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

Residual value or scrape value
The estimated amount that can be realized at the end of a fixed asset’s useful life or in other words the estimated amount that can be recovered from a fixed asset at the time when it will be put out of use by the business

XYZ Company purchased furniture for $6000. Furniture will be used or last for 10 years. After 10 years, it could be sold for $500 as scrape. Therefore, $500 is the scrape or residual value of the furniture

Accumulated Depreciation
The total depreciation expenses of a fixed assets at a specific point in time. In other words, the sum of depreciation expense of an asset for the current accounting period and depreciation expenses of the same asset for the previous accounting periods are the accumulated (total) depreciation expense of that asset

XYZ Company purchased an air conditioner for $2000 on January 2011. XYZ Company charges $500 as an annual depreciation expense. Therefore, accumulated depreciation expense of the air conditioner at 31 December 2012 should be calculated as follow:

Depreciation expense for 2011 = $500
Depreciation expense for 2012 =$500

Accumulated depreciation = Depreciation for 2011 + Depreciation for 2012
Accumulated depreciation = $500 + $500
Accumulated depreciation = $1000

$1000 is the accumulated depreciation of the air conditioner at 31 December 2012

Provision for depreciation
Provision for depreciation is an alternative term for accumulated depreciation. See the accumulated depreciation for its explanation

Methods of Depreciation
As we explained before Depreciation is a portion of a fixed asset’s cost which is expired or consumed during an accounting period, but how to determine what amount/portion of fixed asset’s cost is consumed during an accounting period? The answer is there are a variety of methods to determine what portion of cost should be considered as depreciation. These methods are commonly known as “method of depreciation”. We will discuss these methods in full detail

Book value of a fixed asset
Cost of a fixed asset minus its accumulated depreciation is the book value of that fixed asset.

Book value of a fixed asset = its cost – its accumulated depreciation

Fixed assets are presented in balance sheet at their book value

Method of depreciation

There are several methods or techniques to find out how much cost of a fixed asset is consumed during an accounting period. These methods are known as method of depreciation.

Different methods of depreciation are listed below

1. Straight line method
2. Reducing/diminishing balance method
3. Declining balance method
4. Sum of the years digit method
5. Revaluation method
6. Annuity method
7. Sinking fund method
8. Insurance policy method
9. Repair fund method
10. Units of output method
11. Machine hour rate method
12. Depreciation fund method

As you can see, there are many methods of depreciation but in practice, companies generally use just 3 or 4 methods. The most widely used method is straight line while the least used is Insurance policy method

Why there are so many different methods of depreciation?

Not all fixed assets are same, some fixed asset are more productive in initial years but will be less productive in the later years, some fixed assets remain equal productive throughout their useful life and some other fixed assets diminish when companies use them regardless of passage of time. Therefore, using same method of depreciation for different categories of fixed assets will make our financial statement misleading and deceptive. After all, depreciation is nothing but an effort to mach expenses with revenues (This is the matching concept)

Depreciation is an expense that is presented in income statement. It implies that increase or decrease in a depreciation expense can directly affect the net income of a company. Since depreciation expenses affect net income, companies choose a specific method of depreciation to make net income increase or decrease in order to affect the income tax charges. And finally, there are many other reasons as to why different methods of depreciation are being used