In the world of financial reporting and tax obligations, businesses must show how their assets gradually lose value over time. This accounting procedure, called depreciation, allows them to accurately reflect this decrease and manage their tax liability effectively.
- What is depreciation?
- Characteristics of Depreciation
- Factors Affecting Depreciation
- Benefits of Depreciation Calculation
- Depreciation Calculation Methods and Formulas
- Conclusion
What is depreciation?
What exactly is depreciation? Well, imagine you buy a shiny new asset for your business. Over time, that asset naturally loses value. Depreciation is a smart way to acknowledge this decline and spread out its cost throughout the asset’s useful life.
Now, why does depreciation matter? It’s all about managing your business’s financial statements and tax obligations. By applying depreciation, you can smooth out the financial impact of your asset purchases. This has a direct impact on your income statement and balance sheet, which are two vital financial documents for any company. Plus, depreciation helps you avoid drastic swings in profitability that would occur if you were to expense significant asset purchases all at once.
In simpler terms, depreciation is like a gradual write-off that acknowledges the wear and tear of your assets and keeps your financial records and tax liabilities in order. It’s an essential tool for businesses to ensure their financial health stays steady and their tax burden remains manageable.”
Characteristics of Depreciation
Before delving into the calculation of depreciation, it’s important to understand its defining characteristics.
Permanent
Depreciation refers to a permanent decline that takes place gradually and continuously. The utility value of fixed assets will decrease until the end of their useful life.
Expense Against Profit
Depreciation is understood as a burden on the profit or income earned by the company for a certain accounting period.
Not a Sudden Loss
Depreciation must always be calculated systematically and rationally. This is because asset depreciation is not a sudden loss.
Including Expired Cost Allocation
Depreciation is a cost allocation process that expires and does not include the valuation of fixed assets.
Uncertainty
It is impossible to calculate the exact value of depreciated fixed assets, but it can be estimated.
Caused by Physical and Functional Factors
Depreciation occurs due to physical and functional factors of fixed assets.
To Maintain Nominal Capital
Depreciation has a fundamental purpose: to maintain the nominal capital invested in fixed assets and to allocate part of the fixed assets cost that expires over several accounting periods.
Unavoidable
Depreciation is inevitable, even if the fixed asset is carefully maintained or unused.
Not Affected by Market Value Fluctuations
The market value of a fixed asset may fluctuate, but this does not affect the depreciation of the asset in question.
Only for Fixed Assets
The calculation of the depreciation value only applies to fixed assets such as factories, furniture, or machinery.
Does Not Exceed Its Depreciable Value
The depreciation amount must not exceed the depreciable or initial cost where the salvage value is nil.
Factors Affecting Depreciation
In accumulated depreciation, there are varying influencing factors. Details about the influencing factors of depreciation are as follows:
Acquisition Price
The first factor that affects depreciation is the acquisition price, which is the initial price when the company purchases the asset for the first time. The accountant or finance division usually calculates the depreciation expense every certain period, and the cost is the first benchmark.
Residual Value
The next factor that may affect the nominal depreciation expense is the residual value, which is the final value of an asset after it cannot be depreciated anymore. Some companies generally have benchmarks for the ideal residual asset nominal as desired. After that, the assets were transferred by retaining the rest in control of the business.
Estimated Useful Life
Estimated useful life plays a big role in determining how much it costs to replace or repair something when it wears out over time. Apart from being based on residual value and acquisition price, some companies generally have certain expectations when an asset is declared to be fully depreciated, which can be several months to 10 years, depending on company policy.
Usage Patterns
The process of using assets over a certain period greatly influences depreciation, especially the age of assets. Usually, the more severe the use, the faster the estimated time to run out of its benefits. In this case, you can use the depreciation formula to add up the expenses over the depreciation period.
Benefits of Depreciation Calculation
Calculating depreciation expense is one of the mandatory things accountants should not leave out when making financial reports. If deliberately avoided or manipulated, financial reports have the potential to be invalid and endanger various parties, including technical workers. In addition, the benefits of calculating depreciation are as follows:
Record Profit Acquisition
Depreciation expense is important in calculating a company’s profit. Therefore, the first benefit of depreciation is obtaining profit information because there are expenses for initial and reserve assets that must be recorded in the financial statements.
Knowing the Initial Price of an Asset
The main benefit of calculating depreciation is knowing the initial price of an asset. In accounting, purchased assets are not necessarily only reviewed for their benefits. However, the initial cost of the asset and its use must be accounted for in depreciation.
This measurement is based on work use rights and asset ownership. The combination of these will give rise to the initial price of the asset and is used in the calculation of operating expenses and profit.
Minimizing Losses
Purchasing assets can be a source of company losses if these assets cannot generate productivity. Thus, one of the benefits of depreciation is to minimize losses. Having assets, the company will think of maximizing assets in generating profits and preparing to allocate funds as reserves to buy new assets because their value continues to depreciate.
