Question

Write a detailed note on depreciation, its methods by giving your own examples (numerical), each for straight line and declining method.

Answer 1

Depreciation is an accounting convention that allows a company to write off an asset's value over a period of time, commonly the asset's useful life. Assets such as machinery and equipment are expensive. Instead of realizing the entire cost of the asset in year one, depreciating the asset allows companies to spread out that cost and generate revenue from it.

Develop a detailed answer from the key words given below.

- Depreciation is planned, reduced value of an asset over time due to wear and tear.
- It is the method of allocating the cost of a tangible or physical asset over its useful life or life expectancy.
- It represents how much of an asset's value has been used up.
- As per matching principle, depreciation ties the cost of using a tangible asset with the benefit gained over its useful life.
- Depreciation allows a portion of the cost of a fixed asset to the revenue generated by the fixed asset.
- Depreciation needs to be provided because continuous usage of an asset in the business reduces the working capacity and effectiveness of the asset.
- Four main factors to consider when calculating the depreciation expense include, cost of the asset, its salvage value, useful life and obsolescence.
- Different methods are used to depreciate the assets.

Methods of depreciation:

The following key points will explain the different depreciation methods along with examples.

Methods of Depreciation

- Straight Line Method:

# Commonly used method.
# Equal amount is charged for depreciation of every fixed asset in each of the accounting periods.
# Formula for annual depreciation under straight line method,
Annual Depreciation Expense = (Cost of the asset – Salvage Value)/Useful life of an asset

For example, AB Ltd purchased a machinery for $200,000 from XY Ltd. Its useful life is estimated to be 6 years and at the end of the 6 years it is expected a salvage value of $20,000. Hence, the depreciation under straight line method will be,
(200,000 - 20,000)/6 = $30,000. This $30,000 will be charged to income statement and written off as depreciation every year from the value of the asset.

- Declining Balance Method:

# Fixed percentage of depreciation is charged in each accounting period to the net balance of the fixed asset
# A depreciation rate is charged on the reducing balance of the asset.
# Formula for depreciation under Declining / Diminishing Balance method,
(Book value of asset at beginning of the year x Rate of Depreciation)/100
For example, On 1st January 2019, AB Ltd purchased a machinery for $200,000 from XY Ltd. The asset is depreciated under declining balance method on the closing date of accounts (31st December) at 20%. The deprecation will be,
$200,000 × 20% = $40,000. The first year ending depreciation is reduced from the cost of the asset to get the book value for the next year. Hence, depreciation for next year will be,
(200,000 - 40,000) × 20% = 32,000.
The asset will be depreciated until it reaches the full value of the asset.

- Double Declining Balance Method:

# a mix of straight line and diminishing balance method
# Depreciation is charged on the reduced value of the fixed asset in the beginning of the year
# Fixed rate of depreciation is applied at twice the rate charged under straight line method
# The formula is,
2 x (Cost of an asset – Salvage Value)/Useful life of an asset
For example, the cost of the asset is $100,000 and salvage value is $10,000 with useful life of 9 years. The depreciation will be,
2 × (100,000 - 10,000) / 9 = $20,000

- Modified Accelerated Cost Recovery System (MACRS) Depreciation:

# Companies can recover the capitalized cost of an asset through annual deductions.
# Consult IRS Pub 946 to identify the correct depreciation method and depreciation rate for the asset.

- Units of Production Depreciation Method:

# Measures an asset's value with respect to the number of units it's expected to produce over the course of its useful life.
# The formula for depreciation rate is,
Completed units/ Total expected units

- Sum of the year's digit Method:
# The depreciable amount of an asset is charged to a fraction over different accounting periods under this method.
# The formula is,
Depreciable Cost x (Remaining useful life of the asset/Sum of Years’ Digits