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Comprehensive overview of Depreciation

Depreciation by definition: “Depreciation is a systematic way to charge cost of fixed assets in profit & loss statement over the useful life of the asset”.

Key Features of depreciation:

Following features will help you understand and grasp the concept:

  • Depreciation is an unavoidable instance and it happens gradually with passage of time for every tangible non-current asset

  • Wear & tear of the asset with passage of time is NOT depreciation.

  • The total value of depreciation over the life of the asset should be matching with total cost of the asset. Let’s say an asset has a cost of $100,000 and has a useful life of 5
    the total depreciation over the life of the asset should be same as $100,000 (i.e., $20,000 per year in case of a straight line depreciation)

  • Repair & maintenance expenses incurred on the asset are NOT depreciation.

  • Depreciation is a term which should be used strictly for fixed (or non-current) tangible assets.For intangible assets, the alternative word for depreciation is ‘amortization’.
    Amortization has exactly same features as depreciation, except the fact that the word amortization is used for intangible assets.

Impairment and depreciation are the two different accounting concepts. However, sometimes the words are used as synonyms, which is not correct. It is very important to understand the
difference between two and use right words for the right situation. To understand the impairment and its key features, read our article on impairment of assets.

Accounting treatment:

This area is dealt by IFRS in IAS 16 “Property, Plant & Equipment” and also in IAS 40, “Investment Property”. Depreciation cost is booked as an expense on the debit side and the
credit goes to a reserve of depreciation account. It is important to realize that there is no credit entry in asset account for the depreciation charge. This is because depreciation is an
invisible concept which happens with the passage of time and there is no physical reduction in asset’s quantity or volume.

Therefore, expense is debited in the ‘depreciation expense’ account and credit entry is booked in a reserve created to accumulate the depreciation expense. This account is usually referred to as ‘accumulated depreciation account’ or ‘provision for depreciation account’.

Let’s pass entry for an asset which costed $ 60,000 and has a depreciation charge of $ 20,000 for 3 years.

Below are the accounting entries to be passed:

The accumulated depreciation account offsets the asset account in the balance sheet. In the above example, the balance sheet value in the first year shall appear as $ 40,000 (instead of
$60,000 as available in the asset account). This is because asset account of $60,000 shall be netted-off against $20,000 of accumulated depreciation account, resulting in net figure of
$40,000 on the face of statement of financial position (balance sheet).

Standard rates of depreciation of different types of assets:

For example, if a fixed asset (say a motor vehicle) is purchased at a price of $1,000 and it has a useful life of 5 years, then the annual depreciation will be $200 (using straight
line depreciation method).
So what should be the rate of depreciation of a particular asset? It should be 10% or 20% or 50% in a year? It all depends upon the useful life of the asset. An asset should be
depreciated over its useful life in a manner which depicts usability of the asset. Let’s say that a non-current asset has a useful life of 5 years, the applicable rate of depreciation
will be 20%. Below table provides standard rates for depreciation for different type of assets, however, it is upto the company’s management to decide the useful life of the asset.

Type of assets Estimated useful life Depreciation rate (per annum)
Land Infinite N/A
Building 25 years 4%
Machines 10 years 10%
Furniture & fixtures 5 years 20%
Motor vehicles 4 years 25%
Computers and mobiles 3 years 33%

Useful life of an asset can be assessed by one or more of the following techniques:

i)     Product description and warranty period as provided by the supplier

ii)     Past experience of the useful life of similar assets

iii)     Expert advice related to that specific machinery (e.g., An engineer can advise how long a particular machine be used)

iv)     Other companies’ financial statements having similar fixed assets

Calculation of depreciation:There are two most popular methods for calculating depreciation of fixed assets.

i)     Straight line method of depreciation:

In this method, same amount of depreciation is charged in each year of the useful life of the asset. Let’s say that a machine has costed $ 100,000 and shall be used for production of
1,000 units of a product over it’s useful life of 5 years. The machine shall be disposed-off after 5 years.

As the production of units remains consist over 5 years and there is no decrease or increase in the usability of the machine with passage of time. Therefore, it is suitable to charge same
amount of depreciation expense i.e., $20,000 every year in all 5 years.

ii)     Reducing balance method of depreciation:

Let’s take an example of an asset that is used for 5 years but is most productive during initial years andits usability would decrease in subsequent years.In this case, depreciation charge
should be higher in the initial years and should decrease gradually in subsequent years. This example fits for car rental business. New cars can be rented out at higher premiums while old
cars would not attract much customers. Therefore, the most suitable methods in this scenarios would be a reducing balance depreciation method.

Tax treatment of depreciation expense In most of the tax jurisdictions, depreciation will be treated as inadmissible expenses because it is a non-cash expenses. Further, it
is based on several assumptions and may be subject to revision from time to time (i.e., in case of revaluation of assets). Therefore, most of the tax regimes provide their own ‘tax
depreciation schedule’ which is replaced with accounting amounts of depreciation.

ConclusionDepreciation is a key accounting concept which is often misunderstood towards wear & tear of the assets. It is imperative to comprehend the concept and understand
it’s logic. Further, it is a judgmental item and may affect the profitability of a company in short term. Overall impact, however, remains Nil.