As time passes, the usefulness or productivity of Property Plant and Equipment decreases (except for non-depreciable assets like land). Think of this decrease as a loss of revenue earning power. Accordingly, the cost of these assets is distributed over their useful life to coincide with the revenue earned of the entity. This allocation is known as Depreciation.
Two Kinds of Depreciation
There are two kinds of depreciation: Physical depreciation and Functional or economic depreciation. Physical depreciation is related to the depreciable asset’s wear and tear and deterioration over a period. Functional or economic depreciation arises from obsolescence or inadequacy of the asset to perform efficiently.
Financial Statement Presentation
On the income statement or statement of profit or loss and other comprehensive income, depreciation is listed under operating expenses as depreciation expense. On the balance sheet or statement of financial position, depreciation is used to determine the current book value of an asset. The formula is as follows:
Book value = Original cost – Accumulated depreciation
Things You Need to Know Before Computing Depreciation
- Original cost or Total cost an asset. This includes items such as freight, handling and set-up charges.
- Salvage value, Scrap value, or Trade-in value or the estimated residual value of asset at the time that it is taken out of service.
- Estimated Useful Life (EUL) - There should be an estimate of the useful life of the asset or the length of time it is expected to generate revenue. In order to be depreciated, an asset must have a life greater than one year.
Various Depreciation Methods
- Straight-Line Method - this is the most widely used among all the depreciation methods because of its simplicity. It provides for equal periodic depreciation charges to be allocated over the estimated useful life of the asset.
- Sum-of-the-years’ Digits Method - in this method, the yearly charge for depreciation declines steadily over the estimated useful life of the asset because a successively smaller fraction is applied each year to the total depreciation.
- Declining-Balance Method - this depreciation method uses a multiple of the straight-line rate to calculate depreciation. Most frequently used multiples are 1.25, 1.5 and 2. For example, if 1.25 is used, it is known as the 125% declining balance, 1.5 as 150% declining balance and when 2 is the multiple, the method is known as the double-declining balance.
- Units-of-Production Method or Service Hours Method - This method is applicable if the useful life of an asset is more accurately defined in terms of how much it is used rather than the passage of time. To apply this method, the life of the asset is expressed in productive capacity, such as kilometers driven, units produced, or hours used.