Accounting | Depreciation

Welcome to Depreciation! Understanding Asset Value

Hello future accountant! This chapter on Depreciation is vital—it’s how businesses correctly calculate the true cost of using their long-term assets. Don’t worry if the term sounds complicated; it’s really just accounting for wear and tear.

Think of it this way: When you buy a brand new computer or bike, it’s worth a lot. But a year later, after heavy use, you couldn't sell it for the original price, right? Depreciation is the process of tracking that loss in value in a structured way.

Why is Depreciation Important?

In accounting, we follow the Matching Principle. This means that we must match the expenses related to generating revenue to the same accounting period in which the revenue was earned. Assets like machinery help generate revenue for many years, so we need to spread their cost across those years, rather than charging the entire cost immediately.

Section 1: What Exactly is Depreciation?

Before we define depreciation, let's refresh a key term:

• Non-Current Assets (NCAs): These are items of value owned by the business that are expected to be used for more than one year (long term). Examples include buildings, machinery, vehicles, and fixtures.

Definition of Depreciation

Depreciation is the systematic allocation of the depreciable amount of a non-current asset over its useful life.

Translation into simple English: It is the accounting process of spreading the cost of an asset over the years it is expected to be useful to the business.

Key Terms You Need to Know

• Cost: The original purchase price of the asset, plus any costs needed to get it ready for use (e.g., installation fees or delivery charges).
• Useful Life: The estimated number of years or the total output (e.g., kilometres driven) the business expects to use the asset.
• Residual Value (or Scrap Value/Salvage Value): The estimated amount the business expects to sell the asset for at the end of its useful life.
• Depreciable Amount: This is the part of the cost we actually spread out. It is calculated as: Cost - Residual Value.

Section 2: Causes of Depreciation (Why Assets Lose Value)

Non-Current Assets lose their ability to generate revenue for several reasons. Accountants categorize these causes:

1. Physical Deterioration (Wear and Tear):

   This is the most obvious cause. It happens simply because the asset is being used—machinery parts grind, vehicle tires wear thin, and buildings require repairs due to aging.

2. Obsolescence:

   An asset becomes obsolete when it is out-of-date or less efficient, even if it is still physically working. Example: A company buys a machine for manufacturing that is quickly replaced by a newer, faster, and cheaper model developed by a competitor. The old machine is now worth much less because the technology is outdated.

3. Passage of Time:

   Some assets, like patents or leases, lose value simply because the time period they cover expires. Even if you don't use the asset, its legal life is running out.

Section 3: Methods of Calculating Depreciation

In the IGCSE curriculum, you need to understand two main methods used to calculate the annual depreciation charge.

Method 1: The Straight-Line Method (SLM)

This is the simplest method! It assumes the asset loses value evenly every year. It’s like slicing a pizza into equal pieces—the depreciation expense is exactly the same amount for every year of the asset's life.

How to Calculate SLM

The depreciation is calculated based on the Depreciable Amount (Cost - Residual Value).

Formula 1 (Based on Life in Years):

$$ \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life (Years)}} $$

Formula 2 (Based on Percentage Rate):

$$ \text{Annual Depreciation} = (\text{Cost} - \text{Residual Value}) \times \text{Rate} $$

Step-by-Step Example (SLM)

A machine cost $10,000. It is expected to last 5 years and have a residual value of $500.

1. Calculate Depreciable Amount: \( \$10,000 - \$500 = \$9,500 \)
2. Divide by Useful Life: \( \frac{\$9,500}{5 \text{ years}} = \$1,900 \)

The annual depreciation charge will be $1,900 for years 1, 2, 3, 4, and 5.

Method 2: The Reducing Balance Method (RBM)

This method is more realistic for assets that lose a lot of value early on (like cars). It charges a higher depreciation expense in the early years and a smaller expense in the later years.

The key difference is that the fixed percentage rate is applied to the Net Book Value (NBV) of the asset at the start of the year, not the original cost.

Key Term for RBM: Net Book Value (NBV)

The Net Book Value (NBV) is the current value of the asset in the business’s books.

$$ \text{Net Book Value} = \text{Original Cost} - \text{Total Accumulated Depreciation} $$

How to Calculate RBM

Formula (RBM):

$$ \text{Annual Depreciation} = \text{Net Book Value (NBV)} \times \text{Fixed Percentage Rate} $$

Step-by-Step Example (RBM)

A vehicle costs $20,000. Depreciation is charged at 20% per annum using the Reducing Balance Method.

• Year 1:

  NBV at start = $20,000 (Initial Cost)

  Depreciation: \( \$20,000 \times 20\% = \$4,000 \)

  NBV at end of Year 1: \( \$20,000 - \$4,000 = \$16,000 \)

• Year 2:

  NBV at start = $16,000

  Depreciation: \( \$16,000 \times 20\% = \$3,200 \)

  NBV at end of Year 2: \( \$16,000 - \$3,200 = \$12,800 \)

• Year 3:

  NBV at start = $12,800

  Depreciation: \( \$12,800 \times 20\% = \$2,560 \)

Notice how the depreciation charge gets smaller every year ($4,000, then $3,200, then $2,560).

Section 4: The Double Entry for Depreciation

Depreciation is an estimate, not a cash payment. However, it is a business expense that must be recorded.

When we record depreciation, we use a special account called Provision for Depreciation (or Accumulated Depreciation). We do this so that the original cost of the asset remains recorded in the asset account (e.g., Machinery Account).

Step-by-Step Double Entry Process

Every year-end, the entry to record the annual depreciation expense is:

1. Debit: Income Statement Account (or Profit and Loss Account)

   Reason: Depreciation is an expense for the year, reducing the profit. Expenses increase on the debit side.

2. Credit: Provision for Depreciation Account (for the specific asset)

   Reason: This is a 'Contra Asset' account. It builds up over the years and represents the total loss in value of the asset to date. Credit entries increase this provision.

Did you know? The Provision for Depreciation account is a balance sheet item. It is deducted directly from the Cost of the Non-Current Asset to show the Net Book Value.

Impact on Financial Statements

• Income Statement (P&L): The annual depreciation charge appears as an operating expense, reducing the net profit.
• Statement of Financial Position (Balance Sheet): Non-Current Assets are shown at their Net Book Value (NBV) (Cost minus Provision for Depreciation). This ensures the business adheres to the True and Fair View principle by not overstating the value of its assets.

Section 5: Accessibility Corner and Quick Review

Quick Review Checklist

• Depreciation is the spreading of the cost of an asset over its useful life.
• The Depreciable Amount is always Cost minus Residual Value.
• Straight Line Method: Charges the same amount every year (based on depreciable amount).
• Reducing Balance Method: Charges a higher amount early on (based on the current Net Book Value).
• Provision for Depreciation tracks the total loss in value.

Understanding Net Book Value (NBV)

NBV is the most crucial concept when moving from Straight Line to Reducing Balance.

Imagine you bought a van (Cost: $50,000). Over 3 years, you have charged a total of $15,000 in depreciation (Provision).

$$ \text{NBV} = \$50,000 \text{ (Cost)} - \$15,000 \text{ (Accumulated Depreciation)} = \$35,000 $$

The $35,000 is the value the van holds on the balance sheet today. If you used RBM, the next year's depreciation charge would be calculated using the percentage multiplied by $35,000.

You have successfully tackled one of the most fundamental concepts in bookkeeping! Keep practicing the calculations, especially the Reducing Balance Method, and you'll master this in no time.