Appreciation of Depreciation

Another area people struggle with is depreciation of non-current assets.

What is depreciation and what is it there for?

Depreciation aims to charge the cost of the fixed asset that has been consumed during the period of the profit and loss account as an expense in order to match the income that the fixed asset has earned in the period (the accruals concept).

IAS 16 (Property, Plant and Equipment) has this to say about depreciation:

“Depreciation is the measure of the cost of the economic benefits of the tangible non-current assets that have been consumed during the period. Consumption includes the wearing out, using up or other reduction in the useful economic life of a tangible non-current asset whether arising from use, effluxation of time or obsolescence through either changes in technology or demand for the goods and services produced by the asset”

What does this mean?

• Machinery and motor vehicles wear out over time and so this accounting standard takes care of this wearing out. 

• Leases on buildings are consumed with the passage of time and so their value diminishes. 

• Computer technology becomes obsolete as technology advances and so their value is reduced. 

• Freehold land, however, has infinite life and so cannot be consumed by the business although the buildings on the land may be depreciated.

Methods of Depreciation

Straight Line Depreciation

The aim of the straight line method of depreciation is to charge the same amount of depreciation on the fixed asset each year of the asset’s life.

Before we can work out the depreciation charge, we need to know two things:

• The original cost of the asset
• The estimated useful life of the asset

Example

Jo has a vehicle which cost £15,000 and has a useful life of 5 years. Calculate the annual depreciation charge using the straight line method.

Workings
Cost - residual value		£15,000 - £0
Expected useful life		5 years
Depreciation =		£3,000 per annum

This assumes that the asset has no residual value (value at the end of its useful economic life).

Here the depreciation will, eventually, bring the carrying value to zero.

If the asset does have a residual value, the calculation is slightly different.

Example:

Jo has a vehicle which cost £15,000 and has a useful life of 5 years with a residual value of £5,000. Calculate the annual depreciation charge using the straight line method.

Workings
Cost - residual value		£15,000 - £5,000
Expected useful life		5 years
Depreciation =		£2,000 per annum

Sometimes you will be given the depreciation charge as a percentage using the straight line method e.g. £15,000 –depreciated at 20% on cost.

This would be calculated thus:

Workings

(Cost - Residual value) x % = (£15,000 - £0) x 20% 

Depreciation = £3,000 per annum

Reducing/Diminishing Balance Method

The reducing/diminishing balance method has a higher charge for depreciation in the early years of the fixed asset’s life but a lower charge in later years.

In this method, the depreciation charge is a fixed percentage of the carrying value or carrying amount(the cost of the asset – depreciation to date). The determination of the percentage if a complicated calculation but you will not be required to carry this out, you will be given the percentage.

How it works

Jo has a vehicle which cost £15,000. Depreciation is charged at 30% per annum using the reducing/diminishing balance method.

Workings

Year 1

Cost x % = £15,000 x 30% = £4,500

This leaves the carrying value (net book value) at the year end as: £15,000 - £4,500 = £10,500

Year 2

Carrying value x % = £10,500 x 30% = £3,150

So the carrying value at year end is £7,350

Unlike with the straight-line method, the carrying value under reducing balance will never reach zero.

The double entry for depreciation 

Depreciation is an expense - but a non-cash expense. We do not write a cheque for depreciation (this is important if you study cash management at Level 4!)

Therefore we need to record an expense for depreciation each year.

If we look at the last example, we will see that:

Year 1

Debit Depreciation expense (charge) account £4,500

Credit Accumulated depreciation account £4,500

The Accumulated depreciation is carried forward to next year whilst the expense is transferred to the Statement of profit or loss.

The debit (expense) is recorded in the Statement of profit or loss whilst the credit serves to reduce the value of the non-current asset on the Statement of financial position. 

The t-accounts look like this:

In the statement of financial position we see the following:

In year 2 we see the following occur

Debit Depreciation expense £3,150

Credit accumulated depreciation £3,150

Again the debit is transferred at year end to the Statement of profit or loss whilst the credit builds the value of the Accumulated depreciation to further reduce the carrying value of the non-current asset.

In the statement of financial position we see the following:

 Note:

There is no one 'correct' way to depreciate assets. However, one should always aim to depreciate them according to the expected useful life so, so example, we would aim to depreciate an asset over 5 years if we expected its useful life for us to be 5 years.

It is important to remember that the accumulated depreciation is used to assess whether we have made a gain or loss on disposal (see my first blog entry). Whilst we may want to see the word profit (gain), here it tells us that our depreciation figure was too much and we were over-estimating the value of the 'using up or wearing out' of the non-current asset. Similarly, if we make a 'loss' on the disposal, we haven't depreciated enough.