Depreciation Accounting – Objectives and Methods

We know the concept and method of depreciation Accounting for many reasons if you go to start a business. To run a business, we required to purchase different types of assets including, tangible and intangible. 

So it is clear that all these assets will have a useful life during which they may function properly. After this healthy period, the efficiency of the assets will decrease. It may undergo for maintenance frequently, and at last, we may sell it for a salvage value.

Depreciation is the continuous reduction in the value of the asset. This reduction in value occurred because of the wear and tear, obsolescence, changes in the market trends etc.

In other words, the portion of the total asset is diminishing because of the usage and this reduction records in Profit and Loss Account as an expense for that period.

Depreciation Accounting - Concept

We purchased a new machine for USD 10000 for the production of a product. We can use the machine in the business for at least 4 years. After this period, the machine may stop or reduce production. We can sell the machine at a salvage value of USD 2000.,after the period

In this case, we can not charge the USD 10000 as an expense for the first year of purchase. We have to pay the total amount in the first year. And it will be recorded as an asset in the Balance Sheet as it is Capital expenditure.

In accounting, to find the revenue, the cost should be matched with revenue. We purchased the machine for USD 10000 and can sell it at the end of the fourth year at USD 2000.

Our actual spending will be USD 8000. As we used the machine for four years, we need to distribute the total expense to all these four years.

This is the concept behind depreciation.

Depreciation Accounting helps us to allocate and find the correct calculations of cost, profit, the reasonable value of assets in Balance Sheet, creation of a fund for future asset replacement etc.

Depreciation accounting data used both financial accounting and management accounting for reporting, tax and management information purposes.

Why business needs to charge depreciation

The main reason are

To arrive at correct product costing

 To save the resources

To reduce the inflated price of the asset

Product costing

When we use machines in production processes to produce the product, it is required to add the depreciation of the machine used to the cost of the product. Depreciation Accounting helps the business to ascertain the cost of production properly.

It is a non-cash expense

Depreciation is charging to Profit & Loss Account as an expense or cost against the profit. But actual cash payment for this expense does not occur.

So this process of depreciating the machine will help the business to save their resource.

They can use these resources to replace the original asset in future.

Reduce the inflated price of the asset

All the assets when we start to use in the business will start losing efficiency and reduce the capacity. As a result, its value will reduce. So we provide depreciation, it can avoid the unfair price of the assets in the balance sheet.

Will land Depreciate?

Usually land will not depreciate because of depreciation applies only to those assets which all have a limited useful life. With regards to the land, we can not say the useful life of the land. Accordingly, it is not a practice to require depreciation on land

However, in case the land is having a limited useful life, we need to charge depreciation on it.

When land has a limited useful life?

If the land represents a mine or quarry, in that case, the land has a limited useful life then the depreciation is applicable to land

How to allocate depreciation on Assets

Depreciation must be charged on the assets systematically. We need to select a particular method of depreciation depends on the nature of the business.

 This same method should follow for all the subsequent years.

In case, the company want to change the method of depreciation after a review of the useful life, scrap value, the changes in the value of depreciation of existing assets from the starting of the assets need to be calculated and adjusted.

It must be calculated over the useful life of the asset. 

What is the useful life

The useful life of an asset means the expected period of life of an asset. This life may be for some years. During that period the asset can become productive and the business may get the befit from it. 

The useful life of an asset can increase if we provide preventive maintenance.

The company required to perform the review of the useful life of the asset periodically. If you think the estimate is not in order, you need to change the method of depreciation accounting.

What is residual value

 

Residual Value is the net amount we may receive on disposal of the asset at the end of useful life.

Any expenses incurred on the sale of the depreciated asset should subtract from the residual value of the asset.

 

When we stop Depreciating an asset

When we stop Depreciating an asset

Charging of the depreciation starts when an asset reaches the business. I will stop the depreciation when it held for disposable or fully depreciated

If the asset is lying idle in the company, this asset will not get any freedom in changing the depreciation. 

 

Methods of charging Depreciation

  1. Straight line method
  2. Diminishing balance method
  3. Sum of the units method

Straight line method

This method is also known as Fixes Installment or Equal Installment method of charging depreciation. As the name indicates, a fix or equal amount of the cost of the asset considers as depreciation for the period.

