What is Depreciation and its different methods?
Once in a quarter or a Year, one of the major issues that is faced by SME Owners is when their CA / Auditor asks them give the list of Assets and we need to calculate the Depreciation for those Assets. So what is this Depreciation and how it helps business? Why should we adjust the Asset values by this method? Below are the new words you might encounter here and lets give an explanation for the same.
- Asset Ledger – List of the assets that used for the business.
- Fixed Assets – This is like your Land, building, Vehicles, furniture etc.
- Depreciation – A process of reducing the value of the assets that’s used for production or helping the business.
- Book Value – Book value of Asset at the beginning. This value is same as Original cost of purchase in the first year of depreciation.
What is Depreciation?
From pure accounting terms, Depreciation is the process of reallocating the cost of the Fixed Assets over the lifespan of the assets that’s used to make production or business. Means, by using Depreciation methods, we are reducing the value of Fixed Assets in a pre-defined agreed method till the asset value becomes Zero or Negligible. These assets are called as Depreciable assets. Depreciation is a method of allocation of costs and it determines the value placed on the asset in the balance sheet. As we are aware fixed assets are buildings, Lands, Factory premises, office equipment computers, Machines and Tools and Dies etc. Most of these values are depreciated as the year passes. Only exception to this process is Value of the LAND and this appreciates with time. So be clear with this.
Why we follow this accounting process?
- It helps to allocate the cost of the fixed Assets that used to generate the Revenue. This is important from Accounting principle to get the complete picture of revenue generation with deprecate the value of the assets that are used to generate revenue.
- The second reason for this is, company should keep a provision for the new Asset as the current Asset may not be used in the future after its lifespan is over. So the idea here is to make a plan for the new machines in case the current dies off.
In business the typical behaviour is to book the expenses of the item that bought. However, if a Machine is bought now and its used during its lifespan to generate profits or business (considering the future life of 10 years), then Depreciation method helps to allocate these costs appropriately across the life of the Machine rather than book them in the current financial year as it would change the balance sheet totally. Depreciation allows a portion of the cost of the fixed assets to the revenue generated by that Asset. It depends on the following factors.
- Cost of the asset – This includes the cost of the Assets, Setting up and installation and other expenses till the Asset is usable for production stage.
- Estimated useful life of the asset – Life span during which this asset is used for the Production or used.
- Expected value that could be generated by selling it (Residual value of the assets at the end of the lifespan)
We need to follow an accounting principle in disclosing the depreciation amount in Balance sheet and PL Reports. Depreciation expense is recorded on the income statement of a business and its impact is shown on Balance sheet as Accumulated depreciation, under fixed assets. If we don’t have an Accumulated Depreciation Account on the Balance sheet, then we can directly charged these against individual Asset Accounts. So the values of the Individual fixed assets on Balance sheet will reduce, even though the business has not invested or disposed of any of its assets. So it depends on each business on how to show the Accumulated depreciation separately on the balance sheet as it could keep the original cost of assets on the balance sheet.
How to calculate Depreciation and what methods to follow?
We are explaining the most common methods that are used for SMEs. There are 3 methods used and for a financial year, its expected to keep only One Method and cant change them across the Assets. Please speak to your CA / Auditor for this.
1. Straight line Depreciation
This is the most frequently used method as its easy and simple. In this method, the company estimates the Scrap Value or Residual value of the asset at the end of the period. Please note that Scrap Value can be ZERO, but cant be below Zero. The company will then charge the same amount to depreciation each year over that period, until the value shown for the asset has reduced from the original cost to the salvage value. For example, a vehicle that depreciates over 10 years is purchased at a cost of Rs 1,10,000 and will have a salvage value of Rs 10,000. Then this vehicle will depreciate at Rs 10,000 per year, i.e. (110,000-10,000)/10 = Rs 10,000. As the book value changes every year, (Original value – Depreciated amount), the Book value at any given time equals original cost minus accumulated depreciation. Book value = original cost − Accumulated depreciation So Book value at the end of year becomes book value at the beginning of next year. This asset is depreciated until the book value equals scrap value. Example – Normal Machines used in Factories, Vehicles, Furniture etc.
2. Unit-of-Production Depreciation
In simple terms, we are allocating the depreciation cost per unit of items produced here. This method provides a fixed rate per unit of production. Now this depreciation unit cost per One unit of Production with the total number of units the company produced within a financial period to determine its depreciation expense. Depreciation Unit Expense = (Total Acquisition Cost – Scrap Value) / Estimated Total Units Estimated total units = the total units this machine can produce over its lifetime Example: Company ToolTip purchased an injection Machine Die for Rs 10,00,000 that can produce 20,00,000 component over its useful life. The company estimates that this machine has a Scrap / salvage value of Rs 100,000 at the end of producing so many components. Based on the above, The depreciation per unit = (Rs 10,00,000 – Rs 1,00,000) / 20,00,000 = Rs 0.45 The Depreciation Expense for a year = Depreciation cost / unit X Components produced in a year. Sample Industry examples – Tools and Dies, Specialised Machines used for the production of third party components.
3. Accelerated Depreciation
This method allows companies to write off their assets faster in earlier years and to write off a smaller amount in the later years. The advantage of this method is the tax shield it provides to companies. Companies with a large tax burden might like to use these accelerated-depreciation methods, as it helps them. One of the example is, in IT / Computer Industries Computers, Servers and laptops and other electronic equipment are written off faster as it might be replaced before the end of it’s useful life as the chances of them becoming an obsolete in the industry as the technology is changing so high. So companies that have used accelerated depreciation will declare fewer earnings in the beginning years and will seem more profitable in the later years. Even in Accounting procedures, it’s defined on how to treat some of these Asset classes based on the type of items and where it is used. The two most common accelerated-depreciation methods used in the industry are Sum of year (SYD) method and Double Declining Balance method (DDB):
Depreciation In Year “i” = ((n-i) + 1)) / n!) * (Total acquisition cost – Salvage or Scrap value) Example: For Rs 20,000, Company Tooltip purchased a machine that will have an estimated useful life of 3 years. The company also estimates that in 3 year, the company will be able to sell it for Rs 2,000 for scrap parts. n! = 1+2+3 = 6 n = 5 This Depreciation method produces a variable depreciation expense to start with. However at the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straight-line depreciation and no change except that its expensed at the early stage of the life.
2. Double-Declining-Balance Method:
The DDB method simply doubles the Straight line depreciation amount that is taken in the first year, and then that same percentage is applied to the un-depreciated amount in subsequent years. DDB In year i = (2 / n) * (total acquisition cost – accumulated depreciation) n = number of useful years of the asset.