FAM/U1 Topic 9 Overview to Depreciation (Straight Line and Diminishing Method)
Depreciation is the systematic reduction of the recorded cost of a fixed asset. Examples of fixed assets that can be depreciated are buildings, furniture, and office equipment. The only exception is land, which is not depreciated (since land is not depleted over time, with the exception of natural resources). The reason for using depreciation is to match a portion of the cost of a fixed asset to the revenue that it generates; this is mandated under the matching principle, where you record revenues with their associated expenses in the same reporting period in order to give a complete picture of the results of a revenue-generating transaction. The net effect of depreciation is a gradual decline in the reported carrying amount of fixed assets on the balance sheet.
It is very difficult to directly link a fixed asset with a revenue-generating activity, so we do not try – instead, we incur a steady amount of depreciation over the useful life of each fixed asset, so that the remaining cost of the asset in the company’s records at the end of its useful life is only its salvage value.
Inputs to Depreciation Accounting
There are three factors to consider when you calculate depreciation, which are:
- Useful life. This is the time period over which the company expects that the asset will be productive. Past its useful life, it is no longer cost-effective to continue operating the asset, so it is expected that the company will dispose of it. Depreciation is recognized over the useful life of an asset.
- Salvage value. When a company eventually disposes of an asset, it may be able to sell it for some reduced amount, which is the salvage value. Depreciation is calculated based on the asset cost, less any estimated salvage value. If salvage value is expected to be quite small, then it is generally ignored for the purpose of calculating depreciation.
- Depreciation method. You can calculate depreciation expense using an accelerated depreciation method, or evenly over the useful life of the asset. The advantage of using an accelerated method is that you can recognize more depreciation early in the life of a fixed asset, which defers some income tax expense recognition into a later period. The advantage of using a steady depreciation rate is the ease of calculation. Examples of accelerated depreciation methods are the double declining balance and sum-of-the-years digits methods. The primary method for steady depreciation is the straight-line method. The units of production method is also available if you want to depreciate an asset based on its actual usage level, as is commonly done with airplane engines that have specific life spans tied to their usage levels.
If, midway through the useful life of an asset, you expect its useful life or the salvage value to change, you should incorporate the alteration into the calculation of depreciation over the remaining life of the asset; do not retrospectively change any depreciation that has already been recorded.
Depreciation Journal Entries
When you record depreciation, it is a debit to the Depreciation Expense account and a credit to the Accumulated Depreciation account. The Accumulated Depreciation account is a contra account, which means that it appears on the balance sheet as a deduction from the original purchase price of an asset.
Once you dispose of an asset, you credit the Fixed Asset account in which the asset was originally recorded, and debit the Accumulated Depreciation account, thereby flushing the asset out of the balance sheet. If an asset was not fully depreciated at the time of its disposal, it will also be necessary to record a loss on the undepreciated portion. This loss will be reduced by any proceeds from sale of the asset.
Other Depreciation Issues
Depreciation has nothing to do with the market value of a fixed asset, which may vary considerably from the net cost of the asset at any given time.
Depreciation is a major issue in the calculation of a company’s cash flows, because it is included in the calculation of net income, but does not involve any cash flow. Thus, a cash flow analysis calls for the inclusion of net income, with an add-back for any depreciation recognized as expense during the period.
Depreciation is not applied to intangible assets. Instead, amortization is used to reduce the carrying amount of these assets. Amortization is almost always calculated using the straight-line method.
Straight Line Method (SLM)
According to the Straight line method, the cost of the asset is written off equally during its useful life. Therefore, an equal amount of depreciation is charged every year throughout the useful life of an asset. After the useful life of the asset, its value becomes nil or equal to its residual value. Thus, this method is also called Fixed Installment Method or Fixed percentage on original cost method.
When the amount of depreciation and the corresponding period are plotted on a graph it results in a straight line. Hence, it is known as the Straight line method (SLM).
This method is more suitable in case of leases and where the useful life and the residual value of the asset can be calculated accurately. However, where the repairs are low in the initial years and increase in subsequent years, this method will increase the charge on profit.
Also, while applying this method, the period of use of the asset should be considered. If an asset is used only for 3 months in a year then depreciation will be charged only for 3 months. However, for the Income Tax purposes, if an asset is used for more than 180 days full years’ depreciation will be charged.
Amount of Depreciation = (Cost of Asset – Net Residual Value) / Useful Life
The rate of Depreciation = (Annual Depreciation x 100) / Cost of Asset
Diminishing Balance Method
According to the Diminishing Balance Method, depreciation is charged at a fixed percentage on the book value of the asset. As the book value reduces every year, it is also known as the Reducing Balance Method or Written-down Value Method.
Since the book value reduces every year, hence the amount of depreciation also reduces every year. Under this method, the value of the asset never reduces to zero.
When the amount of depreciation charged under this method and the corresponding period are plotted on a graph it results in a line moving downwards.
This method is based on the assumption that in the earlier years the cost of repairs to the assets is low and hence more amount of depreciation should be charged. Also, in the later years, the cost of repairs will increase and therefore less amount of depreciation shall be provided. Hence, this method results in an equal burden on the profit every year during the life of the asset.
However, under this method, if the rate of depreciation applied is not appropriate it may happen that at the end of the useful life of the asset full depreciation is not provided.
Also, while applying this method, the period of use of the asset should be considered. If an asset is used only for 2 months in a year then depreciation will be charged only for 2 months.