Depreciation – Meaning, Nature, Scope, Importance, Types & Methods, Formula, Examples

In this article we will provide you with an overview of depreciation, including its meaning, nature, scope, importance, types and Methods

Meaning of Depreciation

Meaning of depreciation :

Meaning of Depreciation refers to the gradual decrease in the value of a tangible asset over time due to wear and tear, obsolescence, or other factors. It is a process of allocating the cost of a long-term tangible asset, such as buildings, machinery, or vehicles, over its useful life. Depreciation is an accounting concept used to reflect the decrease in the asset’s value on the balance sheet, and it is used to spread the cost of the asset over its estimated useful life.

Nature and Scope of Depreciation

The following are the nature and Scope of Deprecaition

Nature of Depreciation

Nature of depreciation is given below:

• The nature of depreciation is that it is a non-cash expense, meaning it does not involve an actual outflow of cash.
• Instead, it is an accounting measure used to allocate the cost of an asset over its useful life to reflect its diminishing value.
• Depreciation is a systematic process that occurs over time and is influenced by various factors, such as the asset’s initial cost, estimated useful life, and residual value.

Scope of Depreciation

Scope of depreciation is given below:

• Depreciation is applicable to tangible assets, which are physical assets that have a finite useful life and can be touched or seen.
• Examples of tangible assets that may be subject to depreciation include buildings, machinery, equipment, vehicles, and furniture.
• Depreciation is relevant to businesses and organizations that own tangible assets and use them in their operations.
• It is also important in financial reporting to provide a more accurate picture of the company’s financial position and performance.

An overview of depreciation, including its meaning, nature, scope, importance, types and Methods

Importance of Depreciation

Importance: Depreciation has several important implications for businesses and organizations. Some of the key importance of depreciation are:

1. Proper Financial Reporting: Depreciation allows businesses to accurately report the decrease in value of their tangible assets over time, providing a more realistic representation of their financial position in the balance sheet.
2. Taxation: Depreciation is used for tax purposes, as businesses are allowed to claim depreciation as an expense on their tax returns, which reduces their taxable income and, consequently, their tax liability.
3. Decision Making: Depreciation is considered in various financial decisions, such as asset replacement, capital budgeting, and determining the selling price of an asset.

Types and Methods of Depreciation

Types of Depreciation

Types: There are several methods of depreciation that a business can use to allocate the cost of an asset over its useful life. Some common types of depreciation methods include:

1. Straight-line depreciation: This method allocates an equal amount of depreciation expense each year over the asset’s estimated useful life. It is the simplest and most commonly used depreciation method.
2. Declining balance depreciation: This method allocates a higher amount of depreciation expense in the early years of the asset’s life and gradually decreases the depreciation amount in subsequent years. It is also known as accelerated depreciation.
3. Units of production depreciation: This method allocates depreciation based on the actual usage of the asset, such as the number of units produced or hours of operation.
4. Sum-of-years digits depreciation: This method allocates more depreciation in the early years and less in the later years, based on a predetermined formula using the asset’s useful life.

5. Double declining balance depreciation: This method allocates depreciation at twice the rate of the declining balance method, resulting in higher depreciation expense in the early years.

An overview of depreciation, including its meaning, nature, scope, importance, types and Methods

Methods of Depreciation with Examples

Depreciation is the process of allocating the cost of a tangible asset over its useful life. There are several methods of depreciation that are commonly used in accounting to spread the cost of an asset over time. Here are five examples of commonly used depreciation methods:

1. Straight-Line Depreciation Methods: This method allocates an equal amount of depreciation expense each year over the useful life of the asset. The formula for straight-line depreciation is: Depreciation Expense = (Cost of Asset – Salvage Value) / Useful Life

For example, if a company purchases a vehicle for $30,000 with a salvage value of $5,000 and an estimated useful life of 5 years, the straight-line depreciation expense would be: Depreciation Expense = ($30,000 – $5,000) / 5 = $5,000 per year

2. Declining Balance Depreciation: This method allocates a higher amount of depreciation expense in the early years of an asset’s life, and a lower amount in later years. The formula for declining balance depreciation is: Depreciation Expense = Book Value of Asset x Depreciation Rate

For example, if a company uses a declining balance depreciation rate of 25% and starts with a book value of $30,000, the depreciation expense for the first year would be: Depreciation Expense = $30,000 x 25% = $7,500

