What is depreciation, its methods, and how do you calculate depreciation entries?

What is depreciation, its methods, and how do you calculate depreciation entries?

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In the contemporary business world, accounting plays a crucial role in our understanding of the financial health of companies and institutions. Among the basic concepts that are used in accounting, the concept of depreciation stands out as one of the main factors that must be taken into account when evaluating the financial assets of organizations, as understanding the methods of calculating depreciation and entries represents an essential step for accountants and financial managers to make sound strategic decisions. The term depreciation refers to the decrease in the value of tangible assets over time as a result of continuous use or natural wear, and although it represents an inevitable process, the methods of calculating and estimating it vary according to the assets and the conditions of their use. Therefore, the following article is a comprehensive guide to understanding what depreciation is in accounting and the methods of calculating it.

What is the definition of depreciation?

Recording depreciation is an accounting process that aims to distribute the value of tangible assets over a specific period of time, based on the basic assumption that assets lose their value over time as a result of use and gradual obsolescence.

The importance of depreciation entries 

The importance of depreciation lies in recording the accurate value of assets over the period of their use and determining the losses resulting from the deterioration of their value, in addition to estimating the profits that can be achieved through the use of those assets. When a company buys assets, such as equipment or buildings, it considers those assets as investments for the future. These assets lose their value over time, and if the depreciated value is not distributed over the life of the asset, this may lead to the inflation of the value of the assets in the company’s annual profits and losses.

Methods of calculating depreciation 

Also referred to as types of depreciation, although the basic principle of depreciation is the same, there are depreciation methods according to international standards, which are as follows:

Units of production method

One of the most important methods of understanding the concept of depreciation is the “units of production” method. In this method, depreciation is calculated based on the rate of use of the asset, as it increases with the increase in consumption of the asset in periods of increased production.

It is worth noting that it determines the expected time to fully use the asset, and accordingly, the depreciation cost is divided by the number of units expected to be produced after calculating the production rate.

Straight-Line Method

The straight-line method is another method of calculating depreciation. In this method, it is assumed that the asset is subject to equal depreciation over its useful life. The value of the asset is divided by the number of years expected to last the asset, and thus the lost value is allocated equally over the years.

Declining Balance Method

The “Declining Balance” method assumes that the asset has a higher value in the first years of use and decreases over time. Depreciation here is calculated based on this assumption, as it causes a greater loss in value in the first years, and the loss decreases over time.

Double-Declining Balance Method

There is also the “Double Declining Balance” method, which is based on the same principle of depreciation but speeds up the calculation of depreciation in the first few years. It is worth noting that this method is usually used to calculate the concept of depreciation for assets that lose value quickly, such as mobile phones and electronic devices.

Sum of the Year Digits Method

As for the “Sum of the Years Digits Method,” it depends on calculating depreciation based on the sum of the numbers of years of the asset’s productive life, as it determines the expected life time of the asset, and then depreciation is calculated by dividing the value of the asset by the sum of the numbers of years.

How to calculate depreciation entries

If you are wondering: How is depreciation calculated? There are different methods, which the company chooses according to its specific needs and circumstances. Let us give an illustrative example of this. Suppose there is a company called Y that bought an asset that costs 100,000 Saudi riyals. Its life expectancy is four years, and its salvage value is 20,000 Saudi riyals.

Depreciation here is calculated by subtracting the salvage cost at the beginning first and foremost, then dividing the remainder of the asset cost by the four-year expected life according to the chosen calculation method. Here I will review for you the most important main points of some methods for calculating the concept of depreciation:

Units of production method

  • It requires estimating the number of units an asset will produce during its lifetime.
  • You start by subtracting the salvage value from the cost of the asset.
  • The actual production percentage must be determined for each year.
  • The concept of depreciation is calculated by multiplying the depreciation percentage by the value of the asset after subtracting the salvage value.

If this method is adopted, the number of units that the asset will produce over its lifespan should be estimated, and the salvage value should be subtracted from the cost of the asset at the beginning (100,000 minus 20,000 = 80,000).

Suppose that the production of the asset is 10,000 units over its lifetime, and in the first year its useful life is 2,000 units. The depreciation rate in the first year is (2000/10,000*200 = 40%).

You can calculate the concept of depreciation in the first year by multiplying the depreciation percentage by the value of the asset after subtracting the salvage value from it (0.4 * 80,000 = 16,000).

Notice

It is possible that production will decrease in the second year to 1,000 units, and here the depreciation percentage is (1,000 / 10,000 * 200 = 20%), and the depreciation value is (0.2 * 80,000 = 8,000).

This method is considered the most accurate in calculation because the value of the annual depreciation concept changes in parallel with the actual depreciation rate of the asset.

