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What is Depreciation?
So, depreciation, what’s that? In simple words, it’s a basic idea in money stuff & accounting. It’s about spreading out the cost of a thing you own—a thing you can touch—over the time you use it. Think of it like this: things get old or break down over time. Depreciation shows that these things lose value because they’re used a lot or just because they get old. Businesses use this to make sure the cost of stuff matches up with the money they make from it.
Why is Depreciation Important?
Depreciation is important for some good reasons:
- Accurate Financial Reporting: It makes sure that reports about money show the real cost of things over time.
- Tax Benefits: Since depreciation is an expense, it can lower the amount of taxes a business has to pay.
- Budget Planning: Helps businesses plan when they need to buy new stuff.
- Profit Measurement: Spreads out costs so it’s easier to see if a business is making money.
Key Words in Depreciation
- Tangible Assets: These are things you can touch like machines, cars, buildings, or tools.
- Useful Life: How long something will be useful or work well.
- Residual Value (Salvage Value): What something might be worth after it gets old & isn’t as useful anymore.
- Depreciable Cost: This means how much you paid for something minus what it will be worth at the end.
How Do You Calculate Depreciation?
There are different ways to figure out depreciation. It depends on what kind of thing you have and how your business works with money. Let’s look at the easy ones.
1. Straight-Line Depreciation
This one’s pretty easy-peasy and used often too! It splits the loss in value evenly over each year that thing is still useful.
Formula: Annual Depreciation Expense= Cost of Asset − Residual Value/Useful Life (years)
Example:
Suppose a company buys a machine for $50,000. It will last for 10 years. At the end, it’s worth $5,000.
Annual Depreciation=$50,000−$5,000/10= $4,500 per year.
Every year, they note a $4,500 depreciation expense on the income sheet.
2. Declining Balance Method
This way of calculating speeds up how much depreciation there is in the first few years. It’s good for stuff like tech & vehicles that lose value fast.
Formula: Depreciation Expense=Book Value at Start of Year×Depreciation Rate
Example:
A company gets a vehicle for $30,000. It will last 5 years. The rate of depreciation is 20%. In the first year:
Year 1 Depreciation: $30,000×20%=$6,000.
For the second year, they calculate it on the lower book value:
Year 2 Depreciation: ($30,000−$6,000)×20%=$4,800.
This continues until it hits what’s left to be worth.
3. Units of Production Method
For this method, depreciation is based on how much the asset is used—like output or hours worked. Perfect for factory machines.
Formula: Depreciation per Unit = Cost of Asset−Residual Value/Total Estimated Units
Formula: Depreciation Expense=Depreciation per Unit×Units Produced in the Period
Example:
A machine costs $100,000 with a leftover value of $10,000 after its full use of 500,000 units. If it makes 50,000 units in one year:
Depreciation per Uni t= $100,000−$10,000/500,000 =0.18 per unit.
Annual Depreciation=0.18×50,000=$9,000.
4. Sum-of-the-Years’ Digits (SYD) Method
This is another fast-depreciation method. Higher amounts come off in the early years and less later on.
Formula: Depreciation Expense=Remaining Life of Asset/Sum of Years Digits × (Cost of Asset−Residual Value)
Example:
For something that costs $40,000 & has a leftover value of $5,000 over 5 years:
Add up all the year numbers: 5+4+3+2+1=15.
First-year’s depreciation:
5/15×($40,000−$5,000)= $11,667.
Second year’s depreciation:
4/15×$35,000= $9,333.
The amount goes down every year.
Journal Entries for Depreciation
When noting down depreciation in books, two accounts are looked at:
- Depreciation Expense (Income Statement): Shows what was spent each year.
- Accumulated Depreciation (Balance Sheet): A contra-asset account drops the asset’s book value.
Example Entry (Straight-Line Depreciation):
For yearly depreciation of $4,500:
- Debit: Depreciation Expense $4,500
- Credit: Accumulated Depreciation $4,500
Impact of Depreciation on Financial Statements
- Income Statement: Depreciation brings net income down since it’s an expense.
- Balance Sheet: Accumulated depreciation lowers the asset’s book value.
- Cash Flow Statement: Since it’s a non-cash expense, it’s added back to net income under operating activities.
Depreciation for Tax Purposes
Governments often have rules to calculate this for tax benefits. In the U.S., MACRS is common. In India? They follow the Income Tax Act rates.
When Does Depreciation Not Apply?
Depreciation doesn’t work on:
- Land: Land usually doesn’t depreciate as its useful life doesn’t end.
- Intangible Assets: These are amortized instead (like patents or copyrights).
- Inventory: It’s depleted when sold, never depreciated.
Real-Life Examples
- Manufacturing Industry: A textile business might depreciate sewing machines over a decade to match costs with making clothes.
- IT Companies: A tech firm could use fast depreciation for servers as they become old quickly.
- Transportation: A trucking company may speed up truck depreciation due to wear & tear from heavy use.
Conclusion
Depreciation helps spread out the cost of physical assets over time so financial reports stay accurate and tax benefits are intact. By using methods like straight-line, declining balance, or unit production, businesses can rightly connect what they spend on assets with earned revenue so much better! Knowing about this doesn’t just help with following rules—it aids in making wiser money choices, helping stay profitable and stable!
Sahab Academy is the source of this YouTube video.
Frequently Asked Questions (FAQs)
What is Depreciation?
Depreciation is the accounting process of allocating the cost of a tangible asset over its useful life. It represents the reduction in worn-out, obsolete, or used-up assets that allows businesses to correctly show their lower value on the balance sheet.
Why is Depreciation Important in Accounting?
Depreciation is important as it allows for:
1. Combination of expenses with revenues to determine exact profits.
2. Impartial estimate of asset values in financial statements
3. Allows businesses to Expense it hence Tax benefits.
Which assets are being depreciation?
Examples of depreciable assets are physical, long-term things, such as:
1. Machinery
2. Buildings
3. Vehicles
4. Equipment notes — Land usually does not lose value so it is not depreciable.
In what ways do assets depreciation?
Depreciation applies to tangible assets (e.g., machinery, vehicles), while amortization applies to intangible assets (e.g., patents, trademarks).