Depreciation is the process of allocating the depreciable cost of fixed assets over their estimated useful lives in a systematic and rational manner. Simply stated, depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or obsolescence, depletion, inadequacy, rot, rust, decay or other such factors. Those factors recognize both physical and functional cause of declining service potential. This process matches the depreciation expense with the revenues generated by the assets depreciated in a given period.
Depreciable Cost
Depreciable cost is the capitalized cost less its estimated salvage value known as estimated residual value too. Salvage value is the estimated value of an asset at the end of its useful life.
The entry to record depreciation expense is:
Depreciation Expense or Manufacturing Overhead xxx
Accumulated Depreciation xxx
Regardless of the method used to depreciate property the entry is always the same.
There are five methods of depreciation:
1. Straight Line Depreciation (SL)
2. Accelerated Depreciation
3. Multiple-Asset Depreciation
4. Variable Charge Methods
5. Functional-Year Depreciation
Straight-line depreciation is the simplest and most-often-used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life) and will expense a portion of original cost in equal increments over that period. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero or even negative. Salvage value is also known as scrap value or residual value.
| Book Value – Beginning of Year | Depreciation Expense | Accumulated Depreciation | Book Value – End of Year |
|---|---|---|---|
| $16,000 (Original Cost ) | $3,000 | $3,000 | $13,000 |
| $13,000 | $3,000 | $6,000 | $10,000 |
| $10,000 | $3,000 | $9,000 | $7,000 |
| $7,000 | $3,000 | $12,000 | $4,000 |
| $4,000 | $3,000 | $15,000 | $1,000 Salvage Value |
Straight-Line Method:
In the example above, a vehicle that depreciates over 5 years, is purchased at a cost of US$16,000, and will have a salvage value of US$1,000, will depreciate at US$3,000 per year: ($16,000 - $1,000)/ 5 years = $3,000 annual straight-line depreciation expense. It is the depreciable cost of the asset divided by the number of years of its useful life.
Note that in the straight-line method of depreciation, book value at the beginning of the first year of depreciation is the original cost of the asset. Book value equals original cost minus accumulated depreciation.Book Value = Original Cost - Accumulated Depreciation Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals salvage value.
