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The Basic Concept of Depreciation and How to Calculate It

Scholasticus K Jun 9, 2019
Depreciation is termed as the decrease in the value of any asset due to the passage of time. This calculation is a very important aspect of preparation of financial statements and the method varies according to the nature of the asset.
Most of the experts in finance, bookkeeping, and accountancy, regard depreciation as complex and insignificant. On the other hand, some experts regard it as a very effective technique when it comes to assets such as machinery or loose tools, as the value of such assets indeed decrease with use and time.
However, in cases of fixed assets such as real estate, it is exactly the opposite, as inflationary cycles of the economy push up the value of such assets. Thus, the usefulness of the phenomenon still remains in debate.

The Concept

Every year, when the accounts of any company are closed and tallied, the most important deductions that are made in the books of accounts, balance sheet, and final accounts, are that of depreciation.
The value is deducted from the current monetary value of certain fixed assets, irrespective of their cost price, face value, and current market value. It is deducted from the value of the assets, because everyday use of certain fixed assets causes wear and tear, thus reducing monetary value of the asset. There has been much debate regarding its importance.
Legal systems and government agencies monitoring the finance management and accounting have made the calculation a statutory compliance. It can be calculated with the help of many different methods. The prominent ones have been elaborated further.

Calculating Depreciation Expense

Depreciation expense is calculated on the basis of different methodologies. The basic principle of deduction of fixed sum, is the same. Many organizations use the straight line depreciation method. This is the simplest of all. The formula of this method goes as follows:

Straight Line Depreciation = Total Cost of Asset (/) Estimated Life of the Asset
By using this formula, you will receive a particular figure that has to be deducted from the book value of the asset every year. The cost of depreciation is considered to be a legitimate expenditure, and is thus not taxed. There are several advantages of using this method, some of them can be elaborated as follows.
  • It facilitates excellent financial planning and inventory management.
  • The anticipated depreciation, predicted longevity, of the asset often leads to a very good balance sheet analysis, reduces tax liability, and helps in fixed and recurring expenditure planning.
  • The enhanced finance management facilitates the planning of the inventory. A planned inventory means that the purchase department, finance department, and production department have a very quick purchase procedure.

Declining Balance Depreciation Method

In such cases the calculations are done by deduction of a particular percentage from the asset value. The percentage deducted can be planned by the management of the company, by considering factors such as tax liability, the loan that has been taken for purchasing the asset, inventory planning, current/recurring expenditures of the assets, etc.
Accounting standards that are set by the legal system, put a limit on the percentage that can be deducted from the value of the asset. Here are some advantages of declining balance depreciation method.
  • This method is not exactly time bound, and the management is free to decide the percentage of depreciation on the basis of their forecasting.
  • The total value is seen in the financial statements that are derived on the basis of inventories.
  • As the percentage based deductions are brief representations, it proves easy for the management and decision makers to take decisions.
Though the phenomenon sounds irrelevant and unnecessary in some cases, it is a statutory requirement, and hence, has to be complied with. It is also advisable to analyze the asset on the basis of its productivity, need, and cost. One must also consider estimating recurring expenditures such as servicing, repairs, and energy consumption.