Nature Of Depreciation & Depreciation Methods

Here I would like to explore the essence and nature of depreciation and cover main depreciation methods.

Nature & Essence Of Depreciation

Depreciation is the term used in accounting to define allocation of cost of fixed assets over the years during which these assets are being used by the business
Adding up depreciation charged to expenses during all the period of fixed assets usage we will get its cost less salvage (residual) value
We can say that depreciation is a process, the substance of which is a recognition that the asset wears out or decreases in value while time passes, which means that fixed assets sooner or later will have to be disposed of or written off since it will not be possible to use them in business
Depreciation is calculated and allocated to the expenses during the useful life of the particular asset to show that this asset serves the business for the period longer than one year. Different depreciation methods can be used to calculate these expenses

Other Accounting Terms Which Are Important

Essence of depreciation nd depreciation methods can be explored properly only if the related accounting terms are also understood, i.e.:

Fixed assets - long lived resources which are used in the business for a period longer that one year.
Capital expenditure - expenditure which is incurred in the acquisition of the fixed asset and added up to the cost of the asset acquired or constructed.

Reasons Why Asset Decreases In Value Over Time

Wearing and tearing - declining value due to physical reasons and usage of the asset
Obsolescence - the asset might become obsolete due to changes in technology or fashion and it becomes not efficient or economic to use the asset
Passage of validity time - some assets lose their value after certain period of time passes. As examples we can provide patents or know how, which have certain validity time and after that time can become public and lose their value

How We Calculate Depreciation?

Depreciation Basis

Despite which of depreciation methods is applied the basis to calculate depreciation is a difference between cost value and salvage (residual) value. So for this purpose we will need to estimate salvage (residual) value and useful life of the fixed asset.

Depreciation Methods

Straight line method - the simplest and most commonly used method, where it is assumed that the asset decreases in value in equal amounts during its useful life.
Production method (units of production) - under this method it is assumed that the asset decreases in value depending on its actual usage in production of goods or provision of services, i.e. the depreciation might depend on such factors as how many items were produced or how many hours the asset worked.
Declining (accelerated) method - under this method more of cost is allocated to the expenses during the first years of usage.
Sum of digits method - under this method it is also assumed that more cost of asset is allocated to the expenses during the first years of usage, however such allocation is smoother that under the declining method.

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