Great way to understand Depreciation and Methods of Depreciation
Once in a quarter or a Year, one of the major issues that is faced by SME Owners is when their CPA / CA / Auditor asks them give the list of Fixed Assets and need to calculate the Depreciation for those Fixed Assets. So what is this and how it helps business? Why should we adjust the Asset values by this approach? Below are the new words you might encounter here and lets give an explanation for the same.
- Asset Ledger – List of the Fixed and Current assets that used for the business.
- Fixed Assets – This is like your Land, building, Vehicles, furniture etc.
- Depreciation – A process of reducing the value of the assets that’s used for production or helping the business.
- Book Value – Book value of Asset at the beginning. This value is same as Original cost of purchase in the first year of depreciation.
What is Depreciation?
From pure accounting terms, this is the process of reallocating the cost of the Fixed Assets over the lifespan of the assets that’s used to make production or business. Means, by using Depreciation methods, we are reducing the value of Fixed Assets in a pre-defined agreed method till the asset value becomes Zero or Negligible. These assets are called as Depreciable assets. Depreciation is a method of allocation of costs and it determines the value placed on the asset in the balance sheet. As we are aware fixed assets are buildings, Lands, Factory premises, office equipment computers, Machines and Tools and Dies etc. Most of these values are depreciated as the year passes. Only exception to this process is Value of the LAND and this appreciates with time. So be clear with this.
Why we follow this Accounting process?
- It helps to allocate the cost of the fixed Assets that used to generate the Revenue. This is important from Accounting principle to get the complete picture of revenue generation with deprecate the value of the assets that are used to generate revenue.
- The second reason for this is, company should keep a provision for the new Asset as the current Asset may not be used in the future after its lifespan is over. So the idea here is to make a plan for the new machines in case the current dies off.
In business the typical behavior is to book the expenses of the item that bought. However, if a Machine is bought now and its used during its lifespan to generate profits or business (considering the future life of 10 years), then Depreciation method helps to allocate these costs appropriately across the life of the Machine rather than book them in the current financial year as it would change the balance sheet totally. Depreciation allows a portion of the cost of the fixed assets to the revenue generated by that Asset. It depends on the following factors.
- Cost of the asset – This includes the cost of the Assets, Setting up and installation and other expenses till the Asset is usable for production stage.
- Estimated useful life of the asset – Life span during which this asset is used for the Production or used.
- Expected value that could be generated by selling it (Residual value of the assets at the end of the lifespan)
|
What is Accumulated Depreciation?
We need to follow an accounting principle in disclosing the depreciation amount in Balance sheet and PL Reports. Depreciation expense is recorded on the income statement of a business and its impact is shown on Balance sheet as Accumulated depreciation, under fixed assets. If we don’t have an Accumulated Depreciation Account on the Balance sheet, then we can directly charged these against individual Asset Accounts. So the values of the Individual fixed assets on Balance sheet will reduce, even though the business has not invested or disposed of any of its assets. So it depends on each business on how to show the Accumulated depreciation separately on the balance sheet as it could keep the original cost of assets on the balance sheet.
What is Depreciation and how its calculated? Methods to Depreciation
We are explaining the most common Methods of Depreciation that are used for SMEs. There are 3 methods of Depreciation used and for a financial year, its expected to keep only One Method and cant change them across the Assets. Please speak to your CA / Auditor for this.
1. Straight line Depreciation
This is the most frequently used method as its easy and simple. In this method, the company estimates the Scrap Value or Residual value of the asset at the end of the period. Please note that Scrap Value can be ZERO, but cant be below Zero. The company will then charge the same amount to depreciation each year over that period, until the value shown for the asset has reduced from the original cost to the salvage value. For example, a vehicle that depreciates over 10 years is purchased at a cost of Rs 1,10,000 and will have a salvage value of Rs 10,000. Then this vehicle will depreciate at Rs 10,000 per year, i.e. (110,000-10,000)/10 = Rs 10,000. As the book value changes every year, (Original value – Depreciated amount), the Book value at any given time equals original cost minus accumulated depreciation.
Book value = original cost − Accumulated depreciation.
So Book value at the end of year becomes book value at the beginning of next year. This asset is depreciated until the book value equals scrap value.
Example – Normal Machines used in Factories, Vehicles, Furniture etc.
2. Unit-of-Production Depreciation
In simple terms, we are allocating the depreciation cost per unit of items produced here. This method provides a fixed rate per unit of production. Now this depreciation unit cost per One unit of Production with the total number of units the company produced within a financial period to determine its depreciation expense. Depreciation Unit Expense = (Total Acquisition Cost – Scrap Value) / Estimated Total Units Estimated total units = the total units this machine can produce over its lifetime Example: Company Tool Tip purchased an injection Machine Die for Rs 10,00,000 that can produce 20,00,000 component over its useful life. The company estimates that this machine has a Scrap / salvage value of Rs 100,000 at the end of producing so many components.
Based on the above, The depreciation per unit = (Rs 10,00,000 – Rs 1,00,000) / 20,00,000 = Rs 0.45.
The Depreciation Expense for a year = Depreciation cost / unit X Components produced in a year.
Sample Industry examples – Tools and Dies, Specialized Machines used for the production of third party components.
