A fixed asset is a tangible asset that has a useful life of more than one year and from which future economic benefits are expected.
All fixed assets have a reduction in their value over time through depreciation as the result of their usage or impairment since the varying value is higher than the reliable value.
The reduction is due to obsolescence, wear and tear, or usage is known as depreciation. The 4 methods of depreciation are as follows:
• Double declining
• Sum of year’s digits
• Units of production
Through the first two methods, i.e. Straight-line and double-declining, the depreciation amount is derived by multiplying the cost or NBV of the asset with the rate of the depreciation.
This rate is consistent and can’t be changed through all accounting periods as per the consistency principle of accounting unless there is a significant change in the pattern of future economic benefits derived from the asset.
Does the question arise that how do we determine a fixed rate for the depreciation that would fairly distribute the asset cost over its useful life? You can calculate the depreciation rate from the following two methods:
Formula to calculate depreciation rate (Method 1)
= (Annual Depreciation / Cost of Assets) * 100
In order to calculate annual depreciation, firstly, you must know the cost and the salvage value of the asset. The cost of an asset is the amount you paid for purchasing the asset and bringing it to its useable condition.
Whereas the salvage value of an asset is its scrap value. It is the amount you expect to receive when you sell the asset at the end of its useful life.
Secondly, you need to know the useful life of the asset i.e. the period of time you expect to use your asset. The annual depreciation can be calculated through the following formula:
= (Cost-Salvages Value) / Useful Lift
For example, the cost of an asset is $6,000 and its salvage value is $1,000 with an economic useful life of 5 years. The annual depreciation would amount to $1,000 i.e. $5,000 (6,000-1,000) divided by 5.
The next step would be to divide the annual depreciation ($1,000) by the cost of assets ($6,000). Hence the annual depreciation rate would be 16.67%.
Formula to calculate depreciation rate (Method 2)
In this method, the formula to calculate the depreciation rate would remain the same i.e. = (Annual Depreciation /Cost of Assets) * 100 but the formula for calculating annual depreciation is a bit different.
All you have to do is divide the number 1 by the useful life of the asset and multiply it by the cost of the asset.
For example, Ali and Company purchased a fixed asset costing $9,000. Ali expects to use this asset for at least 10 years before scrapping it out. What would be the annual depreciation expense, Ali, using the straight-line method?
Ali would charge a depreciation expense of $900 ($9,000 x 1/10 ) according to the following formula:
= (Costs of assets – Salvages Value) / Useful Life
What would be the annual depreciation rate for Ali and the company?
900/9000 x 100 = 10%
Ali would depreciate his asset annually at a rate of 10%.