Depreciation is a word that is used in the general english language as well as a specific technical accountancy term. They do not always mean the same thing, which can obviously cause confusion. So from an accounting perspective what is depreciation and what does it mean?
Depreciation is reflecting that as an item of property, plant and equipment is being used, the future benefits that are available from it are falling.
For example, consider an item of machinery that has been purchased at a cost of $5,000. Suppose that it is expected that the machine will be used for the next 5 years at which point it will be scrapped.
Depreciation is reflecting that over the 5 year period, the asset is being worn out. The asset had cost $5,000 and at the end of 5 years it will be worthless and so all $5,000 value of the machine is being used. Assuming that the same amount of benefit is received from the machine in each year, the depreciation will be $1,000 per year ($5,000 / 5 years).
The double entry for depreciation is to reduce the asset in the statement of financial position (SFP) and to record an expense in the statement of profit or loss (SPL).
Consequently the value of the asset in the SFP after each year of use will be $4,000, then $3,000 and then $2,000 etc.
Depreciation is also an application of the matching concept – as income is generated from using an asset, the expense of depreciation is matched against it within the statement of profit or loss.
PPE must be depreciated over the period which it is expected to generate benefits for the business. This is called the useful life of the asset.
All items of PPE are depreciated with the exception of land. Land is deemed to have an an infinite useful life and so can generate benefits for ever. Consequently land can’t be depreciated as it is impossible to divide by infinity.
PPE is depreciated down to its’ residual value i.e. the estimated value of the asset at the end of its useful life. The cost less the residual value is known as the depreciable amount.
Suppose an asset cost $8,000 and the business intends to use the asset for the next 4 years when it will be sold for an estimated $2,000.
In this situation, only $6,000 ($8,000 – $2,000) of the asset’s benefits will be used up by the entity and so this is the total amount that will be depreciated over the 4 year useful life. Assuming the same amount of benefit will be received each year, depreciation will be $1,500 per year (£6,000 / 4 years).
In the above situation, depreciation would be referred to as being charged on a straight line basis because the depreciation expense would be the same amount in each year.
An alternative way to calculate depreciation is on a reducing balance basis. This is appropriate where it is thought that the use of the asset will generate greater benefits in the earlier years of its life and less in its later years. In this case depreciation is calculated as a % of the carrying value of the asset where carrying value is cost less accumulated depreciation.
Suppose an asset cost $10,000 and is being depreciated at 20% on the reducing balance basis.
In year 1, depreciation will be 20% x $10,000 = $2,000 and the carrying value of the asset at the year-end will be $10,000 – $2,000 = $8,000.
In year 2, depreciation will be 20% x $8,000 = $1,600 and the carrying value will be $10,000 – $3,600 = $6,400.
In year 3, depreciation will be 20% x $6,400 = $1,280 and the carrying value will be $10,000 – $4,880 = $5,120.
What isn’t depreciation? In accountancy, depreciation is NOT reflecting that the market value of the asset is falling as time passes. This however is often what the word depreciation means when it is used within the general english language. This is particularly true when the word is used in connection with cars.
Whilst for several types of assets such as cars, machinery or equipment, the depreciated value of the asset in the SFP may be fairly close to the market value this is a co-incidence rather than an intention. For other types of assets, this is definitely not the case. For example, properties are subject to depreciation in financial statements. However the market value of property tends to increase over time.
Another common misconception about depreciation is in relation to tax. Non-accountants often think that by charging more depreciation, they can reduce their profits and so reduce their tax bill. I’m afraid not! Depreciation is a “disallowable expense” from the taxman’s perspective – in other words, he will not reduce the taxable profit by the depreciation expense. Instead he will reduce profits by a specific tax allowance (often referred to as capital allowances). These tax allowances are set by the tax authorities and so cannot be altered by the company to manipulate their tax bill.