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Tuesday, April 16, 2019

What is Depreciation on Assets?


In accounting terms, depreciation is defined as the reduction of recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible.

An example of fixed assets are buildings, furniture, office equipment, machinery etc.. A land is the only exception which cannot be depreciated as the value of land appreciates with time.

Depreciation allows a portion of the cost of a fixed asset to the revenue generated by the fixed asset. This is mandatory under the matching principle as revenues are recorded with their associated expenses in the accounting period when the asset is in use. This helps in getting a complete picture of the revenue generation transaction.

An example of Depreciation – If a delivery truck is purchased a company with a cost of Rs. 100,000 and the expected usage of the truck are 5 years, the business might depreciate the asset under depreciation expense as Rs. 20,000 every year for a period of 5 years.

In accounting terms, depreciation is defined as the reduction of recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible. The monetary value of an asset decreases over time due to use, wear and tear or obsolescence. This decrease is measured as depreciation. An example of fixed assets are buildings, furniture, office equipment, machinery etc.. A land is the only exception which cannot be depreciated as the value of land appreciates with time.

How to calculate depreciation in small business?
There three methods commonly used to calculate depreciation. They are:
1.      Straight line method
2.      Unit of production method
3.      Double-declining balance method
 Three main inputs are required to calculate depreciation:
1.      Useful life – this is the time period over which the organisation considers the fixed asset to be productive. Beyond its useful life, the fixed asset is no longer cost-effective to continue the operation of the asset.
2.      Salvage value – Post the useful life of the fixed asset, the company may consider selling it at a reduced amount. This is known as the salvage value of the asset.
3.      The cost of the asset – this includes taxes, shipping, and preparation/setup expenses.
Unit of production method needs the number of units used during production. Let’s take a look at each type of Depreciation method in detail.

Why do we charge depreciation?
We charge depreciation because most of the long-lived assets used in abusiness have 1) a significant cost, and 2) they will be useful only for alimited number of years. The matching principle (a basic underlying accounting principle) requires that the actual cost of these assets be allocated to the accounting periods in which the company will benefit from their use.

Types of depreciation
 1) Straight-line depreciation method
This is the simplest method of all. It involves simple allocation of an even rate of depreciation every year over the useful life of the asset. The formula for straight line depreciation is:
Annual Depreciation expense = (Asset cost – Residual Value) / Useful life of the asset   OR
Depreciation Expense = (Cost of the asset – Salvage value) / Useful life  
·         Cost of the asset is the purchase price of the asset
·         Salvage value is the value of the asset at the end of its useful life
·         Useful life of asset represents the number of periods in which the asset is expected to be used by the company    
Example – Suppose a manufacturing company purchases a machinery for Rs. 100,000 and the useful life of the machinery are 10 years and the residual value of the machinery is Rs. 20,000
Annual Depreciation expense = (100,000-20,000) / 10 = Rs. 8,000
Thus the company can take Rs. 8000 as the depreciation expense every year over the next   ten years as shown in depreciation table below.
Year                      
Original cost – Residual value
Depreciation expense

1
Rs. 80000
Rs. 8000
2
Rs. 80000
Rs. 8000
3
Rs. 80000
Rs. 8000
4
Rs. 80000
Rs. 8000
5
Rs. 80000
Rs. 8000
6
Rs. 80000
Rs. 8000
7
Rs. 80000
Rs. 8000
8
Rs. 80000
Rs. 8000
9
Rs. 80000
Rs. 8000
10
Rs. 80000
Rs. 8000

2) Unit of Production method
This is a two-step process, unlike straight line method. Here, equal expense rates are assigned to each unit produced. This assignment makes the method very useful in assembly for production lines. Hence, the calculation is based on output capability of the asset rather than the number of years.
The steps are:
Step 1: Calculate per unit depreciation:
Per unit Depreciation = (Asset cost – Residual value) / Useful life in units of production
Step 2: Calculate the total depreciation of actual units produced:
Total Depreciation Expense = Per Unit Depreciation * Units Produced

Example: ABC company purchases a printing press to print flyers for Rs. 40,000 with a useful life of 1,80,000 units and residual value of Rs. 4000. It prints 4000 flyers.

Step 1: Per unit Depreciation = (40,000-4000)/180,000 = Rs. 0.2
Step 2: Total Depreciation expense = Rs. 0.2 * 4000 flyers = Rs. 800
So the total Depreciation expense is Rs. 800 which is accounted. Once the per unit depreciation is found out, it can be applied to future output runs.           
 