Knowing the Depreciation Cost of Each Period
The last benefit of depreciation is that the company can determine each period’s depreciation cost. Depreciation costs are reserve capital to buy new assets because old assets cannot be used anymore. By calculating and recording, the company can calculate depreciation costs within a certain period.
This will also help companies consider making decisions regarding assets, for example, when to buy new assets, what is the maximum production quantity of assets, and so on.
Depreciation Calculation Methods and Formulas
How to calculate depreciation can be done with many depreciation methods. Below are the depreciation method and formula.
Straight Line Method
First, the depreciation method is the straight-line method. The straight-line method calculates depreciation, assuming it is based on a function of time, not usage. As a result, the straight-line method is considered less accurate because the results of asset consumption are the same between periods.
The formula for depreciation using the straight-line method:
Depreciation Value = Cost of Revenue – Residual Value: Economic Age
Example:
A company purchases a piece of machinery for $10,000 with an estimated useful life of 5 years and a residual value (the estimated value at the end of its useful life) of $2,000. The company will record depreciation annually.
To calculate annual depreciation using the straight-line method, we use the formula:
Depreciation Value (DV) = (Cost of Asset – Residual Value) / Useful Life
In this case, the annual depreciation would be:
Depreciation Value = ($10,000 – $2,000) / 5
DV = $8,000 / 5
Depreciation Value = $1,600 per year
Journal Entry:
To record the annual depreciation expense, the company would make the following journal entry:
| Account | Debit | Credit |
| Depreciation Expense | $1,600 | |
| Accumulated Depreciation | $1,600 |
Declining Expense Method
The decreasing expense depreciation method calculates depreciation regarding the total annual income and decreasing balances. So the depreciation expense is greater than the initial period but decreases in the following period.
Decreasing expense depreciation formula:
Depreciation Value = Purchase price of the asset x percentage of depreciation
Example:
Let’s assume we have purchased a machine for $10,000 with a depreciation rate of 20%.
Year 1:
Depreciation Value = $10,000 x 20% = $2,000
Year 2:
Depreciation Value = ($10,000 – $2,000) x 20% = $1,600
Year 3:
Depreciation Value = ($10,000 – $2,000 – $1,600) x 20% = $1,280
| Year | Account | Debit | Credit |
| 1 | Depreciation Expense | $2,000 | |
| Accumulated Depreciation | $2,000 | ||
| 2 | Depreciation Expense | $1,600 | |
| Accumulated Depreciation | $1,600 | ||
| 3 | Depreciation Expense | $1,280 | |
| Accumulated Depreciation | $1,280 |
Activity Method
Next, the depreciation method is the activity method. How to calculate this depreciation is based on asset utilization. So this method measures it from the results of asset productivity.
Activity depreciation formula:
Depreciation = [(Acquisition Cost ― Residual Value) × Estimated Use Age] : Productive Age
Example:
Let’s assume we have purchased a vehicle for $20,000 with a residual value of $5,000. The estimated useful life of the vehicle is 5 years, and the productive age for the current period is 3 years.
Depreciation = [(Acquisition Cost – Residual Value) × Estimated Use Age] / Productive Age
Depreciation = [($20,000 – $5,000) × 5] / 3 = $25,000 / 3 = $8,333.33
| Account | Debit | Credit |
| Depreciation Expense | $8,333.33 | |
| Accumulated Depreciation | $8,333.33 |
Specific Depreciation Method
The Specific depreciation method calculates depreciation using the company’s or accountant’s method. This calculation is to find out the benefits of decreasing asset values.
In this case, you do not need the depreciation formula but use the group and mixed methods. Group method for measuring homogeneous assets with similar functions. Meanwhile, the mixed method is applied based on the accountant.
Example:
Let’s assume a company has a group of computers that are used for administrative purposes, and another group of computers used for design and development purposes. The company decides to use the group method for the administrative computers and the mixed method for the design and development computers.
Group Method:
The company determines that the administrative computers have a useful life of 5 years and a salvage value of $2,000. The total cost of the administrative computers is $40,000.
Depreciation per year = (Total Cost – Salvage Value) / Useful Life
Depreciation per year = ($40,000 – $2,000) / 5 = $7,600
Mixed Method:
The company determines that the design and development computers have a useful life of 3 years. However, based on the accountant’s assessment, it is decided that the depreciation expense for the first year will be $5,000, for the second year will be $4,000, and for the third year will be $3,000.
| Account | Debit | Credit |
| Year 1 – Administrative Computers (Group Method) | ||
| Depreciation Expense | $7,600 | |
| Accumulated Depreciation | $7,600 | |
| Year 1 – Design and Development Computers (Mixed Method) | ||
| Depreciation Expense | $5,000 | |
| Accumulated Depreciation | $5,000 | |
| Year 2 – Design and Development Computers (Mixed Method) | ||
| Depreciation Expense | $4,000 | |
| Accumulated Depreciation | $4,000 | |
| Year 3 – Design and Development Computers (Mixed Method) | ||
| Depreciation Expense | $3,000 | |
| Accumulated Depreciation | $3,000 |
Double-Declining Balance Method
The double-declining balance method of depreciation calculates depreciation based on straight-line depreciation expense without residual value, then multiplying it. This calculation can measure depreciation with the book value of assets at the beginning of time.
