The concept of depreciation is involved when dealing with decreasing values of long term fixed assets over its useful life. Three key numbers of a long term fixed asset are original cost of the asset, expected salvage value (residual value) and estimated useful life.
The portion of value being used up during each accounting period is reported as depreciation expenses on the income statement. The remaining value of assets after depreciation will be reported on balance sheet as book value:
Book Value = the original cost of asset – the accumulated depreciation
Similarly with inventory accounting, there are several ways to calculate depreciation:
- Straight-line depreciation method is used by most of the firms. Under this method, equal amount of depreciation is allocated throughout the useful life of the asset.
- Accelerated depreciation method is more realistic way to calculate depreciation. It speeds up the reorganization in a certain acceleration rate therefore more depreciation expenses are recognized in the early years of useful life. One popular accelerated method is declining balance method which applies a constant rate to the asset’s book value each year:
Annual Depreciation expense = Depreciation rate * Book Value at the beginning of the year
The most common rate used is double the straight-line rate. The method is referred as the double-declining balance method:
Please note that the residual value is not in the calculation for this method. Depreciation should end once the estimated residual value is reached. As a result of different ways of depreciation reporting, net income under straight-line method will be higher in the early years and then lower in the later years compared to accelerated methods.
- Units of Production method expresses the useful life of the asset in terms of the total number of units to be produced by the asset. This is widely used in production industry when depreciating assets like machines.
Firms should try to match the depreciation expenses with the incomes that the asset generates in order to choose the more proper depreciation accounting method.