Home » Accounting Explanation » Depreciation- Its Nature, Calculation and methods

ABC Company purchased a machine for $5000. The machine will be used for 5 years and after that it will be useless/scrape for the ABC Company with nil/zero market value. Since the machine will be used for more than one accounting period (or one year), ABC Company can’t show the full $5000 as an expense in its income statement for current accounting period (or current year). Otherwise, its income statement will not present the true and fair amount of net income/loss for the accounting period and it could be considered as misleading. Keep in mind that by definition an expense is the amount of cost which is consumed or expired during an accounting period. The cost of machine in this example is $5000 which will be consumed gradually in 5 years time period and at the end of 5th year the cost will be zero or fully consumed. It implies that the all ABC Company has do is to determine the amount of cost consumed during this accounting period (or this year) and the issue will get resolved, since it can show the cost of machine consumed during this year in its income statement. Let’s assume the company estimate that approximate $1000 of total cost is consumed every year (or every accounting period) which means $1000 will be presented in income statement as an expense in the first year, $1000 will be in the 2nd year, $1000 in the 3rd year and so on. So, what’s depreciation? The answer is $1000 which is being presented as an expense in income statement for each accounting period or year. Therefore, depreciation expense for the first year = $1000, second year = $1000, third year = $1000, fourth year=$1000 and fifth year which is the last year of vehicle’s useful life =$1000

Definition of Depreciation

Depreciation expense is a portion of a fixed asset's cost (which was vehicle in the above mentioned example) which is expired/consumed/used up during an accounting period.

Why should we bother calculating the depreciation expenses?

A fixed asset has a long life and it provides business with benefits for more than one accounting period. Considering the full cost of a fixed asset as an expense for an accounting period makes a business’s financial statements unreliable and misleading because incomes and expenses arising from that fixed asset should match each other (it is the matching concept of accounting). Therefore, if you ignore depreciation, net income will overstate and considering full cost of a fixed asset as an expense for just one accounting period will understate the net income. Moreover, you need to show the true value of fixed assets in the balance sheet which would not be possible without providing for depreciation. In short, depreciation expense helps financial statements of a business in reflecting true and fair view of the business’s financial position and performance.

Reasons of Depreciation

Depreciation is a portion of the cost of a fixed asset which is expired or consumed during an accounting period. There are several factors which are directly or indirectly responsible for the consumption of fixed asset cost or in plain language factors that cause depreciation

Physical deterioration
With the passage of time fixed assets such as building, plant and machinery physically deteriorate and tear. Resultantly, value of fixed assets declines or their cost continually expires/consumes

Sometimes, companies buy intangible assets (like copy rights, patents) for a specific period of time. Since these intangible assets have limited useful life for the business, cost of these fixed assets gradually used up or consumed with the passage of time. The cost consumed during an accounting period is reported as depreciation expense in the financial statements

Obsolescence is the process of being “out of date”. Some fixed asset could become out of date or old fashioned as a result of new inventions and technological advancements. Since some of the fixed assets continually obsolete and consequently, become useless for the business, their cost gradually uses up/expires/consumes which is known as depreciation

Please note that being out of date or useless for a business doesn’t imply that the fixed asset can’t be used. It has become useless for the business, but some people can still buy and use these fixed assets

Natural resources such as mines, minerals and petroleum resources diminish and deplete when companies extract them. There is a point in time when these fixed assets will reduce to nothing. Therefore, their cost is constantly being consumed by the company that owns these resources

In addition to these factors, there are many more factors that are responsible for the depreciation of fixed assets such as natural calamities, inadequacy, accidents, government restrictions etc.

Important Terms

Depreciation is a portion of a fixed asset’s cost which is expired or consumed during an accounting period.

A company purchased a building for $10,000 and it will last for 20 years. Since it will be useful for a limited time period (i.e. 20 years), its cost is being consumed/expired/used up gradually with the passage of time and after 20 years, it will reduce to nothing. Now assume that company considers 1 year as its accounting period, the specific part or portion of building’s cost consumed during this accounting period must be the depreciation expense. Let’s say $500 out of total building cost gets consumed every year. Therefore, depreciation for one year or one accounting period is $500

Useful life
An estimated period of time (usually more then one year) during which a fixed asset is used and depreciated by an entity or a business.

XYZ business purchased a car for $2000 which will be used by the business for 4 years. Therefore, the car’s useful life is 4 years