Depreciation is the systematic allocation of the cost of certain fixed assets over their useful life. Since fixed assets such as buildings, plants and equipment depreciate and thus they are useable only for a limited time, their cost must be expensed out gradually. This is done by recognizing a calculated portion of their costs as depreciation expense during each accounting period.
As the asset depreciates, its net book value, also known as carrying value, keeps on reducing. At any point in an asset’s life the asset must be represented in the balance sheet and elsewhere at its carrying value and not at its full cost.
Most assets retain a certain residual or salvage value even when their useful life ends. Depreciation of an asset is stopped when its carrying value equals its salvage value. Therefore the salvage value is subtracted from the historical cost and the depreciation is calculated on the remaining amount.
Depreciation is calculated using any of a number of depreciation methods. The following three are most common:
- Straight-line Method:
The asset is depreciated uniformly over its useful life.
- Declining-balance Method:
The asset is depreciated quicker near the start of its useful life and annual depreciation expense reduces gradually.
- Units of Production Method:
Annual depreciation is based on the proportion of the asset’s production capacity that has been used during a given year to the total production capacity of the asset.
The simplest approach is to simply debit depreciation expense and credit the particular asset as shown below:
|Depreciation Expense – Asset XYZ||ABC|
Using the above method, the asset account always represents the net book value of the asset and not its historical cost.
Alternatively, the depreciation expense may be accumulated in a contra-asset account called accumulated depreciation. In this approach the asset is represented in balance sheet as historical cost less accumulated depreciation. The basic journal entries under this approach are:
|Depreciation Expense – Asset PQR||DEF|
|Accumulated Depreciation – Asset PQR||DEF|
A truck costing $40,000 has a useful life of 10 years and a salvage value of $5,000 at the end of its useful life. Calculate the annual depreciation using straight-line depreciation method. Also calculate the net carrying value of the asset at the end of 7th year.
Since the truck has a salvage value at the end of its useful life, it must be subtracted from the cost of truck before allocating the cost over the 10 years equally using the straight line method. Therefore the annual depreciation is given by:
|Anual Depreciation Expense =||40,000 – 5,000||= 35,000|
The net carrying value of the asset at the end of a given year equals historical cost less the total depreciation accumulated up to that year. In case of straight-method, accumulated depreciation is simply the product of annual depreciation and number of years that asset has been used.
Net Book Value at end of 7th Year = 40,000 – 3,500 × 7 = 15,500
Written by Irfanullah Jan