DepreciationDepreciation is systematic allocation the cost of a fixed asset over its useful life. It is a way of matching the cost of a fixed asset with the revenue (or other economic benefits) it generates over its useful life. Without depreciation accounting, the entire cost of a fixed asset will be recognized in the year of purchase. This will give a misleading view of the profitability of the entity. The observation may be explained by way of an example.ExampleABC LTD purchased a machine costing $1000 on 1st January 2001. It had a useful life of three years over which it generated annual sales of $800. ABC LTD's annual costs during the three years were $300.If ABC LTD expensed the entire cost of the fixed asset in the year of purchase, its income statement would present the following picture the end of the three years:

Income Statement200120022003

$$$

Sales800800800

Cost of Sales(300)(300)(300)

Fixed Asset Cost(1000)--

Net Profit (Loss)(500)500500

As you can see, income statement of ABC LTD shows net loss in the first year even though it earned the same revenue as in the subsequent years. Conversely, no fixed asset will appear in ABC LTD's balance sheet although it had earned revenue from the machine's use through out its useful life of 3 years.If ABC LTD, instead of charging the entire cost of fixed asset at once, depreciates the capital expenditure over its useful life, its income statement and balance sheet would present the following picture at the end of the three years:

Income Statement200120022003

$$$

Sales800800800

Cost of Sales(300)(300)(300)

Fixed Asset Cost(333.3)(333.3)(333.3)

Net Profit (Loss)166.7166.7166.7

Balance Sheet (Extract)200120022003

$$$

Fixed Assets1,0001,0001,000

Accumulated Depreciation(333.3)(666.7)(1,000)

Net Book Value666.7333.3Nill

As you can see, the process of relating cost of a fixed asset to the years in which the economic benefits from its use are realized creates a more balanced view of the profitability of the company. Hence, depreciation is an application of the matching principle whereby costs are matched to the accounting periods to which they relate rather than on the basis of payment.Accounting EntryDouble entry involved in recoding depreciation may be summarized as follows:DebitDepreciation Expense (Income Statement)

CreditAccumulated Depreciation (Balance Sheet)

Every accounting period, depreciation of asset charged during the year is credited to the Accumulated Depreciation account until the asset is disposed. Accumulated depreciation is subtracted from the asset's cost to arrive at the net book value that appears on the face of the balance sheet. Using the last example, following double entries will be recorded in respect of depreciation:Depreciation Expense Account

Debit$Credit$

2001Accumulated Depreciation333.32001Income Statement333.3

2002Accumulated Depreciation333.32002Income Statement333.3

2003Accumulated Depreciation333.42003Income Statement333.4

Accumulated Depreciation Account

Debit$Credit$

2001Balance c/d333.32001Depreciation Expense333.3

333.3333.3

2002Balance c/d666.62002Balance b/d333.3

2002Depreciation Expense333.3

666.6666.6

2003Balance c/d10002003Balance b/d666.6

2003Depreciation Expense333.4

10001000

ExplanationStraight line depreciation method charges cost evenly throughout the useful life of a fixed asset.Thisdepreciation methodis appropriate where economic benefits from an asset are expected to be realized evenly over its useful life.Straight line method is also convenient to use where no reliable estimate can be made regarding thepattern of economic benefits expected to be derived over an asset's useful life.FormulaStraight line depreciation can be calculated using any of the following formulas:Depreciation per annum=(Cost Residual Value)

Useful Life

Depreciation per annum=( Cost Residual Value ) x Rate of depreciation

Where:Costis theinitialacquisition or construction costs related to the asset as well as anysubsequentcapital expenditure.

Residual Value, also known as its scrap value, is the estimated proceeds expected from the disposal of an asset at the end of its useful life. The portion of an asset's cost equal to residual value isnotdepreciated because it is expected to be recovered at the end of an asset's useful life.

Useful Lifeis the estimatedtime periodthat the asset is expected to be used starting from the date it is available for useup to the date of its disposal or termination of use. Useful life is normally expressed in units of years or months.

