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Apr 30 2013

Depreciation definition and methods of depreciation of assets

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     Different material assets are spent in the implementation of production activities. Raw materials, fuel, etc. belong to these assets. Human labor is also used to manufacture certain products or services. Equipment and other fixed assets using also plays an important role in business processes. We’ll talk about the specifics of such economic phenomenon as depreciation of fixed assets today.

Each company has its own fixed assets, which are grouped into several groups. The cost of fixed assets is a key part of the company’s capital quite often. It is connected to the fact that fixed assets have mostly a high cost. The cost is one of the main parameters on which a particular asset classified as fixed assets.

Current assets of the company spent during the production cycle and their value completely transferred to the cost of manufactured products. Company uses capital assets for many production cycles and their cost have to be deferred to the cost of finished goods also by certain parts.

Fixed assets are physically worn out during use and after some time they need repair or replacement.

Depreciation, as an economic category, was introduced to justify recovery of assets and rational allocation of their cost.

What is depreciation?

Definition of depreciation.

Depreciation is the process of systematically transferring of value of fixed assets of the company to the cost of finished product.

In other words, depreciation helps to define the portion of fixed assets value which has to be included to the cost of production in a certain period of time.

The funds that the company spends on acquisition of fixed assets are recorded in the form of initial value and not recognized on expenses of the period in which such assets were acquired. The costs of acquisition of fixed assets are transferred by parts to the costs of the company through depreciation only later.

Depreciation can be accrued by various methods.

We mentioned the straight-line method of depreciation and cited the example of its calculation in the article about management of fixed assets of the company.

Straight-line method involves determining the monthly (annual) norm of depreciation by dividing the initial value of the asset by the number of months (years) of such asset use. Number of months (years) of asset use is determined by its technical documents with considering of intensity of its use. The value of depreciation is the same for all periods when using this method.

Let’s also consider other methods of depreciation:

1. Declining Balance Method (residual value reducing).

Residual value (net book value) is the initial value of the asset reduced by the amount of accumulated depreciation.

The depreciation charge is determined by multiplying the residual value of the asset on the defined depreciation rate by this method.

The formula for calculating of depreciation using the method of reducing of the residual value:

Dch = Rv x Dr,

Dch – the depreciation charge for the period,

Rv – residual value (net book value) of fixed assets at the beginning of period,

Dr  – depreciation rate.

Depreciation rate is determined using the following formula:Declining balance method depreciation rate

n – expected useful life of the asset (depreciation years),

Lv – liquidation value of fixed assets,

Iv – initial value of fixed assets.

The liquidation value of assets is the amount of money that the company will receive from the liquidation of such assets.

Example.

Initial value of fixed asset – 10000.

Liquidation value – 100.

The expected useful life – 5 years.

Depreciation rate:Depreciation rate calculating

Calculation of depreciation:

Period

Amount of depreciation

Net book value

Accumulated depreciation

1 year

10000 х 0,602 = 6020

10000 – 6020 = 3980

6020

2 year

3980 х 0,602 = 2395.96

3980 – 2395.95 =1584.04

8415.96

3 year

953.59

630.45

9369.55

4 year

379.53

250.92

9749.08

5 year

151.05

99.87

9900.13

2. Method of residual value accelerated reduction.

The method of accelerated reduction of residual value provides the same depreciation method as straight-line method, but the depreciation rate increases twice.

This method depreciation formula is:

Dr = 2 / ULexp,

ULexp – expected useful life.

Example.

The initial value of fixed asset – 10,000,

The expected useful life – 5 years.

Dr = 2/5 = 0.4

Period

Amount of depreciation

Net book value

Accumulated depreciation

1 year

10000 х 0,4 = 4000

10000 – 4000 = 6000

4000

2 year

6000 х 0,4 = 2400

600000 – 2400 = 3600

6400

3 year

1440

2160

7840

4 year

864

1296

8704

5 year

518.40

777.60

9222.40

3. Sum-of-years-digits method (cumulative method).

Depreciation rate is determined using the cumulative rates (coefficients) in this case. Cumulative coefficients are calculated for each year of using the object.

Cumulative coefficients calculated by the formula:Cumulative rates (coefficients) formula

Cc – Cumulative coefficient (rate),

Ny – number of years before the end of use of the object,

ULexp – expected useful life of asset.

Example.

The initial value of fixed asset – 10,000.

The expected useful life – 5 years.

Cumulative coefficients:Cumulative coefficients

The depreciation expenses are determined by multiplying the residual value on cumulative coefficients of each year.

4. The production method of depreciation (Units-of-production depreciation method).

The depreciation charge for the year (month) depends on the volume of production in this case. Planned production volume is determined first and then production rate of depreciation is calculated.

Production depreciation rate is determined by formula:

Dr = Iv/VPp,

Iv – initial value of fixed assets,

VPp – planned volume of production.

Example.

The initial value of fixed assets – 10,000.

The planned volume of production – 20,000 units.

Dr = 10,000.00 / 20,000.00 = 0.5.

The depreciation charge on the reporting period is determined by multiplying the number of manufactured products on the production depreciation rate.

For example, if 400 units of production were produced per month and production depreciation rate is 0.5, the amount of depreciation for this month will be 200.00 (400.00 x 0.5).

5. Tax depreciation method.

Companies profit tax exists in many countries. The depreciation charge has influence on amount of profit of the company, and thus on the amount of profit tax. Therefore, the procedure of depreciation calculating is regulated by law in many countries. The law provides some specific depreciation rates for different groups of assets very often.

For example, it can be established tax depreciation rate 5% per year for buildings or 15% per year for equipment deprecation.

Depreciation is accounted for each unit of fixed assets or for specific groups of fixed assets in a separate account.

We also need to consider the effects of depreciation on the price of products. We talked about it in the article about the competitive pricing. Depreciation is one of the main articles in the calculation of any product.

     Depreciation funds receiving as part production prices should be aimed primarily the restoration of fixed assets. Depreciation funds which company receives as part of production prices should be aimed to the restoration of fixed assets primarily. Some companies create special separate depreciation fund. Funds for the purchase of new fixed assets are accumulated in these depreciation funds. However, many companies use depreciation funds for current needs and acquire fixed assets through the use of loans or investments.

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