What is Depreciation?

Accounting is called the language of business, in which different jargons are used for each concept. Depreciation is one of them and it is the most important concept used in accounting, finance and economics. Depreciation is the process, in which the value of fixed assets except Land diminishes over the period of time due to variety of reasons. The important reasons of the reduction in the value of an asset are because of its usage, damage, technological obsolescence etc. Depreciation is considered as an expense in accounting, which normally follows the Matching Concept, in which the expenses and revenues of each year must be matched. Depreciation is non cash expense, which affects both the income statement and the balance sheet. In depreciation, the cost of an asset is spread over its estimated life. Each asset has its own estimated life, which normally varies from one another due to nature of an asset. The expense which is calculated every year is called Depreciation expense and the sum of all the previous years’ depreciation is called Accumulated depreciation. Accounting functions on the principle of double entry system, this means that every transaction has two aspects i-e Debit and Credit. When the cost of an asset is spread over its estimated life in the form of depreciation, then the debit part of that transaction would be depreciation expense and the credit part would be accumulated depreciation. Another terminology which is often used in depreciation is the depreciable cost. Depreciable cost is the value of the asset after deducting the residual or salvage value from the total cost. Residual or salvage value is the amount of an asset that can be obtained at the time of sale, when it is fully depreciated. For example ABC Co. bought a Machinery worth of $100, 000 and its estimated life is 5 years, and its residual value is $ 10,000. Let us look, how it works.

Annual Depreciation= Cost-residual value/ Estimated life
= 100,000-10,000/5
= 90,000/5
= 18,000

[adsense1]Annual depreciation for the first year is $ 18,000; and it will remain unchanged throughout the life of the asset. Depreciation in the above illustration is calculated by the straight line depreciation method, which will be discussed later on in full depth. At the end of the fifth year, the asset would be fully depreciated and the depreciation expense would be allocated to each year’s income statement. It affects income statement by reducing its net profit, which will give tax benefit to the company. On the other hand, the worth of the assets in Balance sheet would be shown after deducting accumulated depreciation from the cost price of the asset. Suppose machine is used for two years and at the end of the 2nd year the worth of asset shown in the Balance sheet of that year would be: