According to international accounting standards, depreciation is the allocation of the cost of non-current assets over its useful life. For example, you have purchased a car for $5000 and the expected life of that car is 5 years. Although the purchase of a car is an expense just like the electricity bill, it would be misleading if you show $5000 expense in all of 5 years in the statement of financial position. Therefore the most sensible way as per the IFRS and GAAP (accounting standards) is to divide the cost of the car over five years which is $1000 in this example and show each year $1000 expense in the profit and loss account instead of showing all costs. This $1000 is deducted as an expense from the statement of financial position and on the other hand, the value of assets in the balance sheet will also be reduced by $1000.
The sole purpose of the depreciation is not only mentioning the true value of assets in the balance sheet in fact as per standards it is the application of the matching concepts which states that firms should recognize the expense related to particular revenue in the same period in which revenue is recognized.
There are several methods of calculating depreciation, the most practised one is the straight-line method. According to this approach, we allocate an equal amount of depreciation every year. The formula to calculate depreciation is given below:
Depreciation = (Cost of an asset - scrap value)/Estimated useful life
Example 1
Suppose you bought a car for $18000 and it is expected that the useful life of this car would be 5 years and the scrap value at the end of 5 years would be $3000. So the depreciation would be
Depreciation = (18000-3000)/5
Journal entries
DR Car $18000
CR Cash $1800
DR Depreciation expense $3000
CR Accumulated depreciation $3000
