Depreciation applying one of selected depreciation methods is used as cost of acquired non-current tangible assets is not included into the income statement at the moment of acquisition. The reason for this is that these assets are being used in the business for quite long-period of time (more than a year), therefore their cost must included into expenses in the income statement gradually during useful life of the asset in the form of depreciation applying one of depreciation methods.
Such gradual distribution of non-current tangible asset distribution cost is called depreciation, i.e. the asset depreciated during its useful life and depreciation cost is included into the income statement.
Useful life is either:
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Period during which the asset is expected to be used by the business; or
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Maximum quantity of production expected to be produced or otherwise obtained using the asset
Accounting entries for depreciation expenses:
| D 1000 | C |
| D | C 1000 |
In the Balance Sheet non-current fixed assets are reflected at acquisition cost less accumulated depreciation. Such difference is called Net Book Value.
Usually non-current tangible assets are depreciated till Estimated Residual Value, i.e. price for which the asset can be sold at the end if its useful life.
| Straight-line – the same amount of depreciation expenses each year is included into the income statement | Annual depreciation amount=(Acquisition cost-Residual value)/Useful life in years |
| Production – deprecation expenses amount depend on the quantity of products produced or in other way obtained using the asset | Annual depreciation amount=(Acquisition cost-Residual value)/Maximum quantity of products the asset can produce |
| Accelerated (or reducing balance) – the asset is quicker depreciated in the beginning of its useful life. Depreciation is calculated as a certain percentage applied on the net book value at the end of each year. | Annual depreciation percentage (%)=2*(100/useful life in years) Annual depreciation amount=Net book value*Annual depreciation percentage |
Under step 5 we will be covering fixed assets and depreciation accounting and let’s start from the concept of fixed assets. Fixed assets or plant assets/long term assets these are assets which are used by the business and it is operations for the period longer than the 1 year and examples can be buildings, equipment, vehicles, furniture and other long term assets.
When we acquire such assets we do not include their cost into the income statement at the moment of the acquisition. However, we allocate their cost over the useful period of their usage so they are used for life and we do it by applying different allocation methods which are called depreciation. So depreciation is a term used in their account in which defines how the cost of plant assets is allocated to the expenses of the years during which the particular asset is being used by the business and these operations.
So in this here you can see that when we calculate depreciation we allocate certain amount of the depreciation to the expenses over useful life of the asset and the basis for the depreciation is a difference between cost of the plant asset and salvage all residual value and residual value is a value or money which we expect to get when we will sell the asset after the useful life of that asset is over. So if we adapt total depreciation charged to the expenses during all the useful life of the asset we will get a costless salvage of residual value.
Going to the depreciation we can see that it is a process and the substance of it is to recognize that asset loses its value or wears while time passes. This means that the longer we use the asset its value becomes lower and sooner or later we will have to write off the asset or we will have to dispose of it and usually depreciation is calculated and allocated to the expenses during the useful life and using certain depreciation methods which might be different depending on the type of asset or depending on the useful life and depending on the accounting principles applied by the business.
The main reasons for depreciation is wearing and tearing so it is declining and it can be value of assets due to physical reasons because we use it in the business operations. The other reason might be also obsolescence or the assets might become obsolete due to changes in technology or fashion and also it might become inefficient and we might find another assets which are more efficient and which can replace those assets we have on hand and also related to time.
Some assets they lose their value after certain period of time. Examples can be patents or know-how which have certain value of who certain period of time and after that time is over those assets do not have value and they should be disposed off or written off. And there are principle, there is a principle on how we calculate depreciation. We have cost. I have mentioned that already we deduct salvage value or residual value and we have a depreciation base and this thing shows that we are distribute that depreciation base or locate that depreciation base to the depreciation expenses and this is done through the useful life of the particular asset.
And despite of which depreciation method is used we all the time calculate depreciation on the difference between cost value and residual value or even if we do not use the difference directly we depreciate the asset to reach that residual value and residual value is a cash or it is revenue which we expect to get when we will sell the asset after useful life is over and there are three, there are four main depreciation methods one of them is straight line method and this is simplest and most commonly used method and here we assume that the asset decreases in value in equal amounts during useful life or the depreciation expenses during the useful life are the same within each period of time.
Another is production or units of production method here we assume that the asset decreases in value depending on its actual usage how many items it produced or how many hours it works. So there is no useful life but there is a maximum quantity and certain asset might produce on there might be maximum amount of hours certain equipment might work.
The other depreciation method is declining or we can call it accelerating method and here we allocate to the expenses more depreciation during the first years of the asset usage and this around the clients when the time passes. Another type of declining or accelerated depreciation method is some of digits. This method is similar to the declining or accelerated method when we allocate to the depreciation expenses higher amount during the first years of the asset usage. However, such a location is smoother comparing to the accelerated method.
So these are four main depreciation methods and in the next video we will be covering the formulas in detail calculations which are done in order to calculate depreciation expenses.