Straight-Line Method

  • You start by subtracting the salvage value from the cost of the asset.
  • The rest of the cost is divided by the number of years of lifespan.
  • The fixed annual depreciation premium is obtained.
  • This premium is recorded as a depreciation expense in the given year.

Here, the salvage value is initially subtracted from the cost of the asset (10,000 minus 20,000 = 80,000), then the remainder of the cost is divided by the number of years of the asset’s expected life, and the result is then the value of the annual depreciation concept installment (80,000 minus 8 = 20,000).

20,000 Saudi Riyals are recorded from the depreciation expense account, and in addition, 20,000 Saudi Riyals are recorded to the accumulated depreciation account on the debit side throughout the years of the asset’s virtual life.

In the case of selling the asset, the accumulated depreciation is subtracted from the credit account, and the proceeds from its sale are added to the debt account. The difference between the two accounts is also determined by whether there are losses or profits.

Declining Balance

  • You start by subtracting the salvage value from the cost of the asset.
  • Determines the annual depreciation rate and is applied to the remaining value each year.
  • The depreciation annuity decreases every year.

The concept of depreciation here is calculated based on the useful life of the asset, as well as the depreciation percentage, and subtracting the salvage value (100,000 minus 20,000 = 80,000).

Suppose that the asset has an expected life of four years, the asset depreciation rate is 25% annually, and the depreciation premium in the first year is (80,000 * 0.50 = 20,000).

In the second year, the first year’s depreciation is subtracted before multiplying the cost of the asset by the depreciation percentage (60,000 * 0.50 = 15,000).

Double-Declining Balance Method

  • Similar to declining balance, but with twice the annual depreciation.
  • The remaining value of the cost is divided by the number of years of expected life.
  • The concept of depreciation is multiplied by the residual value to get the depreciation annuity.

We begin by subtracting the salvage value (100,000 – 20,000 = 80,000), and we double the annual depreciation concept rate to become 100%, so the depreciation value in the first year becomes (80,000 * 1 = 40,000), then it decreases to (40,000 * 1 = 20,000) in the second year.

Sum of the Year Digits Method

  • You need to estimate how long the asset will be productive.
  • You start by subtracting the salvage value from the cost of the asset.
  • Sums the number of years of estimated useful life.
  • The percentage of depreciation and its value in different years are determined based on the collected numbers.

After subtracting the salvage value from the cost of the asset (100,000 minus 20,000 = 80,000), the numbers for the estimated useful life in this example are summed to four years (1 + 2 + 3 + 4 = 20).

The percentage and value of the concept of depreciation in the first year is (4/20 * 80,000 = 32,000) and decreases during the following years, as it is equal to (3/20 * 80,000 = 24,000) in the second year and (2/20 * 80,000 = 16,000) in the third year, and eventually reaches (1/20 * 80,000 = 8000) in the fourth year.

Exercises on depreciation 

Suppose that there is a factory that purchased equipment whose cost and direct costs were 10 thousand Saudi riyals, and its expected life is 5 years starting from the date of commencement of use. The purchase process was on 7/1/2015, while the end of the accounting period is on 12/31/2015. Thus, using the entire year reduces 20% of the value of the equipment.

First year

The remaining period of the year is 365–181 = 184 days.

The value of depreciation as a result of using the equipment during the remaining period is 10,000 * 0.2 * 184/365 = 1,008 Saudi riyals.

date Statement Debt Credit
31/12/2015 From/fixed asset depreciation expense (prepared) 1.008
To/accumulated depreciation of an asset (equipment) 1.008

Proving the depreciation concept expense for the first year becomes as follows:

  • The depreciation installment is 1,008 Saudi riyals.
  • Accumulated depreciation = 1,008 Saudi riyals.
  • The book value of the equipment is 8,992 Saudi riyals.

Second Year

The depreciation value is equal to 2,000 Saudi riyals, which is the depreciation value in the remaining three years: the third, fourth, and fifth. adopt the concept of depreciation using the straight-line method.

date Statement Debt Credit
31/12/2016 From/fixed asset depreciation expense (prepared) 2.000
To/accumulated depreciation of an asset (equipment) 2.000

Proof of depreciation expense for the second year becomes as follows:

  • The depreciation installment is 2,000 Saudi riyals.
  • Accumulated depreciation = 3,008 Saudi riyals.
  • Book value = 6,992 Saudi riyals.

Third Year

date Statement Debt Credit
31/12/2017 From/fixed asset depreciation expense (prepared) 2.000
To/accumulated depreciation of an asset (equipment) 2.000

Proof of depreciation expense for the third year becomes as follows:

  • The depreciation installment is 2,000 Saudi riyals.
  • Accumulated depreciation = 5,008 Saudi riyals.
  • Book value: 4,992 Saudi riyals.

