What is Depreciation?
In accounting, depreciation refers to the process of deducting an asset’s cost over its useful life. This method allows companies to spread that cost over several periods. Furthermore, it is also in line with the matching concept in accounting. This concept requires companies to match expenses to the revenues they relate. Therefore, depreciation charges an asset’s cost to the period it helps generate income.
Depreciation is a crucial part of accounting for fixed assets. It allows companies to charge an asset’s cost to the income statement for various periods. Similarly, it helps companies represent the remaining value of that asset in the balance sheet. Companies use depreciation for almost every fixed asset, excluding land. Usually, companies use a depreciation rate to depreciate their assets systematically.
What is Depreciation Rate?
The depreciation rate refers to the percentage of depreciation charged for every asset during a period. Usually, this rate depends on the useful life of that asset estimated beforehand. Alternatively, companies can also use that life to calculate depreciation. However, it may not apply to every depreciation method. Therefore, companies use the depreciation rate to fit into the depreciation formula.
The depreciation rate is a percentage that companies estimate for each asset class. Therefore, this rate will differ from one fixed asset to another. For example, the depreciation rate for property may vary from that used to depreciate vehicles. This rate is a part of the declining and double-declining methods of depreciation. However, it may also cover the straight-line method.
The depreciation rate allows companies to simplify the depreciation calculation. Even when using multiple depreciation methods for different asset classes, this rate can apply to all assets. Consequently, companies use it persistently for each fixed asset. However, it may lose the flexibility of calculating depreciation for each asset individually. Nonetheless, it is a crucial part of the depreciation process.
How to calculate the Depreciation Rate for an asset?
The depreciation for each asset differs based on its useful life. It does not consider the cost of that asset to set the underlying rate. Usually, companies estimate the useful life for each asset before depreciating it. The depreciation rate calculation does not require the same. Instead, companies establish this rate for each asset class.
Companies consider the average useful life of the asset class items before estimating the depreciation rate. Once they do so, they can use the following depreciation rate formula to set that rate.
Depreciation rate = 1 / Asset’s useful life x 100%
Once calculated, companies use the same rate for each asset in that class. This rate then goes into various depreciation methods to calculate the depreciation for every asset.
Example
A company, Green Co., purchases a vehicle for $10,000. The company estimates it to have a useful life of 10 years. Green Co. hasn’t established a depreciation rate for its vehicle asset class. Before depreciating that vehicle, the company must calculate it. Green Co. uses the following formula for the depreciation rate calculation.
Depreciation rate = 1 / Asset’s useful life x 100%
Depreciation rate = 1 / 10 years x 100%
Depreciation rate = 10%
Green Co. has established a 10% depreciation rate for its vehicles asset class. It must use this rate persistently for each asset classifying into this class.
Conclusion
Depreciation allows companies to spread an asset’s cost over its useful life. Sometimes, companies establish a depreciation rate to depreciate their assets. This rate depends on the average useful life of the assets in a specific class. Once companies calculate a depreciation rate, they must use it consistently for each item in that class.
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