What is Depreciation Expense-Meaning, Concept in Detail for Exams

Depreciation is an accounting method used to allocate the cost of tangible assets over their useful lives. It represents the gradual decrease in the value of assets due to factors such as wear and tear, obsolescence, or the passage of time. Depreciation is important for accurately reflecting the consumption of asset value over time and matching expenses with revenues in financial statements. Understanding depreciation is essential for businesses, investors, and financial analysts to assess asset performance, profitability, and financial health. In the realm of accounting, depreciation is defined as the consistent decrease in the value of a tangible fixed asset due to its regular usage, wear and tear, or obsolescence. Assets such as machinery, buildings, vehicles, and equipment are prone to depreciation as they are subject to wear and tear or may become outdated over time.

What is depreciation is a vital topic to be understood for the commerce related exams such as the UGC-NET Commerce Examination.

In this article, the readers will be able to know about what is depreciation along with other related topics in detail.

What is Depreciation Expense?

The term 'Depreciation Expense' refers to the cost associated with the usage of fixed assets during a specific accounting period. This cost is calculated based on the accounting policies of the business.

In accounting records, depreciation expense isn't considered a cash transaction. Instead, it indicates the portion of an asset's value that the business has used over a certain period.

Several factors are considered when calculating depreciation. These include:

• Useful Life: This is the duration for which an asset can function efficiently. After this period, the asset's performance may decline, making it less cost-effective for the business.
• Salvage Value: This is the price at which the asset can be sold after its useful life.
• Cost of the asset: This includes the purchase price of the asset and any additional costs such as taxes, setup, and shipping expenses.

There are two primary methods for calculating depreciation expense:

• Straight Line Method
• Declining balance method

Let's delve into these methods to better understand how depreciation expenses are calculated.

The Straight Line Method

The straight-line method is the simplest and most commonly used method for calculating depreciation. It involves subtracting the residual value from the original cost of the asset and dividing the result by the asset's useful life.

Depreciation Expense = (Original Value – Residual Value) / Useful Life of the Asset.

Let's take an example.

If a company purchases a piece of machinery for Rs. 150000 with a useful life of 15 years and a residual value of 15000, the depreciation expenses can be calculated as follows:

Depreciation Expense = (150000-15000) /15 = Rs.9000

Hence, Rs.9000 will be recorded as the depreciation expense for the next fifteen years.

The Declining Balance Method

The declining balance method, also known as the double-declining method, is based on the assumption that an asset's productivity is higher in the initial years and decreases gradually over time.

This method is also referred to as accelerated depreciation as it considers a higher depreciation rate in the initial years, which progressively decreases in the subsequent years.

The formula for calculating depreciation using this method is:

Double Declining Balance = 2 X Cost of the asset / Useful Life or Double Declining Balance = 2 X Book Value of the Asset / Useful Life

Book value = Cost of the asset – accumulated depreciation value of the asset.

Let's understand this with an example.

If a company purchases machinery worth Rs. 200000 with a useful life of 5 years, the depreciation expenses for the first year can be calculated as:

Double Declining Balance = 2 X 200000 / 5 = Rs. 80000

For the second year, it will be:

Double Declining Balance = (200000-80000) x 2 / 5 = Rs. 48000

This calculation can be repeated for the remaining years.

Understanding the concept of depreciation expenses is crucial in business accounting. It helps in accurately accounting for the decrease in an asset's value over time. Stay tuned for more such intriguing concepts.

What is the Difference Between Accumulated Depreciation and Depreciation Expense?

The difference between accumulated depreciation and depreciation expense lies in their timing and presentation in the financial statements:

• Depreciation Expense: Depreciation expense represents the portion of an asset's cost that is allocated as an expense during a specific accounting period. It is recorded on the income statement as an operating expense and reduces the net income for the period. Depreciation expense reflects the amount of asset value consumed or utilized during the accounting period to generate revenue or perform operations.
• Accumulated Depreciation: Accumulated depreciation, also known as depreciation reserve, represents the total amount of depreciation expense that has been recorded since the acquisition of an asset. It is reported on the balance sheet as a contra-asset account, deducting from the original cost of the asset. Accumulated depreciation accumulates over time as depreciation expense is recorded in each accounting period, reflecting the total depreciation charged against the asset's cost to date.

What Type of Expense is Depreciation?

Depreciation is classified as a non-cash expense in accounting. Non-cash expenses are expenses that do not involve a cash outflow at the time they are recorded in the financial statements. Instead, they represent the allocation of costs or the consumption of assets over time.

While depreciation reduces the value of assets, it does not involve an actual expenditure of cash. Instead, it reflects the gradual decline in the value of tangible assets (such as buildings, machinery, equipment, vehicles) or intangible assets (such as patents, copyrights, trademarks) over their useful lives.

Conclusion

Depreciation is a fundamental concept in accounting that enables businesses to allocate the cost of assets over their useful lives. By spreading the cost of assets over time, depreciation helps match expenses with revenues and accurately reflect the consumption of asset value in financial statements. Depreciation plays a crucial role in asset management, financial reporting, taxation, and decision-making, providing valuable insights into the financial health and performance of businesses.

What is depreciation expense is a vital topic for several competitive exams. It would help if you learned other similar topics with the Testbook App.