Depreciation in accounting is when you make a proportion of the depreciable amount and charge it in the income statement. The proportion is calculated by taking the cost and expected useful life of the asset. It leads to decrease in value of asset with time.
In other words, depreciation is an expense of using asset in the business.
In more simple words, depreciation is a business expense due to use of an asset.
Detailed explanation of depreciation in accounting
To understand depreciation, it’s important to understand the following terms.
- Cost – The cost is the amount incurred to purchase the asset. It’s the value that is paid when you purchase the asset.
- Depreciable cost – It’s the cost less salvage value of the asset.
- Salvage value – It’s an expected amount that can be recovered at the time when the useful life of the asset gets completed. The salvage value is an estimated figure and it might change.
- Useful life – It’s the expected life of the asset. In other words, it’s an expected time an asset is useful for the business. For instance, the business purchases a machine and expects to use it for the next 10 years. Further, it’s important to note that useful life might change. At some point, the business might estimate, the machine is not useful for the remaining useful life. Hence, they have to revise.
Let’s understand depreciation calculation with step by step approach.
- In the first step, depreciable value is calculated by deducting salvage value from the cost of an e asset.
- The depreciable value is divided by the useful life of the asset. It results in a depreciation charge for the period.
The given procedure is when you follow a straight-line method of accounting.
Example of depreciation calculation under the straight-line method
Suppose you have purchased a machine costing $55,000, the expected useful life of the machine is 10 years, and the salvage value amounts to $5,000. Depreciation can be calculated as follows under this method.
Depreciable value = Cost of an asset – salvage value
Depreciable value = $55,000 – $5,000
Depreciable value = $50,000
Depreciation = Depreciable value / expected useful life of the asset
Depreciation = $50,000/10
Depreciation = $5,000
Alternatively, this calculation can also be performed with the following formula.
Straight-line depreciation formula
Depreciation = (cost of an asset – salvage value) / expected useful life of an asset
Remaining balance method
There is another method of depreciation called the remaining balance method. In this method, a certain percentage is applied to calculate depreciation.
Under the remaining balance methods, the following procedure is followed.
- In the first step of this method, the salvage value is calculated by the same method as in the straight-line method.
- A certain/fixed percentage is applied to the depreciable value to get the depreciation amount.
Example of depreciation calculation under remaining balance method
Suppose you have purchased an asset amounting to $20,000 with a salvage value of $2,000. The depreciation rate for the asset is 10%. So, the depreciation can be calculated as follows.
Depreciable value = cost – salvage value
Depreciable value = $20,000 – $2,000
Depreciable value = $18,000
Depreciation expense = depreciable value x factor or depreciation percentage
Depreciation expense = $18,000 x 10%
Depreciation expense = $1800
In this case, Net book value is highly relevant in calculating depreciation for the next accounting period. For instance, after one year, the net book value will be as follows.
Net book value = cost – accumulated depreciation at first year end
What is accumulated depreciation?
The accumulated depreciation account contains depreciation charges in all previous years. Since it has been only one year of asset purchase in our example. So, accumulated depreciation as of now amounts to $1800 which is the depreciation of year one. As the years’ pass, we keep on accumulating depreciation in the accumulated depreciation.
So, after one year, the Net book value can be calculated as,
Net book value = cost – accumulated depreciation
Net book value = $18,000 – $1800
Net book value = $16,200
This is the net book value at the end of year 1. If we need to calculate net book value at the end of a second year, we will use the updated accumulated depreciation account with the following depreciations.
Accumulated depreciation at the end of year 2 can be calculated as follows.
Accumulated depreciation = (depreciation expense at year 1 + depreciation expense at year 2).
So, as we discussed, there are 2 widely used depreciation methods, the next question arises when to use a straight line and when to use the accumulated depreciation method. Here is the answer.
Which depreciation method should be selected by the business?
It depends on the performance statistics of the asset purchased. For instance, if the asset is expected to perform consistently throughout life, the straight-line method should be selected. The reason is that this method allocates equal charges to all periods for the useful life of an asset. On the other hand, if an asset is expected to perform better in the starting years and reduce performance with time, the suitable method will be reducing balance method. The reason is that reducing balance method allocates more charges to income statement in starting years. For instance, if you see a machine, its performance decreases with time. Hence, the straight-line method is more effective when depreciating machine.
Further, it’s important to note that both straight line and reducing balance methods are allowed by International accounting standard and depreciation can be calculated with the following formula.
Formula for depreciation
Straight line method formula = (cost – salvage value) / useful life of the asset.
Reducing balance method formula = (Cost of an asset – salvage value) x depreciation factor.
Also read, Detailed accounting for depreciation
Frequently asked questions
What causes depreciation?
Following are the facts that cause depreciation for the assets.
- Time – As the asset gets older, its value of the asset decreases.
- Wear and tear – The physical condition of the asset gets damaged with time.
- Rights expiry – The business may not be able to use an asset after a certain time.
When should we start applying depreciation?
As per international accounting standard 16, the business needs to apply depreciation once it’s brought in useable form. It does not matter whether you use an asset or not, if an asset is in a useable form, there is a need to apply depreciation.
What are the factors of depreciation?
The following are four main factors that impact depreciation.
- The cost of an asset.
- Useful life on an asset.
- Depreciable value of an asset.
- Salvage value of an asset.