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What is Meant by Depreciation in Accounting

Hamza Haroon | July 17, 2021

Table of contents

    What is Depreciation in Accounting?

    In accounting, the depreciation costs are used to distribute the cost for the useful life of a tangible asset. It is, in simplest words, the decrease in an asset's value due to use, wear and tear or obsolescence with time.

    Therefore, the depreciation is the result of a company's loss of asset’s value over time. For instance, a work tool progressively depreciates its original purchase price to $0 as its productive life goes on.

    Be aware of different finance concepts like what is return on assets and return on investment

    Depreciation Formula

    As there are different methods to calculate the depreciation, hence there is no general formula for depreciation calculation. However, for each different method of depreciation the different depreciation formulas are given below:

    Straight-Line Depreciation Formula:

    Depreciation expense = (Cost of asset – Scrap value of asset) / Useful life of asset

    Units of Production Depreciation Formula:

    Depreciation expense = (Number of units produced/Life of asset in units) x (Cost of asset–Scrap value of asset)

    Declining Balance Depreciation Formula:

    Depreciation rate = 100% / Life of asset

    Sum of the Years Digits Depreciation Formula:

    Depreciation expense = (Remaining life of the asset / Sum of the years’ digits) x (Cost of asset – Scrap value of asset)

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    What are Depreciation Methods

    Depreciation is the process through which the cost of an asset is distributed or allocated across its life. Different enterprises, in particular those in the various industries, might employ different depreciation techniques.

    That is why numerous depreciation methods are available. The most notable depreciation methods are explained below:

    Straight Line

    The depreciation technique which equally extends asset costs across the useful life of the assets, is the straight line depreciation method. Each year, from the initial year to the last year of fixed assets, the depreciation expenditure remains the same.

    This depreciation method, straight line depreciation, is the simplest and the company's most frequently used depreciation technique. The straight-line is the most often utilized depreciation technique among all kinds of depreciation.

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    Declining balance

    The declining balance method is somewhat distinct to other depreciation methods as instead oforiginal depreciable base it applies constant depreciation rate to declining book value of asset.

    Therefore, the depreciation rates become low yearly as the depreciation rate is a multiple of the method, straight line. Depreciation is calculated in two steps:

    First, compute the straight-line annual depreciation rate.

    1 / useful life = ADR

    Next, apply the yearly depreciation rate to the asset balance, average of depreciation from the initial time period.

    Annual Depreciation Expense = (Cost – Accumulated Depreciation) * Annual Depreciation Rate

    Sum-of-the-years Digits

    This, like the double-declining balance technique, is an accumulated depreciation formula, in which, the asset in the beginning of its life loses more value than at the end.

    In this method, for the projected usable life you add first the figures of the year(s) together. Then for each year you make one fraction with the rest of the years on top and the number on the bottom.

    Units of Production

    As this calculation method of depreciation is easy units of production is considered related to the straight line method.

    Depreciation via unit of production is most commonly for equipment that are intended to manufacture specific goods before they become useless.

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    Which depreciation method is best (straight line method)

    How the value of an asset diminishes over time, is represented by the straight line method and is considered the best method to calculate depreciation.

    It's a simple accounting computation that assumes a constant value reduction. This technique is illustrated graphically by a line from the asset's purchase price to its end-of-life value.

    Straight-line depreciation is calculated as follows:

    (Cost - Salvage Value) / Useful Life

    As the straight line depreciation is the most convenient approach to describe asset depreciation. That’s why it is used by various organizations and industries.

    Therefore, the straight-line approach of depreciation is distinct from all other methods to calculate depreciation as it implies an item loses the same amount of value each year. You also can use a depreciation calculator for quick and fast calculations.

    Whereas the double-declining balance approach reduces an asset's worth early in its life.

    Is Depreciation a debit or credit?

    Every year, the depreciation expenditure account is debited, and the accumulated depreciation account is credited. As depreciation is charged against the asset's value, the accumulated depreciation grows.

    However, fixed assets are debit balance. The fixed asset can be compensated by recording depreciation as a credit balance.

    Cumulative depreciation is a contra-asset account, meaning it reduces the value of an asset. Consequently, accumulated depreciation represents a negative amount on the balance sheet.

    However, the fixed asset is valued at its original cost. Investors can assess how much the fixed asset has depreciated by looking at the accumulated depreciation.

    The net difference represents the asset's net book value. Briefly, by recording accumulated depreciation as a credit, investors may readily calculate the fixed asset's original cost, depreciation, and net book value.

    Is Depreciation an asset?

    Depreciation expenditure on a fixed asset up to a certain date is known as accumulated depreciation. Accumulated depreciation is the sum of all past depreciation expenditure on a fixed asset.

    Therefore, it is a contra asset account, containing a negative balance to offset the asset account it is associated with, resulting in a net book value.

    It is separated from conventional asset and liability accounting due to many reasons. It is not an asset since the account balances do not represent something that will generate economic value for the business over time.

    Accumulated depreciation reflects the quantity of economic value consumed before. It is not a liability as well because the account balances do not reflect a payment obligation. It is used solely for internal record keeping and does not imply a payment obligation.

    If you must choose between treating cumulative depreciation as an asset or liability, categories it as an asset. If it were classed as a liability, it would imply that the reporting entity is liable to a third party, which is wrong.

    Why do we use depreciation?

    In accounting, depreciation helps to understand your real business costs (since wear and tear is an expense), lower your tax burden, and estimation of your company’s value. These three reasons why do we use depreciation are explained below.

    Cost of doing business

    To determine your company's profitability, you must know all costs. Depreciation is one of such expenditures since assets need to be replaced eventually.

    Depreciation measures the worth of your assets lost over time. If you don't look for depreciation, you'll undervalue your costs and overestimate your profits.

    Lower Taxes

    Depreciation reduces your profit and thus your tax burden as well. Without depreciation, you'll pay too much tax. The whole worth of an asset might progressively be requested from your tax.

    However, there are tax regulations regarding how rapidly some assets can be depreciated.

    Business valuation

    Your company's value might lose in the similar way assets depreciate. For instance, a transport business with old containers (vehicle) may not be valued as much as one with new trucks.

    Remember that assets are frequently used to secure loans as well. As they lose value, they become less secure and may be difficult to finance.

    Which is better depreciate or expense?

    Money has a value for time being, therefore it's often better to expense an item rather than depreciate it. In order to receive the deduction for an item expenditure, you must expense the item and deduct the expense in the current tax year.

    After you make this deduction, you will be able to spend the money that deduction has freed from taxes. Depreciating the sequence of yearly depreciations may take several years before you obtain the entire tax advantage.

    How is depreciation calculated?

    When determining a depreciation calculation for an asset, three factors must be considered:

    Depreciable base:

    It is calculated by original cost subtracting the salvage value. The OC comprises both the purchase price and any expenditures required to prepare the asset for usage. To calculate the salvage value, subtract the depreciation from the asset's original cost.

    Useful life:

    The expected time an asset may be used before becoming obsolete or worn out. Physical life and useful life may be different from each other.

    Depreciation method:

    Choose a method that must be methodical and reasonable given the asset's nature. Some techniques assume depreciation is based on use, while others believe it is based on time. Methods are typically chosen for their ease of use and low cost.

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