Depreciation equation under SLM 

\frac { Cost\quad of\quad the\quad Asset\quad -\quad Redidual\quad Value }{ Estimated\quad Life\quad of\quad the\quad Asset }

Illustration: 1.

Asset nameCost of assetother expensesResidual valueuseful life
Vehicle25000007000001000006
Plant100000050000100005
Machinery9000010000200008
  • Other Expenses means incurred at the time of purchase of the asset . 

Solution

Asset name (a)Cost of asset (B)other expenses (C )Residual value (d)useful life (E )Total cost of asset (f)Depreciation
Vehicle250000070000010000063,200,000516,667
Plant1000000500001000051,050,000208,000
Machiney9000010000200008100,00010,000

Written Down Value Method

This method is also known as Reducing Balance Method or Diminishing Balance Method.

In this method, depreciation calculates as a percentage. In the first year, depreciation calculates on the original price of the asset.

Subsequent years, the value of the asset will reduce and the depreciation will calculate on the written down value of the asset.

We need to note that the percentage is constant until the asset reaches the expected life of the asset, but the amount will diminish from year to year.

Illustration: 2.
A Machine purchased for USD 75000. At the time of the erection of the machine, installation charges paid USD 25000. Rate of Depreciation estimated as 25% on Reducing Balance Method. Calculate the depreciation for a useful life of 5 years.

Solution

Year .....Price of the Asset at the beginning of the yearrate of depreciationDepreciationprice at the end of the year
Year110000025%2500075000
Year27500025%1875056250
Year35625025%1406342188
Year44218825%1054731641
Year53164125%791023730

Sum of Units Method

\quad \frac { Units\quad of\quad Production\quad for\quad the\quad Year }{ Estimated\quad Units\quad of\quad Production\quad During\quad the\quad Useful\quad Life } \quad X\quad Original\quad Cost\quad of\quad Asset

Illustration : 3.

An asset purchased for 10000. The estimated residual value is 2000. Estimated production of the asset during the useful life of the asset is 50000 units.

Unit of production for the five years as follows
First Year – 2000 Units
Second Year – 1500 Units
Third Year – 1000 Units
Forth Year – 900 Units
Fifth Year – 750 Units

Calculate Depreciation.

Solution

Year .....units producedtotal expected productioncost of asset - residual valuedepreciation
Year1200050008000320
Year2150050008000240
Year3100050008000160
Year490050008000144
Year575050008000120

Related Terms

There are three other terms related to depreciation. We need to have a look at them. They are
1. Provision for Depreciation
2. Disposal of Asset
3. Profit or Sale on Disposal of Asset

What is Provision for Depreciation?.

The provision means the amount which we keep in our account for the future. Provision for Depreciation is the account in accounting to transfer the periodical depreciation.

By maintaining this account, it will not credit the Asset Account depreciation instead, it will credit Provision for Depreciation account.

When the assets sold, depreciation of the concerned assets would transfer to the credit side of the asset’s account.

So, we can find the exact profit or loss on the sale of the Fixed Asset.

What is Asset Disposal Account?

Usually, assets sold when it reaches the expected useful life. There may be other reasons that the assets sold by the business.
Example: obsolescence of machine.
When the assets sold in the above cases, for accounting purpose, the below-mentioned items may transfer to this account.

  • The cost of the asset will transfer to the Asset Disposal Account.
  • The accumulated depreciation also transfer to this account.
  • Depreciation for the year of sales also credits to this account.

Disposal of Asset may lead to Profit or Loss?

Yes, the sale of the asset may result in profit or loss.

These sales may happen because of any urgent situation or after the completion of the useful life etc.

When the amount of sales proceeds is higher than the asset’s original cost less depreciation, then the result will be profit and vice versa. The same will reflect the Profit & Loss Account for the year of sales.

Yes, the sale of the asset may result in profit or loss.

These sales may happen because of any urgent situation or after the completion of the useful life etc.

When the amount of sales proceeds is higher than the asset’s original cost less depreciation, then the result will be profit and vice versa. The same will reflect the Profit & Loss Account for the year of sales.

These are the main objectives and methods of depreciation accounting.

It is very important for any business professionals to know the topic in details and also for those who want to start a business.


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