by John Louie Ramos

Created on: April 30, 2010   Last Updated: October 29, 2010

Depreciation is the systematic allocation of an asset's depreciable cost over its estimated useful life. It is the recognition of the worn out portion of a tangible asset as an expense that needs to be distributed methodically within the periods of its usage.

Property, plant, equipment and other kinds of tangible assets are usable for a number of years after which they have minimal and immaterial value. The difference between the historical cost of the asset and its fair market value once exhausted is an expense that needs to be allocated to the periods in which the firm benefited from its use. That is simply the basis for recognizing depreciation.

Large companies often use various methods of depreciation to reliably compute the fair market value of the specific tangible asset. Depreciation also bases its approach to the matching concept of accounting that calls for the proper matching of income and expenses during a particular accounting period.

Moreover, depreciation is maintained by companies to have each period benefiting from the use of the tangible asset and determining the cost that should be allocated to its total useful life.

There are different kinds of depreciation methods used by business entities to suit their diverse accounting needs. The major accounting methods are physical method of depreciation and the economic method of depreciation.

The physical method of depreciation relates to the wear and tear of the asset caused by physical deterioration such as passage of time due to non use, force majeure or extraordinary events like floods, earthquake and other natural disasters and physical disease applicable to biological assets.

The physical method of depreciation is further subdivided into several depreciation methods, the most notable of which is the straight line method.

Straight Line Method

In the straight line method there are certain factors that should be taken into consideration like the residual value of the asset and the useful life of the asset. The straight line method allocates the depreciable amount of the asset equally over its useful life.

It considers depreciation as a function of time rather than a function of usage.

Equation of the Straight Line Method

Annual Depreciation = Historical Cost of Asset (minus) Residual Value (divided by) Useful Life

Economic method of depreciation, on the other hand, arises from obsolescence and decrease in the open market value of the tangible due to a better product in the open market. It results in a decrease in the fair market value of the asset.

Obsolescence arises when the tangible asset is phased out, therefore decreasing the demand for such asset.

Just like the physical method of depreciation, the economic method of depreciation is also subdivided into several methods the most used of which are the sum of the year's digit and declining balance method.

Sum of the Year's Digit and Declining Balance Method

Both of these methods provide higher depreciation expenses in the earlier years, banking on the philosophy that newer assets tend to be more useful and are capable of producing more efficiently and effectively.

Equation of the Sum of the Year's Digit Method

SYD = Life (Life+1 divided by 2)

SYD Depreciation Expense = Acquisition Cost * n/SYD ; Where n is the remaining useful life of the asset.

Equation of the Declining Balance Method

Declining Balance Depreciation Expense =  1/N of  previous year's value; where N is the number of useful years remaining.

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