What is depreciation? Depreciation methods, Depreciation expense and with lots of examples explained. Also explanations about how depreciation methods work

Depreciation methods, Depreciation expense and examples

Depreciation methods and definition in accounting: Everything explained

What is depreciation?  Depreciation methods, Depreciation expense and with lots of examples explained. Also explanations about how depreciation methods work

Depreciation Methods

     Today we shall nosedive into the accounting topic depreciation in full and we will illustrate it with complete examples.

What is depreciation?

The process of reduction in the value of the asset over time is named depreciation. It is done to keep similarities to the real world deal, as anything gets a lesser value once they are used. So, assets are treated in the same manner.

Why should we depreciate?

Before going for depreciation anybody can ask one simple question and that is should we depreciate all the assets of an entity?

The answer to that question is- NO.

The reason is simple. All the assets of an entity are of diverse nature and it is not possible to blend them in one simple form. So, it is not always the same for all the assets of an entity and the value of all the assets may not decrease over time.

That means some of the assets may get a rise in their values over time. There are loads of examples of those and they are-

  • Land
  • Building
  • Investments

In the third world countries the rise in value of land and buildings is most common. The responsible reason for that is the absence of any mode of safer money saving opportunity.

So, now the perennial question- should we depreciate rest of the assets?

Yes, obviously.

The assets, as used, get their value and life reduced. So, without an effective depreciation method in place, it is impossible to find out what is the amount of such reduction and the amount is perfectly believable.

And also the accounting governing bodies made it mandatory to make depreciation of assets, because, accounting is nothing but a real life projection of all the financial things happening around.

You can check IAS 16 and IAS 38 for the depreciation methods and other specifications they issue.

You can also Read : Basic Accounting Concepts and Definitions

Different depreciation methods

There are four different depreciation methods and they are:

  • Straight line method
  • Double declining method
  • Sum of years digit method
  • Units of production method

Here we will get acquainted to all the methods with their definitions and then we will go through one example that will give us the idea of working with all the methods.

                   Straight line depreciation method

The method which gives the same depreciation for an asset every year

That is called straight line depreciation method. Here a value is determined and then

it is implemented through the useful life of that asset.

                   Double declining depreciation method          

                                             In this method a rate of depreciation is determined and then the rate

is applied every year to derive the depreciation amount. So, it is the rate that

remains the same not the depreciation amount.

The reason it is called double declining method is the most ironic. Once you know the

Straight line depreciation you can easily find out your double declining depreciation

And that will be like:

Double declining depreciation rate = {annual straight line depreciation/ the purchase value of the asset (less the residual value)} * 100*2

 

                 Sum of years digit method  

                                     This method takes the useful life of the asset and treat the whole life time

As a series and then sums the individual years up to derive at the value of

If we consider an asset which has a useful life of 5 years, then,

The sum of the years digit for that asset= 5+4+3+2+1

=15

If the asset is used for three years then the depreciation of the asset will be determined

As followed:

Rest of the lifetime= 15 – (3+2+1)  

                                                   =9

Depreciation= cost of the asset* (6/15)

             Units of production method  

                           This method deals with the production volume of the asset concerned to

determine depreciation. As it is the depreciation amount is the one amount that

considers the values of how much the asset has produced and how much the asset

was supposed to produce.

Example

       XYZ co. purchased an asset at the value of Tk. 200,000. The asset is supposed to have a useful life of 10 years and after all its useful life it is supposed to have a salvage value of Tk. 5,000. The asset is supposed to produce 900,000 units during its entire production lifecycle.

There was an unanimous decision to depreciate the asset @ 10% per annum and the actual production of that asset during the current year is 50,000 units.

If the machine is purchased during September of the first year what will be the depreciation expense in all four depreciation methods?

[I would like to draw everyone’s attention to a little matter that here the depreciation methods are illustrated only through a worked out example and it has nothing to do to suggest the depreciation method to adopt for any asset. The depreciation method to adopt for different assets are described later]

           Workings

                         At first we will go for some workings which are required to calculate the depreciation amount.

Here, the work to be done first is the calculation of depreciable value:

Depreciable value = Purchase price – Salvage value

So, Depreciable value = 200000 – 5000

= 195000

Now, we will go for the annual depreciation calculation:

Annual depreciation = ( depreciable value / Useful life )

= ( 195000 / 10)

= 19500

This is also the straight line depreciation for each accounting year.

The depreciation expense for the first year is-

Depreciation = 19500 / (4/12)

Now, we will move on to calculate the depreciation rate of the current year for double declining method (A rate of 10% is provided for the double declining method, but, for the sake of illustration of calculation it is shown here):

Rate of depreciation= (Annual depreciation/ Depreciable value)*100

= (19500/195000)*100

=10%

For this example there was no need for this calculation as the rate is already been given, so, for this example and for the calculation alike the next step will be:

Rate for double declining method = Rate of depreciation * 2

= 20%

This is the depreciation rate calculation method for double declining method.

Now with the production method:

Depreciation expense = 195000 * (50000/900000)

And at last with the sum of years digit method:

Sum of years = 10+9+8+7+6+5+4+3+2+1

= 55

Life time left = 55- (4/12)

=55- 1/3

= 54(2/3)

Depreciation expense= 195000 * (4/12)

Which method is fitted where?

Straight line method is fit for:

  1. Fringe tools
  2. Office equipment
  3. Assets which are used to store rather than to produce

Double declining method is best fitted:

  1. Assets which are used for production
  2. Transportations
  3. Equipments which lose their value over time quickly (Electric equipments)

Units of production method best fitted:

  1. Ore or, mine
  2. The vehicles
  3. Machineries which have a production estimate for them

 

Sum of years digit method best fitted:

  1. Asset with limited lifetime
  2. Asset which has no or, blurry estimated lifetime
  3. The kind of asset which can provide benefit at a receding rate over time

What the standards have to say?

The standards don’t come on the way that much while depreciation is determined. They altogether modifies opinion to pick a method but, what method to pick- they don’t specify that.

Now, this remains to be seen that what we shall do. The prime concern for us is the determination of perfect depreciation method to make proper disclosures and it is only possible with the help of a professional accountant. Without such help depreciation allocation and calculation is almost near to impossible.

What can go wrong?

If a depreciation expense is absent in financial statements or, there is a lack of the convenient method then the financial statements will be deemed as not giving a true and fair view. With this deeming the entity are exposed to corporate humiliation along with losing valuable investors through the process. So, without the proper determination or, the lack of it they may turn to shut down.

 

 

 

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