Depreciation is one of the most essential concepts in accounting and finance. It represents how a business recognizes the gradual loss of value of its assets—such as vehicles, machinery, and buildings—over time. No asset lasts forever; wear, tear, and obsolescence reduce its worth. Depreciation ensures that businesses record this decline accurately, giving a true picture of financial performance and asset value.
Instead of charging the full cost of an asset at once, depreciation spreads it across its useful life. This not only improves financial reporting accuracy but also helps with better tax planning, budgeting, and long-term investment decisions.
Why Depreciation Matters
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Accurate Profit Reporting
Depreciation helps businesses match the cost of an asset to the years it contributes to revenue. This makes profit figures more realistic and avoids overstating earnings. -
Tax Benefits
Depreciation is often a deductible expense, meaning businesses can reduce taxable income by claiming depreciation each year. -
True Asset Value
It updates the balance sheet to reflect that assets lose value as time passes, ensuring financial statements remain accurate and credible. -
Better Budget Planning
Depreciation helps companies plan for the replacement of assets once they reach the end of their useful life, ensuring business continuity.
Main Methods of Depreciation
1. Straight-Line Method
The Straight-Line Method is the simplest and most widely used approach. It spreads the cost of the asset evenly over its useful life.
Formula:
Depreciation Expense = (Cost of Asset – Salvage Value) / Useful Life (years)
Example:
A company buys a generator for ₦6,000,000, expected to last 6 years with a salvage value of ₦600,000.
Depreciation Expense = (6,000,000 – 600,000) ÷ 6 = ₦900,000 per year
Each year, ₦900,000 is recorded until the asset’s book value reaches ₦600,000.
2. Reducing Balance (Declining Balance) Method
This method applies a fixed percentage to the asset’s book value each year, resulting in higher depreciation in the early years and lower in later years.
Formula:
Depreciation Expense = Book Value at Start of Year × Depreciation Rate
Example:
An equipment costs ₦2,000,000, with a depreciation rate of 25%.
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Year 1: ₦2,000,000 × 25% = ₦500,000
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Year 2: (₂,000,000 – 500,000) × 25% = ₦375,000
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Year 3: (₁,500,000 – 375,000) × 25% = ₦281,250
This method reflects faster asset wear and higher early-year usage.
3. Sum-of-the-Years’ Digits (SYD) Method
The SYD method also charges more depreciation in earlier years but in a systematic, fraction-based way.
Steps:
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Add up the years of useful life (e.g., 5 + 4 + 3 + 2 + 1 = 15).
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Assign fractions to each year (Year 1 = 5/15, Year 2 = 4/15, etc.).
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Multiply the fraction by the depreciable amount (Cost – Salvage Value).
Example:
A delivery truck costs ₦9,000,000, with a salvage value of ₦1,500,000 and a useful life of 5 years.
Depreciable Amount = 9,000,000 – 1,500,000 = ₦7,500,000
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Year 1: 5/15 × ₦7,500,000 = ₦2,500,000
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Year 2: 4/15 × ₦7,500,000 = ₦2,000,000
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Year 3: 3/15 × ₦7,500,000 = ₦1,500,000
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Year 4: 2/15 × ₦7,500,000 = ₦1,000,000
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Year 5: 1/15 × ₦7,500,000 = ₦500,000
4. Units of Production Method
This method ties depreciation to usage rather than time, ideal for assets like machines or vehicles whose wear depends on activity level.
Formula:
Depreciation Expense = (Cost – Salvage Value) / Total Estimated Units × Units Produced in the Year
Example:
A printing machine costs ₦10,000,000 with a salvage value of ₦1,000,000 and a life of 1,800,000 copies.
Depreciation per copy = (10,000,000 – 1,000,000) ÷ 1,800,000 = ₦5 per copy
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Year 1: 400,000 copies × ₦5 = ₦2,000,000
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Year 2: 300,000 copies × ₦5 = ₦1,500,000
This ensures expenses reflect actual asset usage and productivity.
Conclusion
In essence, depreciation is more than an accounting rule,it’s a financial truth that reflects how assets age and lose value. Whether applied through straight-line, reducing balance, SYD, or units of production methods, the goal remains the same: to record expenses fairly, maintain accurate books, and guide smarter business decisions.
Understanding depreciation helps business owners plan asset replacements, control costs, and assess real profitability. At BFI, we simplify complex financial topics like this, helping professionals and entrepreneurs make informed, strategic decisions that drive business success.
👉 Call us today at 08059019581 or 07085053778 to learn how our finance and accounting courses can help you master key concepts like depreciation and asset management.
