What Is Depreciation?

What is Depreciation?

In accounting terms, depreciation is defined as the reduction of recorded cost of a fixed asset in a
systematic manner until the value of the asset becomes zero or negligible.

An example of fixed assets are buildings, furniture, office equipment, machinery etc.. A land is the
only exception which cannot be depreciated as the value of land appreciates with time.

Depreciation allows a portion of the cost of a fixed asset to the revenue generated by the fixed asset.
This is mandatory under the matching principle as revenues are recorded with their associated
expenses in the accounting period when the asset is in use. This helps in getting a complete picture
of the revenue generation transaction.

An example of Depreciation – If a delivery truck is purchased a company with a cost of Rs. 100,000
and the expected usage of the truck are 5 years, the business might depreciate the asset under
depreciation expense as Rs. 20,000 every year for a period of 5 years.

How to calculate depreciation in small business?

There three methods commonly used to calculate depreciation. They are:

Straight line method

Three main inputs are required to calculate depreciation:

Useful life – this is the time period over which the organisation considers the fixed asset to be
productive. Beyond its useful life, the fixed asset is no longer cost-effective to continue the operation
of the asset.

Salvage value – Post the useful life of the fixed asset, the company may consider selling it at a
reduced amount. This is known as the salvage value of the asset.

The cost of the asset – this includes taxes, shipping, and preparation/setup expenses.

Unit of production method needs the number of units used during production. Let’s take a look at
each type of Depreciation method in detail.

Types of depreciation

1) Straight-line depreciation method

This is the simplest method of all. It involves simple allocation of an even rate of depreciation every
year over the useful life of the asset. The formula for straight line depreciation is:

Annual Depreciation expense = (Asset cost – Residual Value) / Useful life of the asset
Example – Suppose a manufacturing company purchases a machinery for Rs. 100,000 and the useful
life of the machinery are 10 years and the residual value of the machinery is Rs. 20,000

Annual Depreciation expense = (100,000-20,000) / 10 = Rs. 8,000

Thus the company can take Rs. 8000 as the depreciation expense every year over the next ten years
as shown in depreciation table below.

Year Original cost – Residual value Depreciation expense

1 Rs. 80000 Rs. 8000

2 Rs. 80000 Rs. 8000

3 Rs. 80000 Rs. 8000

4 Rs. 80000 Rs. 8000

5 Rs. 80000 Rs. 8000

6 Rs. 80000 Rs. 8000

7 Rs. 80000 Rs. 8000

8 Rs. 80000 Rs. 8000

9 Rs. 80000 Rs. 8000

10 Rs. 80000 Rs. 8000

2) Unit of Production method

This is a two-step process, unlike straight line method. Here, equal expense rates are assigned to
each unit produced. This assignment makes the method very useful in assembly for production lines.
Hence, the calculation is based on output capability of the asset rather than the number of years.

The steps are:

Step 1: Calculate per unit depreciation:

Per unit Depreciation = (Asset cost – Residual value) / Useful life in units of production

Step 2: Calculate the total depreciation of actual units produced:

Total Depreciation Expense = Per Unit Depreciation * Units Produced

Step 1: Per unit Depreciation = (40,000-4000)/180,000 = Rs. 0.2

Step 2: Total Depreciation expense = Rs. 0.2 * 4000 flyers = Rs. 800

So the total Depreciation expense is Rs. 800 which is accounted. Once the per unit depreciation is
found out, it can be applied to future output runs.

3) Double declining method

This is one of the two common methods a company uses to account for the expenses of a fixed
asset. This is an accelerated depreciation method. As the name suggests, it counts expense twice as
much as the book value of the asset every year.
The formula is:

Depreciation = 2 * Straight line depreciation percent * book value at the beginning of the accounting
period

Book value = Cost of the asset – accumulated depreciation

Accumulated depreciation is the total depreciation of the fixed asset accumulated up to a specified
time.

Example: On April 1, 2012, company X purchased an equipment for Rs. 100,000. This is expected to
have 5 useful life years. The salvage value is Rs. 14,000. Company X considers depreciation expense
for the nearest whole month. Calculate the depreciation expenses for 2012, 2013, 2014 using a
declining balance method.

Useful life = 5

Straight line depreciation percent = 1/5 = 0.2 or 20% per year

Depreciation rate = 20% * 2 = 40% per year

Depreciation for the year 2012 = Rs. 100,000 * 40% * 9/12 = Rs. 30,000

Depreciation for the year 2013 = (Rs. 100,000-Rs. 30,000) * 40% * 12/12 = Rs. 28,000

Depreciation for the year 2014 = (Rs. 100,000 – Rs. 30,000 – Rs. 28,000) * 40% * 9/12 = Rs. 16,800
Depreciation table is shown below:

Year Book value at the beginning Depreciation rate Depreciation Expense Book value
at the end of the year

2012 Rs. 100,000 40% Rs. 30,000 * (1) Rs. 70,000

2013 Rs. 70,000 40% Rs. 28,000 * (2) Rs. 42,000

2014 Rs. 42,000 40% Rs. 16,800 * (3) Rs. 25,200

2015 Rs. 25,200 40% Rs. 10,080 * (4) Rs. 15,120

2016 Rs. 15,120 40% Rs. 1,120 * (5) Rs. 14,000

Depreciation for 2016 is Rs. 1,120 to keep the book value same as salvage value.

Rs. 15,120 – Rs. 14,000 = Rs. 1,120 (At this point the depreciation should stop).

Why should small businesses care to record depreciation?

So now we know the meaning of depreciation, the methods used to calculate them, inputs required
to calculate them and also we saw examples of how to calculate them. Let’s find out as to why the
small businesses should care to record depreciation.

As we already know the purpose of depreciation is to match the cost of the fixed asset over its
productive life to the revenues the business earns from the asset. It is very difficult to directly link
the cost of the asset to revenues, hence, the cost is usually assigned to the number of years the
asset is productive.
Over the useful life of the fixed asset, the cost is moved from balance sheet to income statement.
Alternatively, it is just an allocation process as per matching principle instead of a technique which
determines the fair market value of the fixed asset.

Accounting entry – DEBIT depreciation expense account and CREDIT accumulated depreciation
account.

If we do not use depreciation in accounting, then we have to charge all assets to expense once they
are bought. This will result in huge losses in the following transaction period and in high profitability
in periods when the corresponding revenue is considered without an offset expense. Hence,
companies which do not use the depreciation expense in their accounts will incur front-loaded
expenses and highly variable financial results.

Final Notes

Depreciation is an important part of accounting records which helps companies maintain their
income statement and balance sheet properly with the right profits recorded.