What Is Depreciation?

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When you open a packet of a perfectly sealed food product you’ve bought from the grocery store, even if you haven’t taken a bite or reduced the contents, the value of the item is reduced to zero. Under normal circumstances, it would mean that you cannot refund your purchase at this point anymore. Depreciation is gonna be our talk for this content.

When you buy a new smartphone for £200, even if it’s just a week old, you won’t be able to sell it for the same price. If you tried reselling the item for whatever reason you may have, you have to settle for a lower price. This deducted cost is the price of breaking off a seal from a brand new item.

Concept of Depreciation

The two examples I have given above are practical applications of the concept of depreciation.

By Investopedia definition, depreciation is the allocated cost representing the used-up portion of an item’s useful life. This means that starting from the date of purchase; an item’s value slowly dwindles down until nothing is left or the value becomes insignificant.

Depreciation largely, if not only, affects tangible assets. This mainly refers to physical items owned by an individual or company. This can include buildings, equipment and machineries, office appliances and tools, vehicles, and more. The only tangible asset that is not affected by depreciation is land which is known to grow its value over time.

Other tangible items that may be exempt from depreciation costs are products that do not deteriorate in quality over time, like jewellery and antiques.

Why Is It Important For A Business To Monitor Depreciation Costs?

A true accounting professional knows just how important depreciation is when it comes to determining a business’s true net worth. If not given much consideration, it can lead to misinformation about a company’s annual revenue. One example of a disadvantage that may arise from improper monitoring of depreciation costs is the inaccurate basis for taxable income.

More than that, there’s also the checking of the condition of tangible assets. For manufacturing companies that use many types of equipment for production, it is important to infer a certain machine’s useful life. This will help anticipate future expenses for repairs and replacements as well as determine whether the profits generated from the use of such machine is worth the cost.

Of course, depreciation does not mean that an item will be deemed useless after it goes past its life expectancy. There is what we call residual value, which refers to the salvage cost or the value an item has after it has consumed its useful life.

 

How Do You Compute For Depreciation Costs?

There are two simple ways to determine the depreciation cost of an item:

1.    Straight Line

(Cost of Asset – Residual Value)/Useful Life = Depreciation per Annum

2.    UOP or Unit Of Production

Formula 1: (Cost of Asset – Residual Value)/Useful Life in Units of Production = Depreciation per Unit

After which, to compute for total depreciation cost:

Formula 2: Depreciation per Unit x Number of Units Produced = Total Depreciation Expense

3.    Double Declining Method

Most businesses would also consider using the Double Declining Method or what is also called the accelerated depreciation method. Here is the formula:

Depreciation Value = 2 (Straight Line Depreciation Percent) (Book Value of Asset From Start of Accounting Period)

Note: Book value is calculated by subtracting all previous depreciation costs up to the current year to the asset’s original cost.

In Conclusion …

These three methods should help you determine how your assets are doing with yearly depreciation costs considered. This will help you stay on top of things and figure out more ways to improve your business operations. If you have questions or concerns relating to depreciation costs and how to manage them better, feel free to get in touch with us through any of our social media/communication channels! Or talk to me directly here.

Annette Ferguson

Annette Ferguson

Owner of Annette & Co. - Chartered Accountants & Certifed Profit First Professionals. Helping Online service-based entrepreneurs find clarity in their numbers, increase wealth and have more money in their pockets.

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