Depreciation lets companies recover an asset’s expense when it got bought. Without depreciation, an establishment’s financial statements might mislead stakeholders and potential investors.
What it does is allows companies to reduce their net income and lower the initial tax liabilities. Now, what exactly is deprecation,and how does it get calculated? Allow this post to learn further about depreciation and its calculation method.
An Introduction to Depreciation: What Exactly Is It?
Depreciation is a term that refers to the accounting process used for allocating a physical or tangible asset’s expense over its useful life. In short, depreciation signifies the amount of asset that gets used. It allows establishments to get revenues from assets they own by paying for them over a timeframe.
Note that companies do not have to account for them in the same year they purchase the asset. Thus, the instant ownership expense gets reduced significantly. But what happens when one does not account for depreciation? Truth be told, it may affect the company’s profit greatly. In general, enterprises depreciate their long-term assets for accounting and tax purposes.
One can compare depreciation with an amortization that accounts for changes in the value over time of intangible assets.
What Are The Conditions To Claim Depreciation?
If you want to know about calculating the income tax depreciation rates, you must learn about the conditions. Remember, the taxpayer should always fulfil the below-offered conditions to claim depreciation:
- The taxpayer must use assets for professional or business purposes and never personal uses
- The asset must get used in a financial year
- Every co-owner may claim it to the asset’s extent that is owned by them
Understanding the Types of Depreciation and How to Calculate Them: Read More
Businesses have control over the process they depreciate assets. Small-scale businesses can calculate, track, and record depreciation. However, you must understand the procedure to make a crucial decision about how businesses record depreciation. On that note, below are the four methods of calculating it.
#1 Production Depreciation Units
The units of product depreciation are on the basis of the items a tool produces. To calculate it, you need to use the formula given below:[The produced number of units] divided by [asset’s life in units] multiply this result with [(asset’s cost) subtract (the asset’s scrap value)]. The result you get is the depreciation expense.
This formula is mostly used for manufacturing equipment expected to produce items before it is any longer useful.
Here are the benefits of using it:
- It’s easy to compute
- It is tied to items produced by equipment, so it offers accurate calculation
Now, what are the downsides? You need to keep an accurate record of the number of items the equipment produces. Production varies from one month to another. So, you may need to enter the expense manually into the accounting software.
#2 Straight-line depreciation
It’s the simplest method to calculate the amount. The following is the formula:[(Asset’s Cost) minus (Scrap value of the asset)]divided by the asset’s Useful life
The result is the Depreciation expense
This method is used mostly for equipment that loses its value steadily over the years.
Here are the perks:
- It spreads the cost evenly over every accounting period
- Extremely easy to automate an adjusting entry for the straight-line depreciation in maximum accounting software
But remember, one miscalculation may contribute to the asset getting overvalued for different years.
#3 Double declining balance depreciation
This type of depreciation is the accelerated depreciation process. Enterprises implement accelerated methods while managing assets that stay productive during the early years. This double declining balance method gets used for equipment, while the units of the production method do not get used.
The formula is:[(100%) divided by (Asset’s Life)]
The result is double the depreciation rate (i.e. depreciation rate x 2).
This method gets used for vehicles and other types of assets that may lose value speedily.
The perk of this method is that it represents certain asset’s lost value more accurately than the other two (as mentioned above).
But the calculations are complicated here.
#4 Sum of a year’s digits depreciation
It is an accelerated depreciation method that does not depreciate the asset as quickly as the double declining balance depreciation. However, it is speedier than straight-line depreciation. The formula is:[(Remaining asset’s life) multiplied with (Sum of the years’ digits)]multiple it with [(Asset’s cost) minus (Asset’s scrap value)]
The amount is the depreciation expense.
This method gets used for assets that become obsolete too quickly.
This method allows you to select the number of years you wish to depreciate the asset, depending on its useful life. But note that it is a complex depreciation method to compute.
So, this post concludes after elucidating depreciation. Now, you know how to measure the amount via four different methods.