3. Accelerated Depreciation
This method allows companies to write off their assets faster in earlier years and to write off a smaller amount in the later years. The advantage of this method is the tax shield it provides to companies. Companies with a large tax burden might like to use these accelerated-depreciation methods, as it helps them. One of the example is, in IT / Computer Industries Computers, Servers and laptops and other electronic equipment are written off faster as it might be replaced before the end of it’s useful life as the chances of them becoming an obsolete in the industry as the technology is changing so high. So companies that have used accelerated depreciation will declare fewer earnings in the beginning years and will seem more profitable in the later years. Even in Accounting procedures, it’s defined on how to treat some of these Asset classes based on the type of items and where it is used. The two most common accelerated-depreciation methods used in the industry are Sum of year (SYD) method and Double Declining Balance method (DDB):
-
Sum-of-Year Method:
Depreciation In Year “i” = ((n-i) + 1)) / n!) * (Total acquisition cost – Salvage or Scrap value) Example: For Rs 20,000, Company Tool tip purchased a machine that will have an estimated useful life of 3 years. The company also estimates that in 3 year, the company will be able to sell it for Rs 2,000 for scrap parts. n! = 1+2+3 = 6 n = 5 This Depreciation method produces a variable depreciation expense to start with. However at the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straight-line depreciation and no change except that its expenses at the early stage of the life.
2. Double-Declining-Balance Method:
The DDB method simply doubles the Straight line depreciation amount that is taken in the first year, and then that same percentage is applied to the un-depreciated amount in subsequent years. DDB In year i = (2 / n) * (total acquisition cost – accumulated depreciation) n = number of useful years of the asset.
What is Zero Depreciation or Nil Depreciation?
As the name says, the Zero Depreciation or Nil Depreciation helps to reimburse the Claims amount that might have reduced due to replacement of depreciate parts. Typically used in Car insurance etc, where due to an accident, you have to replace the parts. Now due to depreciable nature of the parts, your claims could be less than what is asked. Now these depreciation approach, this can be avoided.
Depreciation Examples
Depreciation occurs in various areas, affecting both tangible and intangible assets. Here are some examples of depreciation in different contexts:
- Tangible Asset – Machinery: A manufacturing company purchases a piece of machinery for $100,000 with a useful life of 10 years and no salvage value. Each year, the company records a depreciation expense of $10,000 ($100,000 / 10 years) to allocate the cost of the machinery over its useful life.
- Tangible Asset – Building: A real estate company constructs a commercial building for $1,000,000. The building’s estimated useful life is 30 years, and the salvage value is negligible. Each year, the company records a depreciation expense of approximately $33,333 ($1,000,000 / 30 years) to reflect the building’s gradual decrease in value.
- Intangible Asset – Patent: A technology firm acquires a patent for a new invention at a cost of $50,000. Patents generally have a useful life of 20 years. The firm records a yearly depreciation expense of $2,500 ($50,000 / 20 years) to account for the diminishing value of the patent over its legal life.
- Vehicle Depreciation: An individual buys a car for $30,000, and the vehicle’s estimated useful life is 8 years. At the end of 8 years, the car’s value has significantly reduced, and it may only be worth a few thousand dollars.
- Software Depreciation: A software development company invests in custom software for $80,000. The software has a projected useful life of 5 years. Each year, the company records a depreciation expense of $16,000 ($80,000 / 5 years) to spread the cost of the software over its useful life.
- Furniture and Fixtures: A small business purchases office furniture and fixtures for $20,000. The assets are expected to last for 7 years before requiring replacement. The company applies straight-line depreciation, recording an annual expense of $2,857 ($20,000 / 7 years) for the furniture and fixtures.
Depreciation is a critical concept in accounting, as it allows businesses to match the cost of assets with the revenues generated by those assets over their useful life. Different industries and assets may have unique depreciation patterns, but the underlying principle remains consistent—allocating the cost of assets over time to reflect their diminishing value.
FAQ on Depreciation
What is Depreciation?
Depreciation is a process used in accounting to allocate the cost of tangible assets over their useful life. It reflects the decrease in value of an asset due to factors like wear and tear, obsolescence, or age.
Why is depreciation important?
Depreciation is essential for accurate financial reporting. It helps businesses spread the cost of assets over their useful life, matching expenses with the revenue generated by those assets.
What are the different depreciation methods?
Common depreciation methods include Straight-Line Depreciation, Declining Balance Depreciation, and Units of Production Depreciation. Each method varies in how it calculates and allocates depreciation.
What is the Straight-Line Depreciation method?
Straight-Line Depreciation is the simplest and most commonly used method. It allocates an equal amount of depreciation expense each year over the asset’s useful life.
How is depreciation calculated?
The formula for straight-line depreciation is: (Initial Cost – Salvage Value) / Useful Life. This calculates the yearly depreciation, and for monthly depreciation, divide the result by 12.
What is the difference between depreciation and amortization?
Depreciation applies to tangible assets like machinery and buildings, while amortization applies to intangible assets like patents, copyrights, or trademarks.
Can depreciation be reversed?
No, depreciation is considered a non-cash expense, and once recorded, it cannot be reversed in financial statements. However, assets can be revalued if their fair value significantly changes.
What is the impact of depreciation on taxes?
Depreciation reduces taxable income, thereby lowering the amount of income tax a business or individual needs to pay. This tax benefit is known as a depreciation tax deduction.
What happens if an asset is fully depreciated but still in use?
When an asset is fully depreciated but still in use, it remains on the company’s books, but its value is reduced to its salvage value or a nominal amount.
Can depreciation be claimed for assets used for personal purposes?
Generally, depreciation can only be claimed for assets used for business or income-generating purposes, not for personal use.
What is a depreciation schedule?
A depreciation schedule is a table that outlines the depreciation expense for an asset over its entire useful life, typically listing the yearly or monthly depreciation amounts.
What happens if an asset’s useful life changes?
If an asset’s useful life changes due to unforeseen circumstances, the depreciation method may need adjustment, and the remaining depreciation should be recalculated.
More information, click here
- Check here ACTouch’s ERP Features
- How to implement an ERP Software that’s easy and quick to do?
- Problems that are faced by an ERP implementation