Question

Why are the costs of plant/long term assets recovered through depreciation vs. expensed out during the period purchased? Choose one of the following depreciation methods to discuss: straight line, units of production, declining balance. Share how depreciation using this method is calculated and provide an example of when this would be the most ideal method for application.

Answer 1

Hey buddy !!

Let us understand the concept of depreciation and then also understand why the costs of plant/long term assets recovered through depreciation vs. expensed out during the period purchased ?

The fixed assets are long-term assets. They help in the production of goods and services. However, when an asset is in use the value of such asset decreases due to the normal wear and tear, passage of time and obsolescence. This reduction in the value of a fixed asset is known as depreciation.The assets which are held by a business for the production and supply of goods and services are generally expected to be used for more than an accounting year and have a limited useful life are known as Depreciable Assets. When we purchase a fixed asset we record it at its original cost or purchase price in the books of accounts. An organization uses this fixed asset to earn or generate revenues for a number of accounting years until it sells or discards the asset. Thus, it becomes necessary to allocate a part of the purchasing cost or the acquisition cost to every accounting year until we use it. We call this allocation of cost as Depreciation. Depreciation is an expense of an organization.

For example, Set enterprises purchases machinery for $2000000 and it sells it after using it for 10 years for $200000. Therefore, the cost of machinery for its use in business will be $1800000 ($2000000 – $200000). Now, we need to allocate this cost of $1800000 as an expense of the business for each of the 10 accounting years for which we have been using the machine. This expense is depreciation which comes to $180000 (1800000/10).

In other words, the concept of depreciation is the cost of obtaining services from the use of an asset. We need to match the depreciation cost of the fixed asset against the revenues of the years over which we use it. Thus, we charge depreciation as an expense to the Profit and Loss A/c.

Purpose of Accounting for Depreciation

The main purpose of the concept of depreciation and its accounting is the allocation of the cost of a fixed asset. Depreciation expense does not involve any outflow of cash. Hence, the funds that we charge to the Profit and Loss A/c every year remain in the business itself and thus, we can use them at the time of replacement of the asset.Therefore, the concept of depreciation and its accounting is the process of allocating or apportioning the cost of the fixed assets over their useful life. Its aim is to distribute the cost of the depreciable asset over its useful life and charge the depreciation to the Profit and Loss A/c in order to arrive at the correct profit or loss for the year.

Let us take straight line method as the example and discuss how depreciation is calculated :

Straight line basis is a method of calculating depreciation and amortization. Also known as straight line depreciation, it is the simplest way to work out the loss of value of an asset over time. Straight line basis is calculated by dividing the difference between an asset's cost and its expected salvage value by the number of years it is expected to be used.

To calculate the straight line basis, company’s take the purchase price of an asset and then subtract the salvage value, its estimated sell on value when it is no longer expected to be needed. The resulting figure is then divided by the total number of years the asset is expected to be useful, referred to as the useful life in accounting jargon.

Straight Line Basis = (Purchase Price of Asset - Salvage Value) / Estimated Useful Life of Asset

Example:

Let's assume Company A buys a piece of equipment for $10,500. The equipment has an expected life of 10 years and a salvage value of $500. To calculate straight line depreciation, the accountant must divide the difference between the salvage value and the cost of the equipment, also referred to as the depreciable base or asset cost, with the expected life of the equipment.

The straight line depreciation for this piece of equipment is ($10,500 - $500) / 10 = $1,000. This means that instead of writing off the full cost of the equipment in the current period, the company only has to expense $1,000.

Ideal situation to use SLM method of depreciation is that for small organizations who needn't want much complications it is one of the simplest methods to follow and charge depreciation. Also it helps those entities wishing to claim higher depreciation in the initial phases of the asset life.

In case of any doubts please feel free to ask and don't forget to give your valuable feedback too.