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Depreciation

How do you define Depreciation?

Depreciation is a decrease in the value of an asset over a period of time. Depreciation is also widely used in accounting to designate the cost of an asset over its useful life. In other words, depreciation is the reduction of the value of an asset over time as a result of usage.

Company assets like equipment, machinery, furniture, and improvements to building can be depreciated. Company assets depreciate in value because of devaluation and discontinuance. Most company owners utilize depreciation in order to increase net income by expensing only a portion of the cost.

Depreciation is not a technique but an appropriation process in order to obtain the matching principle for determining the value of an asset— depreciation is a cost-saving degree for companies. 

How is depreciation calculated?

Depreciation is computed in many ways, however, considering the original value of the asset together with the cost of obtaining, delivering and arranging the asset, only three frequent methods are practiced.

Methods of Depreciation:

  • Straight-line method depreciation

The simplest method of computing depreciation is the Straight Line Method- where the expense amount is equal every year during the useful life of an asset

Straight Line Method Depreciation Formula:

Depreciation Expense= (cost- Salvage Value)/ Useful Life

  • Unit of production method depreciation

This depreciation method depreciates an asset based on the number of hours used or the sum of units to be produced by utilizing the asset during its useful life.

The formula for Unit of Production Depreciation Method:

Depreciation Expense: (# of Units Produced/ Life in # of units) x (Cost- Salvage Value)

  • Double-declining balance method depreciation

In comparison to other depreciation methods, this method of depreciation concludes in a larger amount spent in the early years compared to the later years of the asset’s life. This means that assets are more beneficial to the company in the early years compared to the later years. 

  • Sum of years Digits Depreciation Method

In the sum-of-the-years digits depreciation method, the remaining life of an asset is divided by the total years. It is then multiplied by the depreciation base to identify the depreciation cost. 

The formula for Sum of Years Digits Depreciation

Depreciation Expense: (Remaining Life/ Sum of the Years Digits) x (Cost- Salvage Value)

Importance of recording depreciation

As we have come to determine the reason of depreciation, it is important to know why recording depreciation is needed. 

When a company acquired a purchased asset, it is then listed as a collectible which then appears on the Balance Sheet. Asset depreciation enables a business to utilize a tax-write off to cover the expense of fixed assets over time. 

The lack of depreciation can result in over or understating the total expenses for assets, which can mislead the financial information of the business. Depreciation can also help the company recover the expense of an asset by the time it was purchased— this allows companies to replace future assets by utilizing the amount of revenue.

 

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