What is Depreciation? Meaning | Method | Examples | Accounting

What is depreciation 

Depreciation is an accounting method of allocating such costs to amounts expensed over the estimated useful life of a tangible asset. The underlying rationale behind this accounting treatment is that businesses need to expend resources periodically to generate revenues and earnings. 

The depreciation cost is the money set aside yearly to account for the wear and tear on a company's buildings, machinery, and other equipment. This cost is often spread out over the asset's life (known as its "useful life") so that a portion of the asset's value is depreciated yearly.

What are the principles associated with depreciation?

The primary principles associated with depreciation are allocating costs, matching expenses and revenues, and conservatism.

How to calculate depreciation cost?

To calculate depreciation cost, you must determine the asset's expected useful life and then divide that into manageable chunks (usually years).

The depreciation method applied to an asset will be reviewed every financial year. If any significant change in the expected pattern of its future benefits occurs, the method will be changed accordingly.

According to IAS 8, changes are accounted for as changes to an accounting estimate. The Previous year's depreciation is not changed.

Depreciation is calculated by using any of the following methods. The three popular methods are the Straight line, the Diminishing balance, and the sum of digits.

Depreciation methods

There are three main methods of calculating depreciation:

• straight-line depreciation,
• declining balance depreciation, and
• sum-of-the-years'-digits depreciation.

What is straight-line depreciation?

The simplest method is "straight-line depreciation," which spreads the cost evenly over the asset's useful life.

Example

Your plant and machinery cost $60.000. You will sell it in 10 years. The estimated residual value is $6.000. The total amount of depreciation will be $54.000 ($60.000 - $6.000).

The depreciation charge is $5.400 per year. ($54.000/10 years)

What is the Diminishing balance method?

The diminishing balance method of depreciation is a way of allocating the cost of an asset over its lifespan. Under this method, the carrying value of an asset (its book value) decreases each year by a percentage of its original value. This percentage is known as the depreciation rate. 

The advantage of using the diminishing balance method is that it more accurately reflects the loss in value that an asset experiences over time. This is because, under this method, an asset's depreciation expense in any given year is directly proportional to the amount by which its carrying value has decreased. 

Example 

You buy a machine for $20.000. You estimate a high risk of technical obsolescence. You depreciate it at 25% as follows:

Year 1 $2.500 (25% of 10.000)

Year 2 $1,875 (25% of 7,500)

Year 3 $1.406 (25% of 5,625)

Year 4 $ 1,054 (25% of 4,218) 

What is the unit of production method? 

The units of production depreciation method is a method of depreciation that allocates the depreciation expense for an asset over its useful life based on the number of units produced. This method is commonly used for assets in production, such as machines or tools.

Under this method, the depreciation expense for an asset is calculated by dividing the asset's cost by the number of units expected to be produced. The depreciation expense is then allocated evenly over the asset's expected life. For example, if a machine costs $10,000 and is expected to manufacture 10,000 units, then the depreciation expense would be $1 per unit and allocated evenly over its expected life of 10 years.

What is the double-declining balance depreciation method?

The double-declining balance depreciation method is a type of accelerated depreciation method that assigns a higher percentage of depreciation in the early years of an asset's life and a lower portion in the later years. This method is often called the "double-declining balance" or "double-declining" method.

This depreciation method is often used for tax purposes, allowing businesses to claim more significant deductions in the earlier years of an asset's life. However, it should be noted that this depreciation method does not necessarily reflect the actual decline in an asset's value over time.

Under the DDB method, an asset's depreciation expense is determined by multiplying its initial cost by a factor that declines over time. The factor starts at two and decreases by one each year. So, in the first year, the depreciation expense would be 2/3 of the asset's initial cost; in the second year, it would be 1/3 of the original price, and so on.

What is the most accurate method of depreciation?

There is no one "most accurate" method of depreciation. The most accurate depreciation method will be the one that accurately reflects the actual decline in value of the asset being depreciated.

Each of the methods mentioned above has its strengths and weaknesses, and it is essential to choose the way that best suits the specific needs of each business.

In general, however, declining balance depreciation is often considered the most accurate method, as it more closely reflects the actual rate at which an asset's value depreciates over time.

What is accumulated depreciation?

Accumulated depreciation is a contra account that represents the aggregate depreciation expense of an asset, less any accrued depreciation previously recorded against that asset. In other words, it's the total amount of depreciation taken on an asset to date.

It's essential to track accumulated depreciation because it's used to calculate the book value of an asset. You would receive the book value if you sold the asset for its current market value (fewer sales tax or commission). So knowing the accumulated depreciation helps you understand how much an asset has been reduced in value over time.

When is depreciation calculated?

Depreciation of an asset begins when it is available for use. In other words, when the asset is in the location and condition necessary for it to function as intended by its managers.   

Once an asset is classified as held for sale or when it is derecognised, depreciation ceases.

Example

A company has built an office for its use. The construction was completed on 1 November 20X1, but the company did not use the office until 1 March 20X5. 

The straight-line depreciation method is applied.

The company should charge depreciation when the office is available for use. That is on 1 March 20X5. 

Depreciation journal entry

The journal entry for depreciation is a reduction in the value of an asset over its useful life. The asset's value is reduced by a fixed amount each year by using the accumulated depreciation account, which is recorded as depreciation expense in the income statement 

Example of a journal entry

Company A purchased a machine for $20,000 on Apri 1 20X1. The Company follows a January to December calendar year for accounting purposes. The company follows the straight line method and depreciates the assets over a period of five years. 

Journal entries will be

Purchase of Property plant and equipment at time of purchase

Depreciation for 9 months (pro-rata) (20,000/5 years *9/12)

Depreciation Disclosure 

Heres an example of YoY depreciation disclosure in income statement. 

Can depreciation be charged as cost of goods sold?

 Depreciation can be charged as the cost of goods sold, but there are a few things to consider first. To begin with, you need to make sure that the depreciation expense is classified correctly on your financial statements. In particular, it should be shown as an expense in the period it incurred rather than as a decrease in the value of your assets.

In addition, you need to ensure that the depreciation expense is related to the production of your goods or services. For example, if you own a factory and incur depreciation expenses on the machines used in production, these expenses can be classified as part of COGS. However, if you own a retail store and incur depreciation expenses on the building, it cant be classified under COGS.

Why do we add back depreciation in the free cash flow equation?

Adding back depreciation in the free cash flow equation is to arrive at a measure that reflects the cash available to shareholders from the company's operations.

Depreciation is a non-cash expense, meaning it does not involve any actual cash outlay by the company. Including depreciation in the free cash flow equation is essential because it represents a real cost to the company that reduces its ability to generate cash flow from its operations.

Excluding depreciation would give investors an inaccurate picture of the company's proper financial health and ability to generate cash flow for shareholders.

Closing comments

The depreciation cost is an important part of the accounting process. By understanding what it is and how it works, businesses can better plan for the future.

Now that you have understood, try solving a comprehensive question on IAS 16 from a past ACCA DIPIFR paper involving depreciation.

If you're interested in learning more about depreciation or other aspects of accounting, please be sure to check out our other blog posts on the subject.