What is Depreciation Accounting?

In terms of accounting, with the passage of time the value of a fixed asset (like machinery, plants, furniture etc.) goes down over a specific period of time is known as depreciation. Now, the question comes in your mind, why the value of the fixed asset reduces over time.

So, the answer is when the fixed asset is purchased by the company then that asset is used by the company for many years so, due to this the value of asset declines over a year or the asset becomes outdated or obsolete. But, there is an exemption for one fixed asset i.e. land whose value increases over a time.

For example- A company purchases machinery amount $20,000 and the expected useful life of the machine is 4 years. So, the business charges depreciation on machinery under depreciation expense as $5,000 every year for a period of 4 years.

Calculation of Depreciation Methods

There are three depreciation methods that are commonly used are:

Straight line Depreciation method

Straight line depreciation is the simplest method of calculation of depreciation among all the available methods. Under straight line depreciation, the division of the cost of asset is equal during its useful life and this method depreciation is always charged on original price i.e. purchase price. The formula for calculating this method of depreciation is :

• Cost of fixed asset means the original price of the asset i.e. purchase price of that asset.
• Salvage value means the amount that the company expects to get value of that fixed asset at the end of the useful life of that fixed asset.
• Useful life means for how many years company is expected to use that fixed asset.

In this picture x-axis i.e. horizontal line shows time whereas the y-axis i.e. vertical line shows asset value. We see in the picture, with the passage of time the value of an asset declines and comes to its scrap value or salvage value.

 Straight line method example-:

Suppose a company purchases a truck for delivery purpose amount $200,000 with an salvage value of $20,000 and the expected year to use that fixed asset is 6 years.

Solution: According to the above formula of straight line method:

     Depreciation = cost of fixed asset ($200,000)- estimated salvage value ($20,000)

Useful life(6)

                                            = 1, 80,000/6

                                           = $30,000

So, it means the company depreciates the value of the truck with the amount of 30,000 yearly for the next 6 years.

Advantages of straight line method

•  This method is simple, uncomplicated so it’s easy to understand and apply.
• Under this method, the value of the asset becomes zero or negligible or written off completely at the end of the useful life.
• If the company uses a straight line method of depreciation, then the company is able to know the value total depreciation charge.

Disadvantage

• In straight line depreciation, there is no provision of replacement.
• Straight line depreciation method of calculation depreciation is not very reliable if the asset has a long life or if the value of the asset is more.

Written down value method

This is one of another method of calculation of depreciation. In a written down value method, depreciation is charged on the reducing value of the asset at a fixed percentage rate.

That’s why depreciation will be more in the initial phase of the asset and less towards the last phase of the life of the asset. Under the written down value method, the value of the fixed asset cannot be zero. The formula for calculation of depreciation through this method is:                  

For example: Company A purchases a plant and machinery for $22,000 with an estimated scrap or salvage value of $2,000 and a useful life of 3 years. The rate of depreciation is 18%.

Solution: The written down value method of depreciation is calculated as given below.

By using the above formula value of depreciation is calculated in this way:

Depreciation = {cost of asset (22000 )-  salvage value (2000)}*rate of depreciation (10%)

                             = 20,000*10/100

                             = 2,000

So, from the above table we can conclude that in this method, depreciation expense is more in the early phase of life of asset and its decline with every year, in the later life of the asset.

Unit of production method

Unit of production method is also known as a two-step process. In this method, depreciation on asset is charged on the number of units produced annually i.e. on the output not on the number of useful life of an asset is left the formula that is used for calculation is:

For example- a company purchased a truck costing $640,000 with an estimated salvage or scrap value of 40,000 with a estimated useful life of 60 years and estimated to run 10,000 miles.

Solution – by putting the value in the above formula we get

$= \frac{costof asset(6,400)–salvagevalue\left(400\right)*actualunits\left(10,000\right) }{Estimatedusefullife\left(60,000\right)}$

   =  0.6 *10000

   =6000

So, the total depreciation expense is $,6000.

Comparative study between straight line method and written down value method:

Treatment of Depreciation in Financial Statement

As we all know depreciation is an expense so it is written on the debit side of the profit and loss account and in the balance sheet  cost of an asset which has been used is deducted from the cost of the particular asset and shown in the asset side of the balance sheet.

For example- Let Company X purchase a machinery costing 20,000 and 10% depreciation is charged annually. So, depreciation = 2000. It means the value of machinery is reduced by 2000at the end of the year.

In the profit and loss account it is shown as depreciation on machinery 2000 in the debit side. In the balance sheet it is shown as machinery =15000 minus depreciation 2000= 13000(net value of machine) on the asset side.

Content and Applications  

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for

• B.B.A. in Accounts  
• M.B.A in Accounts