Depreciation is a charge made to the income of a company on yearly basis for use of a particular asset. It is the cost of an asset distributed over the entire life of the asset systematically. The charge is made to match the revenue the asset generates over its useful life. The other important reason for depreciation is due to the reduction in the value of the asset purchased, over time.
DEFINITION OF DEPRECIATION AS PER COMPANIES ACT, 2013
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. The depreciable amount of an asset is the cost of an asset or other amount substituted for cost, less its residual value.
FORMULA DEPRECIABLE AMOUNT
Here is the formula to calculate the depreciable amount.
Depreciable Amount = Cost of the Asset - Estimated Residual Value of the Asset
CAUSES OF DEPRECIATION
There are numerous causes of depreciation. A few among them are listed below
1) Wear and Tear due to its use in the business
2) Efflux of time, even when not used.
3) Obsolescence due to technological and other changes
4) Decrease in market value of the asset
5) Depletion - Mainly in case of mines and other natural reserves.
Read causes of depreciation in detail
TYPES OF DEPRECIATION
The following are the most common types or methods of depreciation.
1) Straight Line Method of Depreciation
2) Diminishing Balance Method of Depreciation
3) Units of Production or Production Units Method
4) Sum of Years Digits Method
Other types of depreciation in detail
STRAIGHT LINE METHOD OF DEPRECIATION
The Straight Line Method of Depreciation is also known as Fixed Installment Method of Depreciation is the most simplest form of all depreciation methods. An equal amount is written off from the cost of the asset every year and by the end of the useful life of the asset, the asset is either fully written off or brought down to its residual value.
DEPRECIATION FORMULA: STRAIGHT LINE METHOD:
The formula for Straight Line Method of Depreciation is:
Depreciation Amount = Cost of the Asset - Residual Value
No of years of useful life of the asset
The above formula gives you the Depreciation amount in total.
To calculate the % of depreciation
Depreciation (%) = Depreciation
________________ * 100
Cost of the Asset
WRITTEN DOWN VALUE METHOD OF DEPRECIATION
Under this method of depreciation, a fixed percentage is applied to the reduced balance of the asset value each year. Finally, the asset is reduced to its residual value at the end of its life. The amount of depreciation is the maximum in the first year and it reduces year on year, unlike the straight line method, where the amount of depreciation remains constant throughout the useful life of the asset. Most of the companies adopt this method of depreciation as it creates adequate reserves for replacement of the asset and for meeting the repair cost by charging maximum amount in the first year. Since the repair cost is the lowest during the first few years, the company tends to have enough reserves to meet the increase in repair costs in following years and to meet the replacement cost of the asset at the end of its useful life.
DEPRECIATION FORMULA - WRITTEN DOWN VALUE METHOD
The rate of depreciation under written down value method is calculated using the following formula
Depreciation = 1 - n * sqrt ( residual value / cost of asset) * 100
Where n = Number of years
UNITS OF PRODUCTION OR PRODUCTION UNITS METHOD
This method is adopted by companies to more accurately match with the number of production units produced in any given year. Higher the output, the machinery produces, larger is the amount of depreciation charged in that particular year.
HOW IS THE DEPRECIATION CALCULATED?
Under this method, the actual annual production of the machinery is compared with the estimated production and the percentage of actual annual production to estimated production is applied to the depreciable amount to calculate the depreciation.
This method is applied to all the machineries producing similar kinds of output.
UNIT OF PRODUCTION METHOD DEPRECIATION FORMULA
Depreciation for the period =
Actual number of units produced
Depreciable amount * -----------------------------
Estimated number of units
Where, Depreciable Amount = Original Cost of Machinery - Residual Value
Although, this method seems to be more reasonable and accurate, it is not adopted by many companies generally.
SUM OF YEARS DIGITS METHOD
This method of depreciation is calculated by multiplying the original cost of the asset, less its estimated scrap value by the fraction represented by
The number of years of remaining life of the asset (this includes current year)
Total of all digits of life of the asset (in years)
For example if the useful life of the asset is 5 years, the sum of all digits will be 5 + 4 + 3 + 2 + 1 = 15
The depreciation to be written off during the first year will be
(Cost of the Asset Less Estimated Scrap Value ) * (5 / 15)
The depreciation to be written off during the second year of the asset will be
(Cost of the Asset Less Estimated Scrap Value ) * (4 / 15)
This method is not very popularly followed by Companies, although it is the same as Reducing Balanced Method of Depreciation.
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