Chapter 7 Depreciation
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Depreciation in accountancy refers to the systematic
allocation of the cost of a tangible fixed asset over its useful life. This
process aims to match the cost of the asset with the revenue it generates over
time. Depreciation recognizes that physical assets, such as machinery,
buildings, and vehicles, lose value due to wear and tear, obsolescence, or
usage. Here’s an overview of the key aspects of depreciation:
Key
Concepts of Depreciation
1. Cost of the Asset: The initial purchase price of
the asset, including any costs necessary to bring the asset to its intended use
(e.g., transportation and installation costs).
2. Useful Life: The estimated period over
which the asset is expected to be used by the business. This can be expressed
in years, units of production, or other relevant measures.
3. Residual Value (Salvage Value): The estimated value of the
asset at the end of its useful life. This is the amount the business expects to
recover when the asset is sold or disposed of.
4. Depreciable Amount: The cost
of the asset minus its residual value. This is the amount that will be
allocated over the asset's useful life.
5. Depreciation Methods: Various methods can be used
to allocate the depreciable amount over the useful life of the asset. The
choice of method affects the pattern of expense recognition.
Common
Depreciation Methods
1. Straight-Line Method:
• Formula:
(Cost - Residual Value) / Useful Life
• Description:
This method allocates an equal amount of depreciation expense each year over
the asset's useful life.
2. Declining Balance Method:
• Formula:
Book Value at Beginning of Year × Depreciation Rate
• Description:
This accelerated method applies a constant rate to the decreasing book value of
the asset, resulting in higher depreciation expense in the earlier years and
lower expense in later years.
3. Double Declining Balance Method:
• Formula:
2 × Straight-Line Depreciation Rate × Book Value at Beginning of Year
• Description:
An accelerated depreciation method that doubles the straight-line rate, leading
to even faster depreciation.
4. Units of Production Method:
• Formula:
(Cost - Residual Value) / Total Estimated Production × Units Produced
• Description:
This method bases depreciation on the actual usage or output of the asset,
making it suitable for assets whose wear and tear is more closely related to
usage than time.
Importance
of Depreciation
• Matching
Principle: Depreciation helps in matching the cost of an asset with the revenue
it generates, adhering to the matching principle in accounting.
• Accurate
Financial Reporting: It ensures that the financial statements reflect the true
value of assets over time.
• Tax
Deductions: Depreciation is a non-cash expense that reduces taxable income,
providing a tax benefit to businesses.
• Investment
Decision Making: Helps in assessing the profitability and performance of
investments in fixed assets.
Accounting
for Depreciation
In accounting records, depreciation is recorded as follows:
• Journal
Entry:
• Debit:
Depreciation Expense (Income Statement)
• Credit:
Accumulated Depreciation (Balance Sheet - Contra Asset Account)
This entry reduces the book value of the asset on the
balance sheet and recognizes an expense on the income statement, affecting the
net income of the business.
Understanding depreciation is essential for accurate financial reporting, tax compliance, and informed business decision-making.