Question

Respond to the following in a minimum of 125 words:

What is depreciation? Discuss the various depreciation methods. What is the difference between depreciation, depletion and amortization.

Answer 1

Solution. An organization operating in an economic competitive market make use of resources in order to meet its objective. Capital along with other assets are employed to carry out different activities effectively and efficiently to generate revenues. But over the span of time under the presence of various factors, the monetary value of such assets diminishes. For example decrease in the book value of plant and machinery due to usage, wear and tear such are reported in financial reportings.

Various methods for reporting depreciation are enlisted down:

1. Straight-line depreciation method- It encompasses equal value of depreciation amount to each accounting year into consideration, with the help of the formula: depreciation= (cost - salvage value)/ asset's useful life. Here asset's historical cost, estimated salvage value and useful life are taken into consideration to determine depreciation expense.

2. Units of production depreciation method- It encompasses computing total depreciation per unit for the accounting period with the help of the formula: (cost - salvage value) * (number of units produced / life in number of units) and reported on financial statements.

3. Double declining balance depreciation method- It encompasses calculating higher expense amount during intial years of an asset which reduces/diminishes in subsequent years, with the help of the formula: periodic depreciation expense = book value at beginning * depreciation rate.

4. Sum-of-years digits depreciation method- It encompasses calculation of the expense with the help of the formula: (remaining life/sum of the years digits) * (historical cost - estimated salvage value) and is one of accelerated method of calculating depreciation expense.

Depreciation is the process of allocating the historical cost of tangible/fixed asset over the course of its estimated useful life due to factors such as wear and tear, obsolescence and calculated with the help of above given methods. Whereas, depletion is the process of allocating the cost of mineral assets due to factors such as exhaustion. It is computed per unit with the help of the formula= (cost - estimated salvage value) / number of estimated units and recorded in total considering all the number of units. And, amortization is the process of writing off capital expenses over the limited given intangible asset's lifetime due to factors such as extinction and requires explanations in footnotes.