Question

DB POST:

Why do we need depreciation? What effects do different depreciation methods have on expenses and assets?

Answer 1

As per the matching principle, all revenues and expenditures of a particular period should come in that period's income statement to give true and fair view of the financial statement. However, with regards to Fixed Assets like machinery, they have the useful life of more than one year. Therefore, they are not recognized as an expense. Hence the, a need of recognizing the expense part for machinery to distribute its cost over the useful life is felt. And then, the concept of depreciation originated.

Methods of depreciation:-

1.       Straight Line

2.       Units of Production

3.       Sum of years Digits

4.       Double Decline Balance

5.       Written Down Value

Effects of Depreciation methods on expense and assets: -

1.       Straight Line

It is a method of depreciation where the amount of depreciation is the same therefore, there is a uniform decrease in assets and depreciation amount.

2.       Double Declining Balance:-

It is a kind of accelerated depreciation method where there is the higher amount of depreciation during initial years and the significantly lower amount in later years. Thus, higher expense in starting years and assets will also be reduced more because of the higher rate of depreciation.

3.       Sum of years Digit:-

This method is also accelerated depreciation method where the asset is divided by the sum of assets useful life digits. It results in higher of the amount of depreciation and lower amount of assets in initial years than straight-line methods, however, if compared with the Double Declining Balance method it is lower.

4.       Units of Production:-

This method is based on units manufactured during the year. Depreciation and assets amount depends upon the number of units produced and it can be lower or higher.

5.       Written Down Value

In this method depreciation, amount keeps on reducing every year because the calculation of depreciation is done by reducing the balance. Depreciation will be higher initially but it will reduce every year and so is the assets value.