Depreciation is a non-cash expense that reduces the value of an asset over time.

Assets depreciate for two reasons:

Wear and tear. For example, an auto will decrease in value because of the mileag
e, wear on tires, and other factors related to the use of the vehicle.
Obsolescence. Assets also decrease in value as they are replaced by newer models
. Last year's car model is less valuable because there is a newer model in the m
arketplace.
Depreciation is calculated as follows:
The original cost of the asset, including costs of acquiring the asset, transpor
ting it, and setting it up
Less the salvage value (the "scrap" value)
Divided over the years of useful life of the asset.

depreciation, in accounting, the allocation of the cost of an asset over its eco
nomic life. Depreciation covers deterioration from use, age, and exposure to the
elements. It also includes obsolescence i.e., loss of usefulness arising from the
availability of newer and more efficient types of goods serving the same purpos
e. It does not cover losses from sudden and unexpected destruction resulting fro
m fire, accident, or disaster.
Depreciation applies both to tangible property such as machinery and buildings a
nd to intangibles of limited life such as leaseholds and copyrights. It does not
apply to land. For convenience, depreciation accounts are usually kept for grou
ps of assets with similar characteristics and working life.
The general rule of charging off a depreciable asset during its life does not de
termine what the charge will be each year. Straight-line, fixed-percentage, and,
more rarely, annuity methods of depreciation (giving, respectively, constant, g
radually decreasing, and gradually increasing charges) are standard. Sometimes c
harges vary with use (e.g., with the number of miles per year a truck is driven)
. Special rules allow depletion of nonreproducible capital (such as a body of or
e being mined) for tax purposes to exceed original cost.
Basing depreciation on historical cost rather than on probable replacement cost
and on arbitrary rules rather than on actual use has been practiced to establish
definite tax liability and to standardize audits of accounts; in times of shift
ing price levels, however, such bases for measuring depreciation have proved esp
ecially imperfect.

SLM
Cost of fixed asset must be charged to the income statement in a manner that bes
t reflects the pattern of economic use of the asset. Most common methods of depr
eciation include Straight Line Method and Reducing Cost Method.
Straight Line Depreciation Method
Straight line method depreciates cost evenly through out the useful life of the
fixed asset. Straight line depreciation is calculated as follows:
Depreciation per annum = (Cost - Residual Value) / Useful Life
Where:
Cost includes the initial and any subsequent capital expenditure.
Residual Value is the estimated scrap value at the end of the useful life of the

asset. As the residual value is expected to be recovered at the end of an asset

's useful life, there is no need to charge the portion of cost equaling the resi
dual value.
Useful Life is the estimated time period an asset is expected to be used from th
e time it is available for use to the time of its disposal or termination of use
. Useful life is normally calculated in units of years but it may be calculated
based on an alternative basis. Useful life of an oil extraction company may for
example be the estimated oil reserves.
Test Your Understanding
Which of the following is true regarding Straight Line Depreciation?
It prevents bias in situations when the pattern of economic benefits from an ass
et is hard to estimate
Once straight line depreciation charge is determined, it is not revised subseque
ntly
Example
An asset has a useful life of 3 years.
Cost of the asset is $2,000.
Residual Value is $500.
Annual Depreciation cost will be $500 = (2000 - 500) / 3years
Straight line depreciation method is appropriate where economic benefits from th
e asset are expected to be realized evenly during its useful life. It is also co
nvenient where no reliable estimate can be made regarding the pattern of economi
c benefits over an asset's useful life.

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