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Depreciation

Depreciation is the process of making a regular allocation of the cost of an asset spread over its entire estimated useful life to expense. All assets except land have a limited useful life and eventually lose their productive capacity due to wear and tear, obsolescence, rust, etc. What is left is their scrap value which may be nil or even negative when they are disposed of. Salvage value is also known as scrap value or residual value.

The useful life of an asset is its estimated productive life when it is expected to generate revenues, and it may be the number of years it is productive, the high production of units or if it is a vehicle, its high mileage.

Each time a depreciation amount is written off as an expense item, it is assumed that an equivalent portion of the cost of the asset is used up, and this has to match the income that is received from the use of the asset. Thus, the portion of the cost of the asset that is used up is transferred to the income statement from the balance sheet.

Charging depreciation is not meant to estimate the asset’s market value which is the price a buyer is willing to pay.  An asset’s market value is rarely equal to its net book value. Net book value is the asset’s total cost less the accumulated depreciation. The book value is the same as scrap value at the end of the asset’s useful life. But it is possible that the market value of an asset is increasing while it is being depreciated.

Using the double-entry system, whenever a depreciation amount is debited to the income statement, the same amount is credited to the accumulated depreciation. This accumulated depreciation is recorded in an account called a contra-asset account. By keeping a separate contra-asset account enables it to show the total depreciation accumulated to date from the date the asset was acquired.

If depreciation is not calculated for inclusion in the accounting records, it will understate expenses and therefore overstate the net income. The book values of the assets will be overstated too. But it does not reduce the cash balance of a firm.  This then is why depreciation expense is sometimes referred to as a noncash expense. The cash balance is however reduced when the asset is acquired.

A separate accumulated depreciation account enables the fixed asset to be shown at cost on the financial statements. The cost of the asset is the price paid for it including those expenses incurred in making it functional such as transportation and installation costs, etc. Each asset except land has its own accumulated depreciation account. On the balance sheet, accumulated depreciation is a credit balance shown as a subtraction from the debit asset balance to give its net book value. Once an asset is fully depreciated, no further deduction is made for depreciation even though it could continue to be productive.

At the end of each accounting period, the depreciation account is closed and its balance is written off to the profit and loss account. In the next period, a new depreciation account is opened. The balance in the accumulated depreciation account is carried over to the next accounting period and increases as further depreciation is added to it.

A general journal is used to write off yearly or monthly depreciation charges depending on how often the financial statements are prepared. The depreciation expense account is debited with the depreciated amount and this same amount is credited to the accumulated depreciation. Journal entries can be prepared as of the last day of each month or year as follow.

The accumulated depreciation account in the ledger is shown just below its asset account.

On the balance sheet, the net book value of the asset is shown by deducting the accumulated depreciation from the asset:

Plant and Machinery                    60,000 
Less: Accumulated Depreciation  24,000 36,000

To determine the depreciation expense for an asset, these three factors are usually considered: its cost, its useful life and its expected salvage value. Salvage value is the value that is a firm expects to receive when the asset is sold at the end of its useful life. If no salvage value is expected, the entire cost is charged to depreciation over the estimated useful life of the asset.

Sometimes, after making an estimate of the useful life of an asset and charging depreciation for a few years, a firm may revise the useful life to a shorter period due to some reason. This change in the estimated useful life affects the future depreciation rate but not the deprecation charged in the past. The depreciation charged in the past cannot be changed.

There are five different depreciation methods:

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1 Units-of-production method 746
2 Sum-of-the-years-digits method 751
3 Double declining balance method 765
4 Declining balance method 760
5 Straight-line method 865