Depreciation is an important concept in accounting. By definition, depreciation is the wear and tear in the value of a noncurrent asset over its useful life. In simple words, depreciation is the cost of operating a noncurrent asset producing revenues for business over its useful life. Depreciation is charged every year in the income statement and is deducted as one of the operating expenses. The principle behind charging depreciation against revenues is that an asset was used to generate revenues for a business then as per matching concept, depreciation should be the matching cost incurred to generate those revenues.
There are different types or methods for calculating depreciation on a fixed asset.
Straight Line Depreciation
Normally depreciation is calculated using a straight-line basis in which the depreciable amount is divided by the useful life of the asset. This method assumes that the revenue is generated evenly over the useful life of the asset and it is best to spread the depreciation expense evenly over the useful life of an asset.
Reducing Balance Depreciation
Another common method is reducing balance method in which the depreciation rate is multiplied by the net book value of the asset at the start of the year. This method argues that the depreciation charge should be declined each year as the performance and ability to generate revenues associated with a noncurrent asset declines over time. The calculations will be explained in the examples below.
Number Of Units Depreciation
This method argues that the depreciation expense should be recorded to the extent it has used the asset. For example, a machine has a useful life of 2000 hours. If the machine worked for 500 hours for the first year then the depreciation will be based on the number of hours used.
The Sum Of Years' Digits Method
Under this method, a fraction is computed by dividing the remaining useful life of the asset on a particular date by the sum of the year's digits.
Double Declining Method
This method simply charges the double of the straight-line depreciation rate and is applied to the beginning book value of the asset.
Under this method, the asset’s useful life decides the class in which asset will fall and the depreciation rates are predefined for each class.
Straight Line Method:
Reducing Balance Method:
The Number Of Units Method:
Double Declining Method:
Sum Of The Year’s Digit Method: For an asset with the useful life of four years.
A business should use a depreciation method that follows the pattern of usage of an asset in the generation of revenues. Let us see how.
Mr. Ben purchased a Toyota Corolla 2008 model for $21,000, which he intends to use for escorting customers for next three years. Ben has estimated that after the useful life of three years his car will be sold for $6,000. What would be the depreciation per year under each of the following methods:
Straight line method
30% on Reducing balance method
Depreciation Using The Straight Line Method
Annual depreciation = (21,000-6,000)/ 3
= $5,000 per year for three years
Depreciation Using Reducing Balance Method
Depreciation of year 1 = $21,000 x 30% = $6,300
Depreciation of year 2 = ($21,000-$6,300) x 30% = $4,410
Depreciation of year 3 = ($21,000-$6,300-$4,410-$6,000) = $4,290
Note: The total depreciation under both methods was $15,000 ($5,000 x 3 = $6,300+$4,410+$4,290), only the pattern of usage of car is different so the depreciation of each year is different.
Accumulated Depreciation Definition
Accumulated depreciation account is an account in which depreciation keeps on accumulating till its sales at the end of its useful life or disposal.
Answers from our experts for your tough homework questions