The monetary value of an asset decreases over time due to use, wear and tear or obsolescence. This decrease is measured as depreciation. In accounting terms, depreciation is defined as the reduction of recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible.
An example of fixed assets are buildings, furniture, office equipment, machinery etc. A land is the only exception which cannot be depreciated as the value of land appreciates with time.
Depreciation allows a portion of the cost of a fixed asset to the revenue generated by the fixed asset. This is mandatory under the matching principle as revenues are recorded with their associated expenses in the accounting period when the asset is in use. This helps in getting a complete picture of the revenue generation transaction.
An example of Depreciation – If a delivery truck is purchased a company with a cost of R 100,000 and the expected usage of the truck are 5 years, the business might depreciate the asset under depreciation expense as R 20,000 every year for a period of 5 years.
The most common types of depreciation methods include:
- Straight-line method
- Declining balance or reducing balance method
- Straight -line method
Also known as straight line depreciation, it is the simplest way to work out the loss of value of an asset over time. Straight line basis is calculated by dividing the difference between an asset’s cost and its expected salvage value by the number of years it is expected to be used.
With the straight-line depreciation method, the value of an asset is reduced uniformly over each period until it reaches its salvage value. Straight line depreciation is the most commonly used and straightforward depreciation method for allocating the cost of a capital asset. It is calculated by simply dividing the cost of an asset, less its salvage value, by the useful life of the asset.
Straight-Line Depreciation Formula
The straight-line depreciation formula for an asset is as follows:
Annual Depreciation Expense = (Cost of the Asset – Salvage Value)
Useful Life of the Asset
Where:
- Cost of the asset is the purchase price of the asset
- Salvage value is the value of the asset at the end of its useful life
- Useful life of asset represents the number of periods/years in which the asset is expected to be used by the company
According to straight-line depreciation, this is how much depreciation you have to subtract from the value of an asset each year to know its book value. Book value refers to the total value of an asset, taking into account how much it’s depreciated up to the current point in time.
Straight-line depreciation is a simple method for calculating how much a particular fixed asset depreciates (loses value) over time.
The straight-line method of depreciation assumes a constant rate of depreciation. It calculates how much a specific asset depreciates in one year, and then depreciates the asset by that amount every year after that.
If you visualize straight-line depreciation, it would look like this:
Straight-line depreciation
This is where the “straight line” in “straight-line depreciation” comes from.
Example 8.1:
- Delivery truck is purchased price = R 100 000
- Salvage/scrap Value = R 20 000
- Expected usage of the truck = 5 years
Annual Depreciation Expense = (Cost of the Asset – Salvage Value)
Useful Life of the Asset
= (R 100 000 – R 20 000)
5
= R 16 000 per year
Calculation
|
YEAR |
OPENING VALUE (Rand) |
DEPRECIATION (Rand) |
CLOSING VALUE (Rand) |
|
1 |
100 000 |
16 000 |
84 000 |
|
2 |
84 000 |
16 000 |
68 000 |
|
3 |
68 000 |
16 000 |
52 000 |
|
4 |
52 000 |
16 000 |
36 000 |
|
5 |
36 000 |
16 000 |
20 000 |
- Declining balance or reducing balance method
The declining balance method is an accelerated depreciation system of recording larger depreciation expenses during the earlier years of an asset’s useful life and recording smaller depreciation expenses during the asset’s later years.
Declining Balance Method of Depreciation also called as reducing balance method where assets are depreciated at a higher rate in the initial years than in the subsequent years. Under this method, a constant rate of depreciation is applied to an asset’s (declining) book value each year. This method results in accelerated depreciation and results in higher depreciation values in the early years of the life of an asset.
Declining balance or reducing balance depreciation method considers the value of assets are largely use or highly contribute to operation at the beginning and then subsequently decline. That means depreciation expenses that should be charged to certain types of assets are high at first and then low subsequently. This is the main principle of this depreciation. In other words, the depreciation expenses are subsequently decreased until the value is zero or reaches the residual values.
8.2.1 How to calculate depreciation expenses using reducing balance method?
Calculating the depreciation expenses using reducing balance method is not too difficult.
To calculate, the information we need is book value (Costs of assets) of assets, salvages value, depreciation rate, and useful life of assets.
Book’s value of assets include:
- Its purchase price of fixed assets
- Import duties of assets and non-refundable purchase taxes.
- Costs to bringing the asset to the location.
- Dismantling costs
Second, we need to identify the salvage’s value of assets. We need this to calculate the depreciable value of assets. After identifying the salvage value of assets, we need to find the depreciation rate and useful life of assets.
Finally, it is time for calculating depreciation expenses. To calculate the first-year depreciation, we just need to deduct the salvage value from the value of the book of the asset. Then we will get the depreciable value. After that, multiply the depreciable value with the depreciation rate. We will get the first-year depreciation expenses.
The second-year depreciation expenses are calculated by deducting the scrap value from the first year’s net book value then we multiply the remaining amount with depreciation rate. We then get the second-year depreciation expenses. Then follow this step until the end of assets useful life.
Example 8.2:
- Delivery truck is purchased price = R 100 000
- Salvage/scrap Value = R 20 000
- Expected usage of the truck = 5 years
- Depreciation rate per year = 20%
Calculation
|
YEAR |
OPENING VALUE (Rand) |
DEPRECIATION RATE (%) |
DEPRECIATION (Rand) |
CLOSING VALUE (Rand) |
|
1 |
80 000 |
20% |
16 000 |
64 000 |
|
2 |
64 000 |
20% |
12 800 |
51 200 |
|
3 |
51 200 |
20% |
10 240 |
40 960 |
|
4 |
40 960 |
20% |
8 192 |
32 768 |
|
5 |
32 768 |
20% |
6 554 |
26 214 |