In accounting terms, depreciation is defined as the reduction of the recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible. An example of fixed assets are buildings, furniture, office equipment, machinery etc. The land is the only exception that cannot be depreciated as the value of land appreciates with time. Depreciation allows a portion of the cost of a fixed asset to the revenue generated by the fixed asset. This is mandatory under the matching principle as revenues are recorded with their associated expenses in the accounting period when the asset is in use. This helps in getting a complete picture of the revenue generation transaction. An example of Depreciation – If a delivery truck is purchased by a company with a cost of Rs. 100,000 and the expected usage of the truck are 5 years, the business might depreciate the asset under depreciation expense as Rs. 20,000 every year for a period of 5 years. How to calculate depreciation in small businesses? There are three methods commonly used to calculate depreciation. These are: Straight-line method Unit of production method Double-declining balance method Three main inputs are required to calculate depreciation: Useful life – this is the time period over which the organisation considers the fixed asset to be productive. Beyond its useful life, the fixed asset is no longer cost-effective to continue the operation of the asset. Salvage value – Post the useful life of the fixed asset, the company may consider selling it at a reduced amount. This is known as the salvage value of the asset. The cost of the asset – this includes taxes, shipping, and preparation/setup expenses. Unit of production method needs the number of units used during production. Let’s take a look at each type of Depreciation method in detail. Types of depreciation 1) Straight-line depreciation method This is the simplest method of all. It involves the 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 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