3) Double declining method / Written Down Value Method (WDV) Depreciation
This is one of the two common methods a company uses to account for the expenses of a fixed asset. This is an accelerated depreciation method. As the name suggests, it counts expense twice as much as the book value of the asset every year.
It is also known as Reducing Balance or Reducing Installment Method or Diminishing Balance Method. Under this method, the depreciation is calculated at a certain fixed percentage each year on the decreasing book value commonly known as WDV of the asset (book value less depreciation).
Depreciation = 2 * Straight line depreciation percent * book value at the beginning of the accounting period
Book value = Cost of the asset – accumulated depreciation
Accumulated depreciation is the total depreciation of the fixed asset accumulated up to a specified time.
Example:  On April 1, 2015, company X purchased an equipment for Rs. 100,000. This is expected to have 5 useful life years. The salvage value is Rs. 14,000. Company X considers depreciation expense for the nearest whole month. Calculate the depreciation expenses for 2015, 2016, 2017 using a declining balance method.
Useful life = 5
Straight line depreciation percent = 1/5 = 0.2 or 20% per year
Depreciation rate = 20% * 2 = 40% per year
Depreciation for the year 2015 = Rs. 100,000 * 40% * 9/12 = Rs. 30,000
Depreciation for the year 2016 = (Rs. 100,000-Rs. 30,000) * 40% * 12/12 = Rs. 28,000
Depreciation for the year 2017 = (Rs. 100,000 – Rs. 30,000 – Rs. 28,000)  * 40% * 9/12 = Rs. 16,800
Depreciation table is shown below:
Year
Book value at the beginning
Depreciation rate
Depreciation Expense
Book value at the end of the year

2015
Rs. 100000
40%
Rs. 30,000 * (1)
Rs. 70,000

2016
Rs. 70000
40%
Rs. 28,000 * (2
Rs. 42,000

2017
Rs. 42,000
40%
Rs. 16,800 * (3)
Rs. 25,200

2018
Rs. 25,200
40%
Rs. 10,080 * (4)
Rs. 15,120

2019
Rs. 15,120
40%
Rs. 1,120 * (5)
Rs. 14,000


Depreciation for 2019 is Rs. 1,120 to keep the book value same as salvage value.
Rs. 15,120 – Rs. 14,000 = Rs. 1,120 (At this point the depreciation should stop).

Why should small businesses care to record depreciation?
So now we know the meaning of depreciation, the methods used to calculate them, inputs required to calculate them and also we saw examples of how to calculate them. Let’s find out as to why the small businesses should care to record depreciation.
As we already know the purpose of depreciation is to match the cost of the fixed asset over its productive life to the revenues the business earns from the asset. It is very difficult to directly link the cost of the asset to revenues, hence, the cost is usually assigned to the number of years the asset is productive.
Over the useful life of the fixed asset, the cost is moved from balance sheet to income statement. Alternatively, it is just an allocation process as per matching principle instead of a technique which determines the fair market value of the fixed asset.
Accounting entry – DEBIT depreciation expense account and CREDIT accumulated depreciation account.
If we do not use depreciation in accounting, then we have to charge all assets to expense once they are bought. This will result in huge losses in the following transaction period and in high profitability in periods when the corresponding revenue is considered without an offset expense. Hence, companies which do not use the depreciation expense in their accounts will incur front-loaded expenses and highly variable financial results.

Depreciation Rates for Financial Year 2019-20 & Assessment Year 2020-21

Sl. No.
Asset Class
Asset Type         
Rate of Depreciation
1
Building                               
Residential buildings not including boarding houses and hotels
5%
2
Building               
Boarding houses and hotels               
10%
3
Building                               
Purely temporary constructions like wooden structures
100%
4
Furniture                            
Any fittings / furniture including electrical fittings
10%
5
Plant and machinery      
Motor cars excluding those used in a business of running them on hire     
15%
6
Plant and
MachineryLorries/taxis/motor buses used in a business of running them on hire    
30%
7
Plant and machinery      
Computers and computer software             
60%
8
Plant and machinery      
Books owned by assessee carrying on a profession being annual publications        
100%
9
Plant and machinery      
Books owned by assessee carrying on profession not being annual publications               
60%
10
Plant and machinery      
Books owned by assessee carrying on business in running lending libraries               
100%
11
Intangible assets             
Franchise, trademark, patents, license, copyright, know-how or other commercial or business rights of similar nature              
25%

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