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What is Depreciation?

In accounting terms, depreciation is defined as the reduction of the 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. The land is the only exception that 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 by 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 businesses?

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

1. Straight-line method
2. Unit of production method
3. Double-declining balance method

Three main inputs are required to calculate depreciation:

1. 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.
2. 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.
3. 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 the 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 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 the depreciation table below.

2) Unit of Production method

This is a two-step process, unlike the 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 the 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

Example: ABC company purchases a printing press to print flyers for Rs. 40,000 with a useful life of 1,80,000 units and a residual value of Rs. 4000. It prints 4000 flyers.

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 for. 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 a piece of 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 expenses 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

The depreciation table is shown below:

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 why 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 the balance sheet to the income statement. Alternatively, it is just an allocation process as per the matching principle instead of a technique that 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 that 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. Using good business accounting software can help you record the depreciation correctly without making manual mistakes.

You can try ProfitBooks. It is a simple accounting software that lets you create professional invoices, track expenses and calculate taxes without any accounting knowledge.

Also Read:
What is a Fixed Asset?
What are accounts receivables?
Difference between LIFO and FIFO methods