Depreciation Methods Explained

Depreciation is the charging of cost of Fixed Assets as an expense over the duration of the useful life of the asset. Since the asset value will not be the same with the passing of time due to the wear and tear and age of the asset, the accountant needs to reduce its value in the company’s books by recording a depreciation expense.

Fixed assets are plant, machinery, vehicles, office furniture, equipment, lighting, buildings etc. owned by a business. Buildings are assumed to have a longer useful life than all the aforesaid assets. Real Estate (land and property) in many countries have no depreciation but an appreciation in value and therefore do not need to be depreciated.

The cost of the asset less its scrap value is accounted as depreciation expense over the gainful life of the asset, and the depreciation expense thus calculated is deducted from the income it helped generate during that period.

There are several methods for calculating depreciation depending on the usage of the asset, the passage of time, the activity of the business, the useful life of the asset and salvage /scrap value etc. The straight line depreciation method is the simplest and most widely used owing to its simplicity.

Straight line depreciation: Cost of the asset less salvage value divided by the useful life of the asset.

For eg. if an asset cost $ 2,000 and has a scrap value of $ 200 and can be gainfully used in the business for 5 years then the depreciation expense per year would be 2000(-) 200/5 = 360 per year.

Accelerated Depreciation Method is also used by many businesses:

This method is based on the principle that higher depreciation values be accounted in the initial years of the asset since it would produce greater income and benefits in the initial years. Depreciation expense under this method using the above asset value would be 2000/5=400x2=800$ in the first year. This depreciation is reduced from the value of the asset and the resulting value considered as the cost for the subsequent year and depreciation calculated using the above formula but with the new reduced value of the asset ie 1200/5=240x2=480$ being the depreciation expense for the second year and so on. This method is also called the double –declining balance method since the depreciation is double the straight-line method and calculated on the reduced balance each year. In this method the salvage value is not considered.

In both methods the book value of the asset is never brought below the salvage value and therefore in the last year an adjustment in the depreciation value or no depreciation would be required in order to keep the scrap value in the books.

There are other depreciation methods such as activity based depreciation which is dependent not on time but the amount of activity of the asset such as mileage for vehicles or production based depreciation for production equipment.

Activity based depreciation:

For eg. if a vehicle that cost $ 40,000 can cover 100,000 km during its useful life and would have a salvage value of $ 5,000 then depreciation using the straight line method would be calculated as follows:
40000-5000/100000= .35$ per km. Depreciation for any given period would be .35$ multiplied by the kilo-meters covered during the period.

Production based depreciation:

For eg. an equipment which cost $25,000, has a salvage value of $2,000 is estimated to produce 5000 units during its life. Depreciation would be calculated as $25000(-) 2000/5000= 4.6 per unit produced. $4.6 multiplied by the number of units produced in a given period would be the depreciation expense of the period.

Depreciation values are recorded as follows in the general ledger/company books:

Dr. Depreciation Expense Account
Cr. Accumulated Depreciation Account

In general, depending on the business and usage or activity of the asset and using any of the above criteria, depreciation is calculated to logically spread the cost of the asset over its useful/gainful life and thereby calculate a more realistic income generated. When income generated is conservatively calculated with the accounting of higher depreciation, it helps generate a reserve for acquiring new assets or, replacement of fixed assets, since depreciation expense is only a book adjustment and therefore no cash outflow is involved.

In the income statement/profit & loss account, the depreciation expense account balance alongwith other overhead expenses is deducted from the gross income, inorder to arrive at the net income during the period.

In the balance sheet the accumulated depreciation appears as a deduction to the fixed asset balance. Accumulated depreciation account is a contra-asset account.

A contra account is an account with a balance that is opposite to the balance of the account to which it is a contra. For example, the fixed assets account would have a debit balance (since at the time of purchasing assets, the bank or cash account is credited and asset account debited).
The accumulated depreciation account would have a credit balance (since during the relevant accounting period, depreciation value is entered as credit to accumulated depreciation account and debit to depreciation expense account). The accumulated depreciation account is therefore a contra account to the fixed asset account.

Accumulated depreciation account balance is shown as a deduction to the fixed assets account in the balance sheet, inorder to record the depreciated value of the fixed assets.

If an accumulated depreciation account is not maintained, then the calculated depreciation expense is directly debited to the fixed assets account thereby reducing the fixed asset balance.

However, it is advisable to maintain an accumulated depreciation account since it helps to show the original cost of the asset.