Depreciation
Layman's explanation: Let's say the company buy a table for
$5000 and use it for 5 years. If they expensed the whole $5,000 in
the first year they bought, it's like the table costs $5,000 to use
for the first year, then the next 4 years is free. So a more
appropriate way is to have a certain expense for each of the 5
years the table is used.
The 5 years mentioned here is known as the useful life.
This will be provided in the question.
This is in line with the matching principle that you've earned -
to match cost of using the fixed asset in a particular year against
the revenue earned in that year to get the true profit.
If I don't use depreciation, let's say my revenue is $10K each
year.
My profit for year 1 will be = $10K - $5k = $5K
Year 2 - Year 5 is $10K each. This is an
understatement of the true profit in year 1 and
overstatement of the true profit in year 2 - 5
because I've only used 1/5 of the table in year
1.
2 methods to
calculate depreciation
1
Straight-line method
Annual depreciation = (original cost - scrap value) / no. of
years of useful life
E.g. If the table costs $5,000 and the scrap value (that is at
the end of the 5th year, it is expected to bring me $500 if I sold
it off) and useful life is 5 years.
Annual depreciation = ($5000 - $500) / 5 = $900 per year.
Annual
depreciation is constant every year.
Disadvantage of this method - it assumes that the fixed asset
gives the same service or I prefer to phrase it as - it
assumes we use the table for the same amount of frequency each
year. For some assets, we use it more in the first few
years when it's brand-new and use it less as it gets older and less
efficient etc. Sometimes when business is very good, we will use it
very often, while if economy is bad like now we use it less. So
straight-line method may not be the most appropriate choice.
2 Reducing
Balance/Diminishing Balance Method
I shan't explain this method using words but rather with an
example.
Let's say a van costs $10K and I expect to sell it for $256 at
the end of its life. Its useful life is 4 years, rate of
depreciation = 60%
Year 1 Depreciation expense = 60% x 10K = $6K
Book value now = $10K - $6K = $4K
Year 2 Depreciation expense = 60% x $4k = $2.4K
Book value now = $4k - $2.4K = $1.6K
Year 3 Depreciation expense = 60% x $1.6K = $960
Book value now = $1.6K - $960 = $640
Year 4 Depreciation expense = 60% x $640 = $384
Book value at end of year 4 = $640 - $384 = $256. (=
scrap value)
Advantage:
- Useful for assets that are most efficient in earlier years.
(more truthful allocation)
- Overall expenses is more or less constant for the use of a
fixed asset because the lower depreciation cost in the later years
is offset by the high maintenance and repair costs.
Disadvantages:
- Fixed asset takes a long time to be written off
- In order to write-off the whole cost of the asset, the rate of
depreciation has to be quite high. This will cause the book value
to be lower in the earlier years and not very realistic when
compared to current market value of the asset.
there is the 3rd method i think its called the revaluation
method. its basically finding the market value of your product then
minus from cost price to find depreciation
advantage is its the most accurate to calculate your
depreciation
disadvantage is require lots of effort.
thats all i can think for now. maybe will add in later.