the years digit also expenses depreciation at a higher pace in the initial years compared to the letter years. It continues until the asset value becomes zero.
The depreciation formula for this method is:
Depreciation = Remaining Life of Asset / Sum of the Years Digits X (Total Cost – Salvage Value of Asset)
What is the difference between depreciation and amortization?
The term depreciation and amortization appears confusing, and they are indeed similar in nature but what sets them apart is the type of asset they are used for. While depreciation reduces the cost of usage over the useful life of a tangible asset, amortization reduces the cost of usage over the useful life of an intangible asset. Intangible assets are the types of assets that hold value to a business but cannot be seen or touched.
Depreciation is used for assets such as plants, machinery, building, furniture, vehicles, etc. While amortization is used for trademarks, patents, copyrights, etc.
While depreciation is calculated using different methods, amortization uses the straight-line method. It ensures a steady reduction in the value each year.
The bottom line
Depreciation reduces the cost of an asset from the total benefits received from it over its useful life, such as increased earning. A company has to account for depreciation on assets using any written down value method at the end of the year and on its quarterly report submissions as well. It is a fixed cost for a company as depreciation is deducted each year whether the company makes a profit. Though depreciation also provides tax benefits, it reduces the earnings and thus saves costs.
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