Rate of depreciationis thepercentage of useful lifethat is consumed in a single accounting period. Rate of depreciation can be calculated as follows:

Rate of depreciation=1x 100%

Useful Life

e.g. rate of depreciation of an asset having a useful life of 8 years is 12.5% p.a.1x 100%=12.5% per year

8

TipRemember to adjust the depreciation expense downwards when an asset has been acquired or disposed offduringthe accounting period to avoid charging depreciation for the time the asset was not available for use. SeeExample 1Example 1A fixed asset having a useful life of 3 years is purchased on 1 January 2013.Cost of the asset is $2,000 whereas its residual value is expected to be $500.Calculate depreciation expense for the years ending 30 June 2013 and 30 June 2014.

Depreciation expense per annum shall be:=($2000 $500)= $500 p.a.

3 Years

Depreciation expense for the year ended 30 June 2013:$500 x 6/12 =$250As $500 calculated above represents the depreciation cost for 12 months, it has been reduced to 6 months equivalent to reflect the number of months the asset was actually available for use. Depreciation expense for the year ended 30 June 2014:

$500 x 12/12 =$500

As the asset was available for the whole period, the annual depreciation expense is not apportioned.

Alternatively, you may express useful life in months and calculate depreciation charge as follows:Useful life in months=12 x 3=36 months

Monthly depreciation charge=($2000 $500)=$41.67 p.m.

36 months

Depreciation expense for year ended 30 June 2013=$41.67 x 6=$250

Depreciation expense for year ended 30 June 2014=$41.67 x 12=$500

Revision in Estimates of Useful life and Residual ValueThe estimates of useful life or residual value of an asset may need to be revised in subsequent accounting periods in order to reflect more accurately the pattern of economic benefits in light of new information.In such cases, it will be necessary to account for the effects of revision in estimatesprospectively, i.e. the change in depreciation expense is accounted for in the period in which the revision takes place and subsequent accounting periods (seeExample 2below).Following formula can be used to calculate straight line depreciation for the current and subsequent accounting periods in case of a revision:Depreciation expense=( Cost - Revised Residual Value - Accumulated Depreciation)

Revised Remaining Useful Life

Where:Accumulated depreciationis the total depreciation that has been chargedin previous accounting periodssince the capitalization of the asset.

Revised remaining useful lifeis the estimated number of useful years or months of the asset remainingsince the last accounting period in which depreciation was charged.

TipDepreciation already charged in prior periods is not revised in case of a revision in the depreciation charge due to a change in estimates.ReferIAS 8for treatment of changes in accounting estimates.Example 2A fixed asset is purchased on 1 January 2011.Information relating to the asset is as follows:Cost of acquisition$110,000

Residual Value estimated at the time of acquisition$10,000

Residual Value revised estimate on 1 January 2012Nil

Useful Life estimated at the time of acquisition10 years

Useful Life revised estimate on 1 January 20138 years

Calculate depreciation expense for the years ended 31 December 2011, 2012, 2013 & 2014

2011Depreciation expense=$110,000*- $10,000**= $10,000.

10 Years***

*Cost**Residual Value***Useful Life

2012Depreciation expense=$110,000 - $0* - $10,000**= $11,111.

9 Years***

*Residual Value (revised)**Depreciation charged in the year 2011.***Remaining Useful Life. Since depreciation for only 1 year has been charged so far, remaining useful life is equal to 9 years (10 - 1)

2013Depreciation expense=$110,000 - $0 - $10,000 - $11,111*= $14,815.

