Depreciation is the systematic allocation of the cost of a fixed asset over its useful life. The purpose of depreciation is to match the cost of the asset with the revenue it generates during its useful life, thereby spreading the cost of the asset over multiple accounting periods.
There are several depreciation systems that companies can use to calculate and record depreciation, including the straight-line method, declining balance method, and sum-of-the-years’ digits method. Each method has its own advantages and disadvantages, and companies may choose a method based on the nature of the asset and their specific accounting needs.
The straight-line method is the simplest and most commonly used depreciation method. It involves dividing the cost of the asset by its useful life to determine the annual depreciation expense. For example, if a company purchases a machine for ₹1,00,000 with a useful life of 5 years, the annual depreciation expense using the straight-line method would be ₹20,000 (₹1,00,000 divided by 5 years).
The declining balance method is a more accelerated method of depreciation that involves applying a fixed percentage rate to the asset’s remaining book value each year. This results in higher depreciation expenses in the early years of an asset’s life, which can help to offset the higher maintenance and repair costs that typically occur during this period.
The sum-of-the-years’ digits method is a variation of the declining balance method that assigns a higher depreciation rate to the earlier years of an asset’s life. This method takes into account the fact that assets typically experience more wear and tear in the early years of their useful life, which can result in higher maintenance and repair costs.
Overall, the depreciation system used by a company will depend on a variety of factors, including the nature of the asset, its useful life, and the company’s specific accounting needs. It is important for companies to carefully consider their depreciation methods to ensure that they accurately reflect the cost and value of their fixed assets over time.