Depreciation is not a good word to hear. This seems contrary to “praise” which is very strange. But all of you will probably appreciate tax savings, depreciation helps you save tax. Even if you depreciate everything for your accountant, brush up on the basics and make sure you are taking advantage of the maximum depreciation.
# What is Depreciation?
Depreciation is the process of cutting the total cost of something expensive that is purchased for your business. The monetary value of an asset decreases over time due to use, wear, or obsolescence. This decrease is measured as depreciation, it only applies to fixed assets. But instead of doing all of this in a tax year, you write parts of it over time. When you depreciate assets, you can plan how much money will be written off each year, so that you can have more control over your finances.
# What is the Purpose of Depreciation?
The purpose of depreciation is to match the cost of productive assets. That is, to try to match the historical cost of a productive asset with a useful life of more than one year from the income earned using a company’s assets. Over the asset’s useful life, depreciation systematically shifts the cost of the asset from the balance sheet to the income statement. Where both revenue and expenditure appear in the income statement in the same liability period because of how well the company has performed in a given period.
# What are the Causes of Depreciation?
The causes of depreciation are:
Wear and tear:- Some property deteriorates physically due to wear and tear. Assets decrease in their value because they are constantly used in the organization. When an asset is used continuously for production, the asset deteriorates. The higher the use of an asset, the greater the wear and tear. The physical deterioration of a property is caused by agitation, stress, friction, corrosion, etc. For example, wear and tear of buildings, machinery, furniture, vehicles, plants, etc. is common, this is the primary cause of depreciation.
Perishability:- All items, such as raw materials and commodities, deteriorate over a quick period of time. It is faster with respect to a fixed asset, which usually lasts for at least a few years. This depreciation of assets is a very serious consideration point for accounting. There are some assets that are very small. This situation applies to other inventions rather than immovable properties.
Maintenance:- A good maintenance of the machine will naturally extend its life. When no maintenance is good, the depreciation value itself is high. When there is good maintenance, the life of the machines is long. The long life of the machine depends entirely on good and efficient maintenance.
Usage rights:- Some assets, such as software and licenses, have a specific duration over which it can be used. As soon as this time expires, the owner has to give up the use of the asset. So the depreciation of this asset should be done over time, it cannot be written off only on the day of expiry.
Obsolescence:- Obsolescence means that the property goes out of fashion. This is the loss arising due to new inventions, technological changes, improvement in methods of production, legal hurdles, etc. Another reason is the infallible nature of some assets. Over time, each property loses its novel value. A new option can always be developed to replace the asset and its functions. These factors make it economical to convert property, although they are still usable. Market changes can also be a disturbing factor.
Natural resource usage:- If a property is from a natural resource, such as an oil or gas reservoir, resource depletion causes depreciation. In this case, it is called depreciation. If a company subsequently changes its estimate of the remaining reserves, the pace of depletion may change.
# Which Asset is Depreciated and Which is Not?
All depreciation assets are fixed or tangible assets, but not all fixed assets are covered for depreciation. You cannot depreciate property for personal use & property held for investment.
Examples of non-depreciable assets are Land, cash in hand, receivables, stocks, and bonds, Personal property (Not used for business), Leased property, etc.
Examples of non-depreciable assets are Tangible assets such as Manufacturing machinery, Vehicles, Buildings you rent out for income (both residential and commercial property), Office buildings, Computer equipment, etc.
# How to Calculate Depreciation?
Three methods are commonly used to calculate depreciation.
Straight line method:- The method described below is called straight-line depreciation, in which the amount deducted for depreciation is the same for each year of the asset’s life.
The formula for straight line depreciation is: Annual depreciation expense = (asset cost – residual value) / useful life of the asset
Unit of production method:- Some assets contribute varying amounts of revenue from year to year. The depreciation expense of these assets may be higher or lower in a few years. In these cases, depreciation expense for each year is based on units of production generated by production or assets. An example of this would be a machine that makes car parts. The formula for unit of production depreciation is:
Computation of depreciation per unit:- Depreciation per unit = (asset cost – residual value) / useful life in units of production.
Calculate the total depreciation of the actual units produced:- Total depreciation expense = depreciation per unit * units produced
Double-declining balance method:- This method includes an “accelerator”, so this property depreciates more at the beginning of its useful life (used with cars, for example, a new car depreciates faster than an old one) . With this method, depreciation expense decreases every year for the asset’s useful life. The formula for double-declining balance depreciation is:
Depreciation = 2 * Straight line depreciation percent * book value at the beginning of the accounting period
Book value = Cost of the asset – accumulated depreciation
# These 3 Main Inputs are Required to Calculate Depreciation
Useful life – This is the time period over which the organization considers the asset to be productive. Beyond its useful life, the fixed asset is no longer cost-effective to continue the operation of the asset.
Salvage Value – Post the useful life of the Assets, the company may consider selling it for a lesser amount. That amount will be considered as the salvage value of the asset.
Cost of asset – This also includes taxes, shipping and preparation / setup expenses.
# Depreciation Expense Vs. Accumulated Depreciation
|Basics|| Depreciation Expense||Accumulated Depreciation|
|Definition||It is the amount of cost allocated and reported at the end of each reporting period.||It is the total depreciation incurred on an asset.|
|Reporting in the books of accounts||It reported in the income statement||It reported in the balance sheet|
|Debit/Credit||Result in a debit.||Result in a credit.|
|Computation||If the value is likely to be completely liquid at the time of acquisition and then divided by the asset’s life span, the value is calculated by subtracting.||Accumulated depreciation is deducted from the original cost of an asset.|
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