Overview:

According to International Accounting Standards, the cost of a long term asset should not be expense out in a single year profit & loss. It state that this cost should be capitalize on its estimated useful life.

The depreciation is an expense allowed to deduct from company’s profit. This is a non-monetary expense.

And only arrives due to the natural wear and tear in the life of an asset. This wear and tear decrease the assets life and ultimately the firm should be going to purchase a new one.

International Accounting Standard(IAS) 16 defines property, plant and equipment with the way how to determine their estimated life and how to depreciate them over the period of time. You can study the IAS=16 for further reference.

How to calculate the depreciation expense:

To calculate the depreciation expense, companies might uses one of the following methods:

The GAAP recommended the straight line method to calculate the depreciation expense. Let have a look on the example so you can easily understand the idea:

Description Amount $
Value of Property, Plant and Equipment 1,800,000
Estimated useful life 20 years
Salvage value at the end of 20 years 200,000

The depreciation expense will be calculated on the following formula

Depreciation expense = Amount of Asset – (Residual Value)/Estimated life of Asset

Depreciation Expense = 1,800,000-200,000/20

Depreciation Expense=80,000 per year

So 80,000 is the total depreciation expense for the year. This amount should be deducted from the income statement of the company.

As there is no real expense in the shape of money but this the capitalize amount of fixed asset.

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To record these entries in the books of accounts we created an account call accumulated depreciation account. This account is used to keep record of total depreciation expense in for the whole life of the said asset.

Accounting Entries to Record Depreciation:

The above entries should be recorded in the following manner.

At the yearend like 30, Dec we will record the following entries

Depreciation expense (Income Statement)      80,000

              Accumulated depreciation (Balance Sheet)                80,000

So at the first year we have charged the depreciation expense to the income statement and we have a credit balance of 80,000 in our accumulated depreciation account.

In the next year the depreciation expense will be that same 80,000 and the following entry should be passed:

Depreciation expense (Income Statement)       80,000

              Accumulated depreciation (Balance Sheet)                80,000

It means that the in the second year we charge depreciation expense for the year to income statement. While the accumulated depreciation account will be increased to 160,000 as the 80,000 from the second year also add up within account.

The accumulated depreciation account will add up all the depreciation expense through the life of asset.

And when the carrying amount becomes the residual amount of asset. And company sell the asset for a value of its residual, then we should record this entry.

Cash                                                           200,000

Accumulated depreciation                                               1600,000

Property, Plant and Equipment                          1800,000

So in this way we calculate and record the depreciation expense. In this example we use the straight line method to calculate the value of depreciation.

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You can also use any of the method but the entries will be the same for all the methods.

Benefit of Calculation Depreciation:

The main idea behind the depreciation is the matching concept use in accounting standards. Because this is not logical that when you buy a new asset and you less the value from company income statement.

As the asset is not use for a very first time. So the standards says that when the asset is installed and ready to use then you should calculate its life and depreciate its amount over the estimated period.