Depreciation in accounting refers to non-cash expenditures that every business body has to incur. These expenses result from employing tangible assets (like tools, machinery, equipment etc.) in business; the value of which tends to deplete because of continuous usage.
It is the explicit expense that businesses account for throughout an asset’s life prospects. To know the particularities of depreciation in accounting, refer to the sections below!
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What Is Depreciation in Accounting?
Depreciation is taken into account as a significant business expenditure. Entities allocate it in order to levy a proportion of depreciable amount during the asset’s expected useful life in every accounting period of a business. Depreciation in accounting helps business entities gain an understanding of the actual cost of conducting a business operation.
Depreciation costs also help entities identify the total amount of wear and tear caused due to the effect of decay, dust and erosion. Not to mention, it allows them to generate revenue from those fixed assets by making payments for them over a span of time.
Importance of Depreciation in Accounting
Depreciation in accounting enables business bodies to spread the asset value over many years. It is important to record as one cannot avoid it. It is not possible to maintain the original condition or form of an asset, while technologies become obsolete, few assets become inoperable because of their inefficiency.
The depreciated amount can be utilised to buy new machinery which ensures smooth business operations, leading to higher profitability. There are certain terms that define the working of depreciation in accounting.
Know About the Important Terms Relating to Depreciation
- Salvage Life: This refers to the residual cost which business owners can recover after selling the fixed asset when its useful life gets exhausted.
- Useful Life of Fixed Asset: This is the estimated time span when an asset remains highly efficient and productive. It is no more cost-effective to use this fixed asset beyond its useful life.
- Depreciation Rate: It refers to the percentage that is chargeable as depreciation on a business’ fixed asset.
- Fixed Asset Cost: It refers to the cost that a business body bears while purchasing a tangible asset.
Types of Depreciation Methods
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Straight-Line Depreciation
Straight-line depreciation method is the most convenient way to compute depreciation cost. The amount of expense remains the same throughout the asset’s useful life. In this depreciation mode, the same depreciation amount is chargeable.
| Straight-line depreciation = (Asset cost – residual value)/ Useful Life in Units of Production |
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Double Declining Depreciation
Double declining depreciation results when there is a high percentage of asset value that is depleted in the initial years of the useful life of a fixed asset. It is an accelerated mode of depreciation which highlights that the assets used by businesses remain more productive in the initial years. It also indicates that the asset loses its worth in the first years of its usage.
| Depreciation = (Net Book Value – Salvage Value) X (2/ Useful Life) X Depreciation rate |
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Units of Production Method
In this depreciation method, there is an estimation of the total units that a fixed asset will produce throughout its useful life. Units of the production method revolve around the work that the asset is capable of doing rather than focusing on the time for which it will be functional.
| Per unit depreciation = (Asset cost– Residual Value/salvage value)/ Total units produced over the useful life |
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Sum-of-Years Digit Method
It is another accelerated depreciation mode where the asset’s residual life is divided by the total sum of years and multiplied by the depreciating base. As the name suggests, this depreciation mode takes into consideration the total useful lifetime/years of the asset.
| Depreciation expense = (Remaining asset life / Sum of the years) X (Asset cost – Salvage value) |
Example of Depreciation
At the end of the first year, the accumulated depreciation would be Rs 9,000. At the end of the second year, it would be Rs18,000, and so on until the end of the fifth year when the accumulated depreciation would be Rs 45,000. At this point, the company would have fully depreciated the truck, and its net book value on the balance sheet would be the salvage value of Rs 5,000.
How Does Depreciation Affect Accounting Ratios?
- Return on assets (ROA): Depreciation reduces the value of assets over time, which reduces the denominator of the ROA ratio. As a result, the ROA ratio can increase or decrease depending on the level of depreciation expense.
- Debt to equity ratio: Depreciation reduces net income and, in turn, retained earnings. This can impact the denominator of the debt-to-equity ratio, which is shareholders’ equity. A decrease in equity can increase the debt-to-equity ratio, making the company look riskier to lenders.
- Earnings per share (EPS): Depreciation is a non-cash expense that reduces net income. This can impact the numerator of the EPS ratio, which is net income. A decrease in net income can result in a lower EPS.
- Price-to-earnings (P/E) ratio: Depreciation reduces net income, which can impact the denominator of the P/E ratio. As a result, a decrease in net income due to depreciation can increase the P/E ratio, making the stock look more expensive.
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Frequently Asked Questions
What is the difference between depreciation and amortisation?
While depreciation is the gradual depletion or reduction of a tangible asset’s recorded value, amortisation shows the consumption of intangible assets over their useful life. These two accounting processes also differ in the usage of salvage value in the calculation. Salvage value comes under the calculation of depreciation while in amortisation it does not.
Is there any difference between depreciation expense and accumulated depreciation?
While depreciation in accounting comes on the income statement, accumulated depreciation appears on the balance sheet. Depreciation expense is the asset’s cost, allocated and reported after every financial year. It can also reduce tax liability. On the other hand, accumulated depreciation records the total depreciation incurred for a fixed asset. The relative age of the asset can be determined via accumulated depreciation.
What are some of the assets a business uses that lose their value with time?
Buildings, automobiles, furniture, fixtures, machinery and equipment, computer systems etc., are assets that keep depreciating with continuous usage. Thus, these assets are often regarded as depreciable assets, capital assets etc.
What is book value?
The book value refers to a business's net asset value which one can evaluate as total assets less total liabilities. It is an important determinant that helps business bodies to track growth and acts as a standard of real-time worth for investors.