Double declining balance depreciation formula:
Depreciation = (Acquisition Price: Economic Age) × 2
Let’s assume we have purchased a machine for $10,000 with an estimated useful life of 5 years.
Year 1:
Depreciation = ($10,000 / 5) x 2 = $4,000
Year 2:
Depreciation = (($10,000 – $4,000) / 5) x 2 = $2,400
Year 3:
Depreciation = (($10,000 – $4,000 – $2,400) / 5) x 2 = $1,440
| Year | Account | Debit | Credit |
| 1 | Depreciation Expense | $4,000 | |
| Accumulated Depreciation | $4,000 | ||
| 2 | Depreciation Expense | $2,400 | |
| Accumulated Depreciation | $2,400 | ||
| 3 | Depreciation Expense | $1,440 | |
| Accumulated Depreciation | $1,440 |
Units of Production Method
Finally, the depreciation method is the units of production method. The unit of production method calculates depreciation detailing the calculation of assets in units of time (hours) and weight (kg).
Production unit depreciation formula:
Depreciation = (Revenue price – Residual value) x (Asset utilization : Estimated age)
Example:
Let’s say a company purchased a machine for $100,000 with an estimated useful life of 5 years and a residual value of $10,000. The machine’s estimated total production is 100,000 units.
Now, let’s assume the machine produced 10,000 units in its first year. The revenue price per unit is $5, and the asset utilization for the first year is calculated as follows:
Asset utilization = Units produced / Estimated total production
Asset utilization = 10,000 units / 100,000 units
Asset utilization = 0.1
Using the formula for the unit of production method, we can calculate the depreciation expense for the first year:
Depreciation = (Revenue price – Residual value) x (Asset utilization : Estimated age)
Depreciation = ($5 – $10,000) x (0.1 : 5)
Depreciation = (-$9,995) x (0.02)
Depreciation = -$199.90
| Date | Account | Debit | Credit |
| 12-12-2022 | Depreciation Expense | $199.90 | |
| 12-12-2022 | Accumulated Depreciation | $199.90 |
FAQs
What kind of assets can you depreciate?
In general, tangible assets can be depreciated. Tangible assets are physical assets that have a finite useful life. Some examples of assets that can be depreciated include:
- Buildings
- Vehicles
- Machinery and Equipments
- Furniture and Fixtures
- Land Improvements
- Leasehold Improvements
- Intangible Assets
What is a depreciation schedule?
A depreciation schedule is a helpful table that provides information about how much your assets will decrease in value over time. It includes important details such as:
- Asset description: A brief description or name of the asset, such as “Office Furniture” or “Delivery Vehicle.”
- Date of purchase: The date when you acquired the asset.
- Total purchase price: The amount of money you initially spent to buy the asset.
- Expected useful life: The estimated time the asset will be useful or productive.
- The depreciation method used:
- The approach or formula used to calculate the depreciation expense (e.g., straight-line method, declining balance method).
- Salvage value:
- The estimated value of the asset at the end of its useful life, such as its resale or scrap value.
- Depreciation amount deductible in the current year:
- The portion of the depreciation expense can be claimed as a tax deduction in the current year.
- Cumulative depreciation amount:
- The total depreciation recorded for the asset since its purchase.
- Net book value:
- The remaining value of the asset after subtracting the cumulative depreciation from the total purchase price.
Having a depreciation schedule lets you track how your assets are losing value over time, understand their current worth, and make informed decisions about replacements or upgrades.
Is depreciation a fixed cost?
No, depreciation is not considered a fixed cost. Fixed costs are expenses that do not vary with changes in production or sales volume. Depreciation, on the other hand, is an accounting method used to allocate the cost of an asset over its useful life. It is a non-cash expense that reflects the wear and tear or obsolescence of an asset. Therefore, it does not directly depend on production or sales levels and is not classified as a fixed cost
Conclusion
In conclusion, depreciation is an essential accounting procedure businesses use to accurately reflect the decrease in the value of their assets over time. It allows for spreading out the asset’s cost throughout its useful life, helping manage financial statements and tax obligations effectively. Depreciation is a permanent and gradual decline in value, considered an expense against the company’s profit. It is calculated systematically and rationally, considering acquisition price, residual value, estimated useful life, and usage patterns. Depreciation is crucial for maintaining nominal capital, avoiding drastic swings in profitability, and ensuring financial health and tax management for businesses.
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