6 Years***

* Depreciation charged in the year 2012.** Remaining Useful Life (revised). The revised estimate of useful life is 8 years. As depreciation has been charged for 2 years, the remaining useful life relevant to depreciation calculation is 6 years.2014 Depreciation expense = $14,815** Depreciation for the year 2014 is equal to the depreciation expense charged in the year 2013 because there has been no change in estimates since then.Reducing Balance Depreciation MethodReducing Balance Method charges depreciation at a higher rate in the earlier years of an asset. The amount of depreciation reduces as the life of the asset progresses. Depreciation under reducing balance method may be calculated as follows:Depreciation per annum = (Net Book Value - Residual Value) x Rate%Where: Net Book Value is the asset's net value at the start of an accounting period. It is calculated by deducting the accumulated (total) depreciation from the cost of the fixed asset. Residual Value is the estimated scrap value at the end of the useful life of the asset. As the residual value is expected to be recovered at the end of an asset's useful life, there is no need to charge the portion of cost equaling the residual value. Rate of depreciation is defined according to the estimated pattern of an asset's use over its life term.Example:An asset has a useful life of 3 years.Cost of the asset is $2,000.Residual Value is $500.Rate of depreciation is 50%.Depreciation expense for the three years will be as follows:NBVR.VRateDepreciationAccumalated Depreciation

Year1:(2000-500)x50%=750750

Year2:(1250-500)x50%=3751125

Year3:(875-500)x50%=375*1500

*Under reducing balance method, depreciation for the last year of the asset's useful life is the difference between net book value at the start of the period and the estimated residual value. This is to ensure that depreciation is charged in full.As you can see from the above example, depreciation expense under reducing balance method progressively declines over the asset's useful life.Reducing Balance Method is appropriate where an asset has a higher utility in the earlier years of its life. Computer equipment for instance has better functionality in its early years. Computer equipment also becomes obsolete in a span of few years due to technological developments. Using reducing balance method to depreciate computer equipment would ensure that higher depreciation is charged in the earlier years of its operation.ExplanationSum of the years' digits depreciation method, like reducing balance method, is a type of accelerated depreciation technique that allocates higher depreciation expense in the earlier years of an asset's useful life.Calculation of depreciation under this method can be summarized in the following 4 steps:Step 1: Calculate the sum of the years' digits in an asset's useful lifeFor an asset having a useful life of 4 years, the sum of the years' digits will be calculated as follows:Sum of years' digits = 4 + 3 + 2 + 1 = 10Step 2: Calculate the depreciable amountDepreciable amount, as with all depreciation methods, is equal to: Asset's cost of acquisition or construction including any subsequent capital expenditure Less:Estimated residual value or scrap value at the end of the asset's useful lifeStep 3: Calculate the un-depreciated useful lifeUn-depreciated useful life is equal to the number of years in the asset's useful life that havenotyet been subjected to depreciation.Hence, for an asset that has a useful life of 4 years, the un-depreciated useful life to be used in calculating depreciation shall be 4 years in the first year of depreciation, 3 years in the second year and so on.Step 4: Calculate depreciation using the sum of years' digits & un-depreciated useful lifeDepreciation using the sum of the years' digits method can be calculated using the following formula:Depreciation Expense=Un-depreciated useful life (Step 3)xDepreciable Amount (Step 2)

Sum of the years' digits (Step 1)

ExampleFollowing information relates to a fixed asset:Cost$100,000

Residual Value$10,000

Useful Life3 Years

Calculate depreciation over the useful life of the asset using the sum of the years' digits method.

Step 1: Calculate the sum of the years digitsSum of the years' digits = 3 + 2 + 1 =6Step 2: Calculate the depreciable amountDepreciable amount = $100,000 - $10,000 =$90,000Step 3: Calculate the un-depreciated useful lifeYear 1Year 2Year 3

Un- depreciated useful life (years)321

Step 4: Calculate depreciation expenseYear 1: Depreciation expense =3 (Step 3)x $90,000 (Step 2) = $45,000

6 (Step 1)

Year 2: Depreciation expense =2 (Step 3)x $90,000 (Step 2) = $30,000

6 (Step 1)

Year 3: Depreciation expense =1 (Step 3)x $90,000 (Step 2) = $15,000

6 (Step 1)

Note:Over the life of the asset, the total depreciation charge equals to the depreciable amount , i.e. $90,000 (Step 2). Also note that the amount of annual depreciation progressively declines as the asset ages. This method of depreciation is therefore appropriate for assets whose utility and productiveness is greater in the earlier years of their life (e.g. computer equipment).