Fourth year

date Statement Debt Credit
31/12/2018 From/fixed asset depreciation expense (prepared) 2.000
To/accumulated depreciation of an asset (equipment) 2.000

Proof of depreciation expense for the fourth year becomes as follows:

  • The depreciation installment is 2,000 Saudi riyals.
  • The accumulated depreciation is 7,008 Saudi riyals.
  • Book value = 2,992 Saudi riyals.

Fifth year

date Statement Debt Credit
31/12/2019 From/fixed asset depreciation expense (prepared) 2.000
To/accumulated depreciation of an asset (equipment) 2.000

Proof of depreciation expense for the fifth year becomes as follows:

  • The depreciation installment is 2,000 Saudi riyals.
  • Accumulated depreciation is 9,008 Saudi riyals.
  • Book value = 992 Saudi riyals.

Last year

Remember that the remaining period of the final year is only six months. Therefore, the value of the depreciation concept is 10,000 * (181/365) * 0.2 = 992 Saudi riyals.

date Statement Debt Credit
31/12/2020 From/fixed asset depreciation expense (prepared) 992
To/accumulated depreciation of an asset (equipment) 992

Proof of depreciation expense for the last year becomes as follows:

  • The depreciation installment is 2,000 Saudi riyals.
  • Accumulated depreciation is 10,000 Saudi riyals.
  • The symbolic book value is 1 Saudi riyal.

The asset’s accumulated depreciation account is then settled with the asset’s account when it is depreciated and turned into scrap.

Depreciation methods calculation form word

If you are looking for a template for calculating depreciation methods in Word format, all you have to do is click here.

What is the difference between depreciation and amortization?

Depreciation and amortization are two terms used in the financial and accounting fields to describe the loss of value of assets, but they differ in what they mean and the assets they refer to.

Depreciation

The concept of depreciation refers to the loss of value that occurs to tangible assets, which are those assets that the company can see, touch, and evaluate physically, such as buildings, machinery, and equipment.

Depreciation occurs as a result of repeated use of assets, their deterioration over time, or technological obsolescence and is usually classified into several types, such as temporal depreciation (natural depreciation over time) and economic depreciation (depreciation resulting from technological development and changes in the market).

Amortization

It refers to the loss of value that occurs for intangible, salable assets, as these assets include intellectual property, such as copyright, patents, and trademarks, as well as contracts and licenses.

Amortization of these assets occurs as a result of the expiration of their useful life or a change in circumstances that renders them unusable or salable at their initial value.

How to calculate depreciation in the Qoyod accounting program

When talking about how to calculate the concept of depreciation in the Qoyod accounting program, there are several main points you should take into consideration, which are:

  • Accessing the Fixed Assets List: Enter the program and select the Fixed Assets List from the available drop-down list.
  • Add new depreciation: After entering the fixed assets list, click on the “Add depreciation” option to create a new depreciation for an asset.
  • Select the depreciation type: Choose the appropriate depreciation type from the available options; for example, “recorded depreciation” can be selected as the depreciation type.
  • Filling in the data: After determining the type of depreciation, some necessary data must be filled in. This data includes the reference number, asset classification, and name.
  • Determine the depreciation period: You must specify the type of depreciation period required, whether it is daily, two weeks, monthly, or annual.
  • Next, the time period for depreciation must be determined based on the concept of specific depreciation.
  • Depreciation calculation: After filling in the required data, the list of registered assets will be displayed with the calculated value of depreciation for each registered asset.
  • Save the depreciation: After verifying the data and ensuring that the calculations are correct, click the “Save” button to save and apply the depreciation process.

In this way, the list of registered assets that have been depreciated will appear on the main depreciation page. You can view this list and check the calculated depreciation values for each asset.

Conclusion

One question comes to mind: Can numbers be attractive? After reviewing the concept of depreciation and its importance, we come to understand that it is a vital part of the financial world that affects any organization or company, regardless of its size or activity. It gives us a deep understanding of the accumulation of costs over time and helps us make sustainable strategic decisions. When we realize that all of our possessions are damaged and lose value over time, we find ourselves in dire need of properly understanding depreciation methods and restrictions. It gives us the ability to accurately evaluate assets and determine the actual value of a company or organization, and if we ignore it, we may be exposed to significant financial risks and lose the ability to make informed financial decisions.

Do not forget that successful companies are those that recognize the importance of depreciation and integrate it into their financial and operational strategies. So be one of them and use the Qoyod program. To help you easily calculate depreciation, it is worth noting that the program also offers all its clients: electronic invoice systems, as well as point-of-sale systems, stores, customers, and so on.

Dear reader, after knowing the concept of depreciation, Try Qoyod now for free for 14 days. It is an accounting program that makes you witness an amazing transformation in your business.

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