Here I would like to explore the essence and nature of depreciation and cover main depreciation methods.
Nature & Essence Of Depreciation
Depreciation is the term used in accounting to define allocation of cost of fixed assets over the years during which these assets are being used by the business
Adding up depreciation charged to expenses during all the period of fixed assets usage we will get its cost less salvage (residual) value
We can say that depreciation is a process, the substance of which is a recognition that the asset wears out or decreases in value while time passes, which means that fixed assets sooner or later will have to be disposed of or written off since it will not be possible to use them in business
Depreciation is calculated and allocated to the expenses during the useful life of the particular asset to show that this asset serves the business for the period longer than one year. Different depreciation methods can be used to calculate these expenses
Other Accounting Terms Which Are Important
Essence of depreciation nd depreciation methods can be explored properly only if the related accounting terms are also understood, i.e.:
Fixed assets – long lived resources which are used in the business for a period longer that one year.
Capital expenditure – expenditure which is incurred in the acquisition of the fixed asset and added up to the cost of the asset acquired or constructed.
Reasons Why Asset Decreases In Value Over Time
Wearing and tearing – declining value due to physical reasons and usage of the asset
Obsolescence – the asset might become obsolete due to changes in technology or fashion and it becomes not efficient or economic to use the asset
Passage of validity time – some assets lose their value after certain period of time passes. As examples we can provide patents or know how, which have certain validity time and after that time can become public and lose their value
How We Calculate Depreciation?
Despite which of depreciation methods is applied the basis to calculate depreciation is a difference between cost value and salvage (residual) value. So for this purpose we will need to estimate salvage (residual) value and useful life of the fixed asset.
Straight line method – the simplest and most commonly used method, where it is assumed that the asset decreases in value in equal amounts during its useful life.
Production method (units of production) – under this method it is assumed that the asset decreases in value depending on its actual usage in production of goods or provision of services, i.e. the depreciation might depend on such factors as how many items were produced or how many hours the asset worked.
Declining (accelerated) method – under this method more of cost is allocated to the expenses during the first years of usage.
Sum of digits method – under this method it is also assumed that more cost of asset is allocated to the expenses during the first years of usage, however such allocation is smoother that under the declining method.
In this video we will be covering depreciation methods in more details and remembering from a previous video there are 4 main depreciation methods used straight line method. It is production or units of production method is declining or accelerated method and sum of the digits method.
Starting from straight line method and just to remind you that under this method we assume that asset depreciates in equal parts over the useful life and the following formula is used and now depreciation we have cost. We deduct estimated residual value and we divide it by estimated useful life in years.
And this is the same amount for each year. An example can be like this if we have an asset. The cost of which is $25 a thousand dollars residual value is $1,000 and useful life is 6 years. We will calculate annual depreciation amount. We deduct from cost residual value. We divide it by 6 years and we get that annual depreciation is $4,000 and each year the same amount will be included in to the expenses and the following accounting entry will be made.
We will debit depreciation expenses and we will credit accumulated depreciation account which is contrary to the cost value of the asset. So under annual depreciation the same amount will be included into the expenses over the 6 years. The next method is production method here the asset decreases in value depending on how many units of goods were produced or how many hours their asset was working.
And the formula would be the following: First of all we will have to calculate depreciation per one hour or per one unit of production. We have cost. We deduct estimated residual value and we divide it by the estimated hours or units of production and here use maximum quantity of hours of production which the asset is able to produce. And if we want to calculate the annual depreciation then we will have to know how many items the equipment produced during that year or how many hours the asset was working during the particular period of time.
An example can be like this if we have an asset cost of which is 20,000 residual values 1,000 and maximum units of production is 100,000 and per current year we know that the equipment produced 25,000 units. So depreciation per unit is calculated using the formula of the previous slot. We deduct from cost residual value. We divide this difference by the maximum units of product and we get that if the equipment produces one unit depreciation expenses would be 0.24.
For the year depreciation expenses are calculated in the following way so we know that during the current year quantity produced is 25,000 units we multiply it by the depreciation expenses for one unit. And in the current year we made the following entry so we debit depreciation expenses and we credit accumulated depreciation and we record the depreciation expenses in this way.
Next year, we would have to know how many items the equipment produced in order to account for the depreciation expenses properly. The next one is declining or accelerated method and here we use the following formula. Remember that applying this method we include into depreciation expenses higher amounts or higher values during the first years of the asset usage.
We deduct from cost accumulated depreciation at the beginning over here and we divide it by estimated youth for life and we multiply the amount we get by two in order to accelerate depreciation and please pay attention that here we deduct from not residual but accumulated depreciation at the beginning of each year and we depreciate their asset until we reach the residual value.
So the example here is a cost residual value and useful life of the asset and we will be calculating depreciation for each year since it is different for each year. For the first year we have cost accumulated depreciation at the beginning of the year is zero since we just had acquired the asset and we divide it by 5 and multiply by two. So first year depreciation is $9,840 and we make the same entry as it was done for straight line method or for production method so we debit depreciation expenses and credit accumulated depreciation.
For the second year we do the same. However, in the formula accumulated depreciation at the beginning of the year is not zero it is taken from the first year and it is deducted from the cost. Again we calculate depreciation and we include it in to the expenses during the second year. Since in the formula we need accumulated depreciation we have to calculate the amount of that depreciation at the end of the second year and you can see it how it is calculated so we adopt first year and second year depreciation and this will be used for calculation of the annual depreciation expenses for the third year.
Next you see a summary in the table and since residual value or there it is $2,000 we calculate depreciation until we reach that amount and accumulated depreciation at the beginning of the year it covers all depreciation expenses during the previous years and residual value is $2,000 so we depreciate the asset until we reach that residual value. This is amount which we expect to get for the sale of the asset. And the last depreciation method is sum of digits where we allocate again cost to the expenses during the first usage years of the asset however here we have smoother allocation.
The formula used to calculate annual depreciation is the following. We use currently a digit and currently a digit we start from the last from the period for example if we have 6 years useful life we start from 6 and then we go to 5, 4, 3, 2, and 1. We deduct from cost estimated residual value and divided by the sum of the useful years digits so that is why this method is called some of the digits method and an example here is provided we have an asset with the cost of $21,000 residual value 0 and useful life is 5 years.
So before the first year we calculate depreciation as it is indicated in the formula and current year digit is 5 so we have 5 years for the first year we will be using 5 and some of the years digits is 15 so we adopt 1 plus 2 plus 3 plus 4 plus 5 an we get 15 and first year depreciation expenses is $7,000 for each year this amount will be different since it declines during useful on the asset and below you can find calculations for the whole period and you can see that rate is declining so for the first year we are using 5 divided by 15 then we are using 4 divided by 15 and etcetera.
And here we have some of useful life year digits and residual value is zero so with depreciate the asset until we reach residual value. Here it was 0 of course it might be higher than 0 if we expect to get some money for the sale of the asset. However, in this example we depreciate the asset until we reach 0 residual value so this was the sum of digits depreciation method and calculation example.