Depreciation

Depreciation is a process of reducing the value of an asset over time to reflect its gradual deterioration or obsolescence. It is used in accounting and financial reporting to allocate costs over the useful life of an asset.

Key Concepts:

• Depreciable asset: An asset that is used in the production or sale of goods and services and can be depreciated over its useful life.
• Depreciable cost: The cost of the asset less any residual value.
• Depreciation expense: The amount of depreciation expense incurred in a particular accounting period.
• Depreciable period: The number of years over which the asset is expected to be used.
• Straight-line depreciation: The most common depreciation method, where the asset’s value is reduced by a uniform amount in each period.
• Double-declined depreciation: A depreciation method that reduces the asset’s value by a double the amount in the first period and then by a uniform amount in each subsequent period.
• Units-of-production depreciation: A depreciation method that reduces the asset’s value based on the number of units produced.

Types of Depreciation:

• Straight-line depreciation
• Double-declined depreciation
• Units-of-production depreciation
• Sum-of-the-years-digits depreciation

Formula for Depreciation Expense:

Depreciation Expense = Depreciable Cost x Depreciation Rate

Depreciation Rate:

Depreciation Rate = 1 / Useful Life

Example:

A company purchases a machine for $10,000 with a residual value of $2,000 and a useful life of 5 years. The depreciation expense for each year is:

Year 1: $1,600Year 2: $1,600Year 3: $1,600Year 4: $1,600Year 5: $1,600Total depreciation expense: $8,000

Benefits of Depreciation:

• Tax savings
• Reduced accounting complexity
• Reflects asset deterioration over time
• Provides a consistent pattern of expense deductions