Depreciation Process in Accounting
Depreciation is considered as the process of allocating the initial cost of a plant asset over its useful life by following a rational and methodical manner. The cost allocation process of depreciation enables the companies to match expenses against the revenue that is earned by the asset in accordance with the matching principle.
However, the process of depreciation is only being able to allocate the cost. It is not a process of asset valuation as businesses do not record depreciation based on the market value of their plant assets.
Basically depreciation is applied to those plant assets whose usefulness revenue-producing ability will be decline over its useful life. Such as:
- Land improvements
Each asset of plant assets is a depreciable asset. Though land is also a plant asset but it is not a depreciable asset due to its unlimited life and revenue-producing ability to the company. Sometimes land is even more valuable over time because of the insufficiency of good land sites.
A depreciable asset basically loss its revenue-producing ability over its useful life for two reasons which are as follows:
- Wear and tear: For example a service delivery van that has been driven 200,000 miles will considered as less useful for a company than a van that has driven only 1,000 miles.
- Obsolescence: Obsolescence is the function of becoming out of date before the asset physically carries out. An asset is regard as obsolete if another asset can perform better. For example, in some cases some airports doesn’t have capacity to provide required facility for new big air jets for what big airplanes have to consider different airport for flying. Moreover, for the changes in customer requirements that reduce the need and demand of asset for which it was projected. For example: a company has to replace their computers before projected time due to new improved technology which make the old computers obsolete.
During ownership of an asset, there is no attempt are taken or made by the companies which can measure the change in an asset’s market value. Therefore, the book value of a plant asset often does not agree the current market value. This is acceptable in accounting because a fixed asset is actually bought for performing operational activity rather than for resale. Basically depreciation does not have any cash fund to replace fixed assets as they wear out.
The process of depreciation and accumulated depreciation are not same Accumulated depreciation is sum of the total amount of the asset’s cost that the company has currently charged to expense.
Factors in Computing Depreciation
Depreciation is measures based on the following three factors:
- Estimated useful life
- Estimated residual value
Cost is known to companies but other two factors are estimates.
- Cost: the first factor that affects the computation of depreciation is cost of any depreciable asset. It has already mentioned that companies record all plant assets at cost in accordance with the cost principle.
- Useful life: Useful life of an asset is an estimation of the expected productive life which is also called service life of the asset. Useful life could be expressed in terms of time, units of activity, such as machine hours, or units of output. For example, equipment’s life is expressed in years, but a delivery van is expressed in miles. To estimate the useful life of an asset, management considers some factors like the projected use of the asset, expected repair and maintenance, and its vulnerability to obsolescence, past experience of similar assets.
- Salvage value: Salvage value or residual value is the expected cash value of a depreciable asset at the end of its useful life which may be based on the asset’s value as scrap or on its expected trade-in value. To estimate the useful life of an asset management considers how it plans to order of the asset and its experience with other similar assets. However estimated salvage value is not depreciated as a company often looks forward to receive this amount at the end. The asset’s depreciable cost is the difference between a fixed asset’s costs and its salvage value. The entire cost will be allocated to depreciation if a fixed asset has no residual value.