Depreciation is an accounting approach that systematically and rationally allocate the cost of asset to those period (as expense) in which the asset is expected to provide benefit as a result of its use.
In simple words depreciation is an accounting technique to allocate the cost of asset over its useful life.
Majority of assets have finite useful life and can provide benefits to the entity for a certain time. With use of asset, the total utility available in the asset reduces and ultimately asset expires at the end of its useful life.
To fairly present and record the declining potential of asset a logical approach is followed that reduces the value (cost) of asset by deducting a specific amount every period called depreciation. And the formula or approach that is used to determine the depreciation amount is called depreciation method.
1 Causes for devaluation or depreciation of asset
Here are some of the reasons or causes of depreciation:
- Physical loss
Any damaging change in the physical features of the asset or in the productivity, efficiency or effectiveness of the asset either because of the usage, perishability, or any mishap will result in the decrease in the value of asset and subsequent disposal will not fetch the same amount as was paid at the time of acquisition.
- Technological advancement
- Extinction may be because of tastes and fashion or support service, spare parts not available etc. Required raw material or input is not available due to any reason or the output carry no customers in the market.
- Expiry right to use has expired over time
- Exhaustion in case of natural resources such as mines and wells exhaust as a result of extraction of minerals
However, following are some examples which many students might misinterpret as causes of depreciation are not. Rather these examples can be one the causes of impairment.
- Market perception stolen and recovered subsequently will not have the sameperceived value as the new one has or the old one with of same condition. Legal documents have been misplaced and thus ownership is not evidenced or with duplicate book where duplicate book is taken not as good as original documents.
- Legality no longer legal to be used or the input required or output obtained is no longer legal.is declared hazardous. All machinery which was used to manufacture Freon gas after it
- Market perception: due to any reason customers’ perception of asset’s utility has been hampered. For example, ownership documents has been misplaced.
2 Basic concepts underlying depreciation
Before we discuss the calculation of depreciation following important aspects should be clear:
- useful life of asset
- residual value or salvage value of asset
- depreciable value of asset
- depreciation method
- Accumulated depreciation
2.1 Useful life of asset
Useful life is a unit to estimate how long asset will operate under reasonably optimum circumstances. Useful life may expressed in terms of years, hours, production runs, units or any other way deem fit.
Useful life is often confused with asset’s physical life. For entity asset is good for use until it can operate economically with favourable cost-benefit balance. Under normal circumstances asset is only useful for the entity until the benefits of using the asset exceed the cost of using the asset hence the term useful life.
Even after the end of useful life asset may still very well be in working condition but no longer economical, efficient or effective. For example, 10 years old personal computer may still be running excellent however, it is incapable of running today’s application software and to conduct task in efficient manner.
2.2 Residual value or Salvage value of asset
Residual value also called salvage value or scrap value is an estimated amount asset may fetch on disposal at the end of its useful life. Though the terms residual, scrap and salvage value are used interchangeably but they do have a little different meaning.
- Residual value means the net book value of asset at end of useful life of the asset. In other words it is the value of asset once it is fully depreciated.
- Salvage value is the value of benefit asset can render if it is put to alternate use or recycled.
- Scrap value is simply the amount asset will fetch if its disposed at the end of useful life.
Remember, this estimate is made at the time of acquisition of asset and may change later.
2.3 Total depreciable amount of asset
Total depreciable amount is the amount of cost the asset will loose over its useful life. Usually deperciable amont is determined by deducting residual value from cost of the asset at the acquisition date. And later on systematic basis a portion of depreciable amount is charged to income statement as expense. The formula to calculate depreciable amount is:
Total depreciable amount = Cost – Residual value
As it is dependent on residual value of asset, if its calculated on that basis, therefore, it may change later.
2.4 Depreciation method
Depreciation method is simply a mathematical formula that entity uses to determine the part of cost that needs to be expensed out from the net book value of the asset. Ideally the method used should match the rate at which entity is extracting benefits from the asset.
Entities are free to employ whatever method they deem fit however some popular ones are following:
- Straight-line method
- Accelerated depreciation methods
- Units of production method
2.5 Accumulated depreciation
Accumulated depreciation is simply the total amount by which an asset has been depreciated so far.
Instead of recording the depreciation expense in the asset account itself causing it to reduce, most often a separate contra-asset account is maintained so users can know the original cost or revalued amount of the asset and also the depreciation expense charged so far. For reporting net book value of asset, accumulated depreciation amount is deducted from the cost of the asset.