Introduction to depreciation

Depreciation is a revenue expenditure that is reported in the income statement annually against fixed assets due to usage, wear and tear or obsolescence.

Since, all entities are required to report the non-current assets on the balance sheet at original cost less depreciation less impairment; every entity must adopt a depreciation policy.

This depreciation policy is also reported in the notes to financial statements in every accounting period which includes name of the depreciation method and the rate or basis of depreciation.

Four commonly known methods of depreciation:

  • Straight-line
  • Double declining
  • Sum of year’s digits
  • Units of production

The international accounting standards ask every entity to choose one depreciation method that best fits the pattern of income generated from the asset.

The consistency principle of accounting is applied here so that the financial statements show a true and fair view of the business.

For example, if we were allowed to depreciate the asset in whatever way we want, there would be chances of fraudulent activities because every company would depreciate the asset in a way that would cost them lower depreciation expense than what was actually incurred.

Units of production method:

In this article, I am going to explain you how to depreciate assets based on the units of production method of depreciation including examples.

As we know that the depreciation expenses should be based on the benefits we derive from the asset, we could use the number of units produced as a basis of allocating the depreciation.

In simpler words we can allocate the cost of asset over the capacity or number of units we expect to produce from the fixed asset instead of the useful life of the asset.

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The formula for calculating annual depreciation using the units of production method is as follows:

= Depreciable Amount ( Unit Produced During the Year / Estimate Total Production

Depreciable amount = Cost – Salvage Value

Cost is the total amount paid to the supplier in exchange of the asset.

Salvage Value or scrap value is the amount you expect to receive at disposal of the asset.

Estimated total production is the total capacity of the asset or the total number of units you expect to produce until the disposal of the asset.

Example:

Softdrinks and Co. purchased a machine on 1st January 2010 for $550,000. It has an estimated useful life of 5 years and an estimated residual value of $50,000. Softdrinks and Co. plans to dispose of the machine at the end of 2014.

It is expected that the machine would produce a total of 20,000 liters of softdrink during its useful life. The production plan for the next 5 years is as follows:

Year           Liters

2010         5000

2011         3000

2012         5500

2013         4500

2014         2000

Calculate annual depreciation using the units of production method for all 5 years.

Answer:

Year Working Annual Depreciation($)
2010 500000 x 5000/20000 12,500
2011 500000 x 3000/20000 7,500
2012 500000 x 5500/20000 13,750
2013 500000 x 4500/20000 11,250
2014 500000 x 2000/20000 5,000

As shown in the working column, to calculate the annual depreciation we will multiply the depreciable amount of the asset with the ratio of units produced to total expected production.

The depreciation is based on liters. As the production is increased, the depreciation charge increases simultaneously and vice versa.