In every Business there are a number of assets which are put into use for business purposes. Every asset has a limited life. Thus after the completion of its life, the asset needs to be disposed off. But the life of asset cannot be determined. This life is an estimate. After every year the value of the asset gets decreased. This decrease is known as Depreciation. Thus Depreciation is the wear and tear of the asset. It results in the reduction of the value of the asset. Depreciation takes place due to following reasons:
In case of reduction in the value of intangible goods, the reduction in the value is known as Amortization. The reduction in the value of the Natural Resources, mines, Mineral Reserves, is known as Depletion. Thus Depreciation is a very delicate concept of accounting.
In accounting language Depreciation can be defined as,” Reallocating of the cost of the asset over its useful life is known as Depreciation.”
Applying depreciation over the life of the asset will leave the value of the asset at the end of its life at zero or at its scrap value.
No depreciation is applied on land. Land is not a depreciable asset i.e. on which depreciation can be allowed because its useful life cannot be estimated. Depreciation can be allowed only on those assets whose useful life can be estimated. But land’s useful life cannot be estimated. In fact, land is always an appreciable asset. This is why there is no depreciation allowed on land.
Depreciable Value: The value of the asset is never considered to be depreciable. Depreciable value is the value that is obtained after subtracting the residual value of the asset after its life from the value of the asset. The value so obtained is the value on which the depreciation is to be applied.
Value of the asset is $ 50,000. The Residual Value of the asset after 10 years is $2000. There for the Depreciable Value of the asset will be $48,000 (50,000-2,000).
There are three factors to be taken into consideration while calculating depreciation:
1. Useful Life of the Asset: The useful life of the asset needs to be knows so that the cost of the asset can be apportioned over the age of the asset. The wrong estimate of life of the asset may run the firm into losses.
2. Residual Value: The residual value of the asset at the end of the period is to be known to find the Depreciable value of the asset i.e. the value on which the depreciation is to be charged.
3. Depreciation Method: It is important to determine the method for calculation of Depreciation. Every company or business follows a certain method of Depreciation as per its convenience. There are several methods of providing depreciation like, Annuity Method, Straight line method, written down value method etc.
There are two ways of presenting Depreciation in the books of accounts. Both the methods are appropriate to be followed. It just depends upon the company how they want their assets to appear in the books of accounts. Both the methods work on the same basis, only their presentation differs. These ways are:
1. Depreciation as a Loss: In this method the depreciation is shown as a loss in the profit and loss account of the company. The value of the asset gets decreased by the relative amount by which the depreciation appears in the profit and loss account. In Balance Sheet the Asset shows the Actual Value after Depreciation.
2. Accumulated Depreciation: In Accumulated Depreciation method, the depreciation is not charged to the asset. It is instead credited to another account known as Accumulated Depreciation Account. The Asset is shown at its original price in the Balance Sheet but on the Credit side, the Accumulated Depreciation is shown as a liability. Whenever the asset is to be disposed off or sold, the accumulated Depreciation is to be reduced from the value of the asset.
Value of asset = Original Value of Asset – Accumulated Depreciation.
Let’s discuss a few of them in detail:
1. Straight Line Method: In straight line method the depreciation charged over the years is the same. The depreciation does not change i.e. the depreciation charged in the first year will be charged in the following years. This method of depreciation is followed where the capacity of the asset does not change and remains the same over the years. For example, the use of building is constant over the years; this method can be applied there. If a machinery is put to use and it produces the same number of units every year; the straight line method can be used.
For straight line method,
2. Reducing Balance Method: The reducing balance method is a depreciation strategy in which the depreciation keeps on decreasing every year. It will be the highest in the first year, lower in second year and subsequently it will keep decreasing. It is the depreciation calculated on the remaining balance of the asset after every year. This kind of method is used in the business where the productivity of the asset keeps on decreasing every year.
For Diminishing Value Method,
Depreciation = Value of Asset at the end of the year X Depreciation Rate. Here,
3. Sum of the Years Digits Method: Sum of the Years Digits Method is one of the most useful methods of calculating depreciation. It is one of the methods who take into consideration the acceleration writes off of assets. This method is based on the assumption that an asset is more useful and productive in the initial years of its use. This is why the maximum depreciation is provided for in the initial years only.
For Sum of the Years Digits Method,
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