Depreciation have a important concept in accounting, especially for business owners who use long term assets. depreciation helps in presenting accurate financial statements and making better financial decisions. In this article, we understand what is depreciation in accounting in very simple word and provide you a better guide why it is necessary in accounting. And we also discuss how depreciation is calculated, and its different methods and go through some common mistakes that should avoid by every business owner.
What is Depreciation?
In simple words, Depreciation cover the part of an asset’s cost that is overhead during the accounting period. Instead of recording the entire purchase cost of an asset in one year, depreciation spreads the expense across several years. That helps to provide a clear image of a company and give a accurate financial report that increases the financial performance.
Why is Depreciation Important in Accounting
The role of depreciation in accounting is mainly to help present the true financial status and performance of a business. The following points explain its significance:
- It follows the matching principle: An asset such as a computer or a car is not used in one year only but in multiple years. Depreciation allocates the asset’s cost to the different years of its expected usage, hence the cost of the asset is expensed in the periods that also see the benefit of the asset (matching principle).
- Allows the figure of net income be more realistic: If one does not take into account the depreciation, the income figure will be misleadingly high. Depreciation helps you to present real and accurate company earnings.
- Provides a more realistic book value of the asset: The value of an asset gradually decreases due to its being used or because it becomes outdated. Depreciation is the amount that decreases the asset’s carrying value, thus, the balance sheet report displays a more realistic asset value.
- Depreciation helps reduce the burden of tax payment on firms: Depreciation is a cost that causes the taxable income to be lower, thus, the taxpayer pays less tax and saves the amount tax legally.
- Make business decisions management can be considered more informed: If the depreciation costs are properly accounted for, management can effectively consider aspects such as the timing of acquiring new assets, pricing policy, and cost control.
- Contributes to capital green-up: Depreciation loop a portion of profit to be used for acquiring replacement for assets that are getting old and worn out.
- Standard compliance in accounting: Incorporating depreciation in accounts is a requirement as per accounting standards which facilitate consistency and comparability of financial statement.
How to Calculate Depreciation
Depreciation is essentially the systematic allocation of the cost of a fixed asset over the period it is used to reflect the decrease in its value due to factors such as usage, wear and tear, or the passage of time. With the straight-line method, the first step of the calculation is to pinpoint the total cost of the asset, which covers both the purchase and installation costs, and then make an estimate of its scrap or residual value after the end of its useful life. The depreciable amount is the result of the asset’s cost minus the scrap value, and this amount is then distributed equally over the asset’s useful life. The equation for calculating depreciation is Depreciation = (Cost of Asset – Scrap Value) / Useful Life, which indicates the yearly depreciation expense recorded in the financial statements.
Method of Depreciation
Depreciation in accounting use some calculation method, those methods are listed below:
1. Straight Line Method
During this method, the same amount of depreciation is charged every year over the useful life of the asset. It is easy to calculate and widely used.
Example:
- A machine costs ₹1,00,000 and its useful life is 10 years.
- Annual Depreciation = ₹1,00,000 ÷ 10 = ₹10,000 per year
We can use this method when the asset gives equal benefit every year (e.g., furniture, buildings).
2. Written Down Value Method
In this method, depreciation is charged on the rest of their value of the asset each year. And the amount of depreciation reduces annually.
Example: Asset cost = ₹1,00,000, Depreciation rate = 20%
- Year 1: 20% of 1,00,000 = ₹20,000
- Year 2: 20% of 80,000 = ₹16,000
The best time to use this method is when Assets lose more value in the early years (e.g., machinery, vehicles).
3. Units of Production Method
In this unit of production method, depreciation is totally based on the actual usage or output of the assets. It’s not based on time.
Example:
- Machine cost = ₹50,000
- Total estimated units = 10,000
- Depreciation per unit = ₹5
- If production in a year = 2,000 units
- Depreciation = 2,000 × 5 = ₹10,000
The best time to use this method is when asset usage varies each year (e.g., factory machines).
4. Sum of Years’ Digits Method
This method known as accelerated depreciation method because higher depreciation is charged in earlier years.
Example:
Asset cost = ₹60,000, Useful life = 5 years
Sum of years = 5+4+3+2+1 = 15
- Year 1 depreciation = (5/15) × 60,000 = ₹20,000
- Year 2 depreciation = (4/15) × 60,000 = ₹16,000
This accelerated method is used when assets become obsolete quickly due to technology changes.
5. Annuity Method
This method considers both depreciation and interest on the capital invested in the asset.
Example:
- An asset costing ₹1,00,000 with interest factor applied will have depreciation calculated so that total annual charge remains equal.
Best used when Assets involve heavy investment and interest consideration is important.
Common Mistakes that Avoid from a Business Perspective
Breakdown some depreciation mistakes that should be avoided from a business perspective
- Make sure all related costs to the asset are considered: Purchase price, transportation, installation, and other costs necessary to make the asset operational should always be taken into account. Failure to consider these results in under-depreciation.
- Don’t pick an unrealistic useful life: Avoid setting a time frame for the asset’s useful life that is either too short or too long. An inaccurate period of life will account incorrectly for both the annual profit and the asset’s value.
- Take care when deciding on scrap value: Assuming zero or a scrap value that is too high is not a good idea. Use realistic market prices to work out the correct depreciation figure.
- Choose the right depreciation method: Don’t over-simplify and use just one method for all assets. The method should reflect how the asset actually loses its value.
- Examine your depreciation: Do not let your depreciation assumptions remain static for years. Change them when the operations, technology, or economic conditions of your business change.
- Don’t stop depreciating the asset if it is idle: Depreciation must be charged as long as the asset is physically there and available for use, even if it is hardly used.
- Recognize the differences between repairs and capital expenditures: Routine repairs and maintenance must never be added to the cost of the asset because that causes the depreciation amount to be higher than it should be.
- Keep asset records in good order: If asset registers are not properly updated it may lead to mistakes in depreciation calculations and financial statements.
Conclusion
Depreciation in accounting plays a crucial role and help to show a true value of assets and real financial performance of a business. You can use various methods of depreciation that help to calculate the depreciation. In this article, we cover all the important point like common mistake and their importance. If you want to understand more information related to depreciation like book depreciation vs tax depreciation in detail. You can read a related blog by clicking on the provided link.