Understanding Depreciation: A Simplistic Explanation and Examples
Within any business, costs are incurred related to the business' tangible assets
. An example of such costs is the cost of a depreciable asset, which is an asset that not only produces benefit in a current period, but is expected to produce benefit in future periods as well. Machinery, equipment, buildings, furniture, and cars are all examples of depreciable assets that will not last indefinitely, but will indeed last and be beneficial for more than one year. If the asset will produce benefit in future periods, as depreciable assets do, the cost of such as asset must be deferred rather than treated as a current expense. With that being said, it becomes imperative to allocate such costs to the periods anticipated to benefit from the utilization of the asset, which is known as the method of depreciation. In following the method of depreciation, the costs are allocated in an orderly manner to each period in which the asset is being used and reported as a Depreciation Expense on the Income Statement. Appropriately, depreciation can be further explained as the transfer of a portion on an asset's cost from the Balance Sheet to the Income Statement during each year of the asset's life. Therefore, depreciation is objectively a method of allocation, not valuation, which requires knowledge of the following criteria:
Cost of the asset,
Expected salvage value of the asset, and
Estimated useful life of the asset
When calculating depreciation, there are several methods that can be used. Such methods are based on either the passage of time or the level of activity of the asset and can be generally grouped in two categories: Straight-line depreciation and Accelerated depreciation.
Straight-line depreciation is the simplest and most frequently used technique for determining the depreciation expense of an asset. Under this method, the equation for finding the depreciation expense is:
Depreciation expense = (cost of the asset salvage value) / estimated useful life
Accelerated depreciation methods such as the double-declining balance method, provide for initially a higher depreciation charge in the first year of an asset's life and then gradually decreasing charges in subsequent years. The major difference under this method is the need to calculate the straight-line depreciation rate first and foremost. Under the double-declining balance method the steps for finding the depreciation expense are:
Step 1: Straight-line rate = 100%/useful life
Step 2: Double-declining balance rate = 2 x Straight-line rate
Step 3: Depreciation expense = Double-declining balance rate x Beginning period book value
For example, a tractor that depreciates over 4 years, is purchased at $18,000, and will have a salvage value of $2,000. Following the straight-line method, the tractor will depreciate at $4,000 per year: ($18,000-$2,000)/ 4 years = $4,000. Following the double-declining balance method, the tractor will depreciate at $9,000 per year: 100%/4 years = 25%, 25% x 2 = 50%, 50% x $18,000 = $9,000.
To sum this up lesson simply, depreciation is a method used to determine the cost of such an asset that is expected to be utilized over a period of time. Depreciation shows the proper reduction in the value of the asset, while also providing the current value of the asset during any given period. Deprecation of an asset is recorded in the general journal as a Depreciation Expense and the entry is written as a debit to Depreciation Expense and a credit to Accumulated Depreciation.
Understanding Depreciation: A Simplistic Explanation and Examples
By: Mastur123
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