Depreciation is calculating the asset’s cost to expense over the accounting periods that the asset is likely to be used. For Example, if a business purchases a delivery truck at the cost of 100,000 and it is expected to be used for 5 years, the business might have depreciation expense is 20,000 in each of the five years. The above example notifies each year there will be adjusting entry with a debit to Depreciation Expense for 20,000 and a credit to Accumulated Depreciation for 20,000. Since the adjusting entries do not involve cash so depreciation expense is referred to as a noncash expense.
There are three methods to calculate the Depreciation in small businesses. They are
- Straight line method
- Unit of production method
- Double-declining balance method
Straight line method:
It’s the simplest method of all and It involves simple allocation of an even rate of depreciation every year over the useful life of the asset. The formula for straight-line depreciation is:
Annual Depreciation expense = (Asset cost–Residual Value) / Useful life of the asset
Example – Suppose a manufacturing company purchases a machinery for Rs. 100,000 and the useful life of the machinery are 10 years and the residual value of the machinery is Rs. 20,000
Annual Depreciation expense = (100,000-20,000) / 10 = Rs. 8,000
Therefore the company can take Rs. 8000 as the depreciation expense every year
Unit of production method:
This Method is a two-step process, unlike straight-line method. In this, the calculation is based on output capability of the asset rather than the number of years.
Step 1: Calculate per unit depreciation:
Per unit Depreciation = (Asset cost – Residual value) / Useful life in units of production
Step 2: Calculate the total depreciation of actual units produced:
Total Depreciation Expense = Per Unit Depreciation * Units Produced
Example: ABC company purchases a printing press to print flyers for Rs. 40,000 with a useful life of 1,80,000 units and residual value of Rs. 4000. It prints 4000 flyers.
Step 1: Per unit Dep. = (40,000-4000)/180,000 = Rs. 0.2
Step 2: Total Dep. expense = Rs. 0.2 * 4000 flyers = Rs. 800
Hence the total Dep. expense is Rs. 800 which is accounted. Once the per unit depreciation is found out, it can be applied to future output runs.
Double-declining balance method
This is an accelerated depreciation (Dep.) method. As the name suggests, it counts expense twice as much as the book value of the asset every year.
The formula is:
Dep. = 2 * Straight line depreciation percent * book value at the beginning of the accounting period
Book value = Cost of the asset – accumulated depreciation
Accumulated Dep.is the total depreciation of the fixed asset accumulated up to a specified time.
Example: On April 1, 2012, company X purchased an equipment for Rs. 100,000. This is expected to have 5 useful life years. The salvage value is Rs. 14,000. Company X considers depreciation expense for the nearest whole month. Calculate the Depreciation(Dep.) expenses for 2012, 2013, 2014 using declining balance method.Useful life = 5
Straight line Dep. percent = 1/5 = 0.2 or 20% per year
Dep. rate = 20% * 2 = 40% per year
Dep.for the year 2012 = Rs. 100,000 * 40% * 9/12 = Rs. 30,000
Dep. for the year 2013 = (Rs. 100,000-Rs. 30,000) * 40% * 12/12 = Rs. 28,000
Dep. for the year 2014 = (Rs. 100,000 – Rs. 30,000 – Rs. 28,000) * 40% * 9/12 = Rs. 16,800