DEPRECIATION

The process of allocating the cost of a long-term tangible asset over its useful life is known as
depreciation. It is the allocation of the original cost of an asset to the periods benefited by its use. In
layman words, Depreciation means a fall in the quality or value of an asset.

But in accounting terminology, the concept of depreciation refers to the process of allocating the initial
or restated input valuation of fixed assets to the several periods expected to benefit from their
acquisitions and use.

The international accounting standards committee (IASC) (now the International Accounting Standards
Board) defines depreciation as follows: depreciation is the allocation of the depreciable amount of an
asset over the estimated useful life. The useful life of an asset is defined as the period over which a
depreciable asset is expected to be used by the enterprise. Residual or salvage value is the expected
recovery or sales value of the asset at the end of its useful life. Depreciation is also deducted for income
tax purposes in financial statements. Sometimes depreciation is referred to as a tax shield because it
reduces (as do other expenses) the amount of income tax that would otherwise have to be paid.

The two main factors that contribute to the decline in the usefulness of fixed assets are deterioration
and obsolescence.

Deterioration is the physical process wearing out whereas obsolescence refers to the loss of use due to
the development of improved equipment or processes, changes in style, or other causes not related to
the physical conditions of the asset. The other causes of depreciation are fall in market price, efflux of
time, accidents, etc. The need for depreciation accounting arises on three grounds i.e. to calculate
proper profit, to show true financial position, and to make provision for replacement of assets.

There are three methods of depreciation: straight line, units of production, and double-declining
balance.

1. Straight Line Method: The straight-line method of depreciation allocates the cost of the asset
evenly over time. This method calculates the annual depreciation as follows:

Depreciation = (Acquisition Cost - Residual Value)/Life

It is the most popular method for presenting depreciation in the annual report to stockholders.
 2. Units of Production Method: Depreciation is determined as a function of the number of units
the asset produces.

The depreciation per unit can be calculated as follows:

Depreciation per Unit = (Acquisition Cost - Residual Value)/ Total Number of Units in Asset’s Life.

The annual depreciation for a mentioned year can be calculated based on the number of units
produced during that year.

Annual Depreciation = Depreciation per Unit * Units Produced in Current Year

The units-of-production method is most appropriate when the accountant is able to estimate
the total number of units that will be produced over the asset’s life.

3. Accelerated Depreciation Methods: A higher amount of depreciation is recorded in the early

phase and a lower amount in the later phase. One form of accelerated depreciation is the
double-declining-balance method.

In this method, depreciation is calculated at double the straight-line rate but on a declining
amount. Calculation of the straight-line rate as a percentage is the first step. Doubling the
straight-line rate is the second step. This rate will be applied in all years to the asset’s book value
at the beginning of each year. As depreciation is recorded, the book value declines. Hence, a
constant rate is applied to a declining amount. This constant rate is applicable to the full cost or
initial book value. Although, the machine cannot be depreciated below its residual value. The
double-declining-balance method of depreciation results in an accelerated depreciation pattern.
It is most appropriate for assets subject to a quick decline in usefulness as a result of technical or
obsolescence factors.

When depreciation is calculated for financial statement purposes, a company generally wants to submit
the most favorable impression (the highest income) possible. Therefore, most companies choose the
straight-line method of depreciation. If the objective of the company’s management is to minimize its
income tax liability, the company will generally choose accelerated depreciation methods for tax
purposes as accelerated depreciation allows the company to save more on income taxes because
depreciation is a tax shield. Thus, it is not unusual for a company to use two depreciation methods for
the same asset, one for financial reporting purposes, and another for tax purposes.