3. Units of Production Depreciation: This method allocates depreciation based on the actual usage or production of an asset. The formula for units of production depreciation is: Depreciation Expense = (Cost of Asset – Salvage Value) / Total Expected Units of Production x Actual Units of Production

For example, if a company purchases a machine for $50,000 with a salvage value of $5,000 and expects it to produce 100,000 units over its useful life, and it produces 20,000 units in the first year, the units of production depreciation expense would be: Depreciation Expense = ($50,000 – $5,000) / 100,000 x 20,000 = $9,000

4. Sum-of-the-Years’-Digits Depreciation: This method allocates more depreciation in the early years of an asset’s life, and less in later years. The formula for sum-of-the-years’-digits depreciation is: Depreciation Expense = (Cost of Asset – Salvage Value) x Remaining Useful Life / Sum of the Years’ Digits

For example, if a company purchases equipment for $40,000 with a salvage value of $4,000 and an estimated useful life of 5 years, the sum of the years’ digits would be 15 (1 + 2 + 3 + 4 + 5). If the asset is in its second year of use, the depreciation expense would be: Depreciation Expense = ($40,000 – $4,000) x 4 / 15 = $8,533.33

5. Double Declining Balance (DDB) Depreciation: This method allocates a higher amount of depreciation in the early years of an asset’s life, and a decreasing amount in later years. The formula for double declining balance depreciation is: Depreciation Expense = Book Value of Asset x 2 x Depreciation Rate

For example, if a company uses a double declining balance rate of 20% and starts with a book value of $50,000, the depreciation expense for the first year would be: Depreciation Expense = $50,000 x 2 x 20% = $20,000

An overview of depreciation, including its meaning, nature, scope, importance, types and Methods

ILLUSTRATIONS:

Let’s illustrate the methods of depreciation using a hypothetical example of a company purchasing a delivery truck for $50,000 with a salvage value of $5,000 and an estimated useful life of 5 years.

1. Straight-Line Depreciation: Under straight-line depreciation, the company will allocate an equal amount of depreciation expense each year over the useful life of the truck, which is 5 years.

Depreciation Expense = (Cost of Asset – Salvage Value) / Useful Life Depreciation Expense = ($50,000 – $5,000) / 5 Depreciation Expense = $9,000 per year

So, the depreciation expense for each year using straight-line depreciation would be $9,000.

2. Declining Balance Depreciation: Let’s assume that the company uses a declining balance depreciation rate of 20% for the truck.

Depreciation Expense = Book Value of Asset x Depreciation Rate Depreciation Expense = Book Value of Asset x 20%

Year 1: Depreciation Expense = $50,000 x 20% = $10,000

Year 2: Book Value of Asset = $50,000 – $10,000 = $40,000 Depreciation Expense = $40,000 x 20% = $8,000

Year 3: Book Value of Asset = $40,000 – $8,000 = $32,000 Depreciation Expense = $32,000 x 20% = $6,400

And so on, until the book value of the asset reaches the salvage value or the end of the estimated useful life.

3. Units of Production Depreciation: Let’s assume that the company estimates the truck will have a total expected units of production of 100,000 units, and in the first year, it produces 20,000 units.

Depreciation Expense = (Cost of Asset – Salvage Value) / Total Expected Units of Production x Actual Units of Production Depreciation Expense = ($50,000 – $5,000) / 100,000 x 20,000 Depreciation Expense = $9,000

So, the depreciation expense for the first year using units of production depreciation would be $9,000.

4. Sum-of-the-Years’-Digits Depreciation: As mentioned earlier, the sum of the years’ digits for a 5-year useful life is 15 (1 + 2 + 3 + 4 + 5).

Depreciation Expense = (Cost of Asset – Salvage Value) x Remaining Useful Life / Sum of the Years’ Digits Depreciation Expense = ($50,000 – $5,000) x Remaining Useful Life / 15

Year 1: Depreciation Expense = ($50,000 – $5,000) x 5 / 15 = $10,000

Year 2: Remaining Useful Life = 4 Depreciation Expense = ($50,000 – $5,000) x 4 / 15 = $8,000

Year 3: Remaining Useful Life = 3 Depreciation Expense = ($50,000 – $5,000) x 3 / 15 = $6,000

And so on, until the remaining useful life becomes 0.