Accounting Treatment of Depreciation

Depreciation 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.

Accounting Entry
Double entry involved in recoding depreciation may be summarized as follows:

Debit Depreciation Expense (Income Statement)

Credit Accumulated 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 $
Accumulated
2001 333.3 2001 Income Statement 333.3
Depreciation
Accumulated
2002 333.3 2002 Income Statement 333.3
Depreciation
Accumulated
2003 333.4 2003 Income Statement 333.4
Depreciation
1,000 1,000

Accumulated Depreciation Account

Debit $ Credit $
2001 Balance c/d 333.3 2001 Depreciation Expense 333.3
333.3 333.3
2002 Balance b/d 333.3
2002 Balance c/d 666.6 2002 Depreciation Expense 333.3
666.6 666.6
2003 Balance b/d 666.6
2003 Balance c/d 1000 2003 Depreciation Expense 333.4
1000
Depreciation Methods

Cost of a fixed asset must be charged to the income statement in a manner that best reflects the
pattern of economic use of assets.

Types of depreciation
Common methods of depreciation are as follows:

Straight Line Depreciation
Reducing Balance Depreciation
Sum of the Year' Digits Depreciation
Units of Activity Depreciation
Same depreciation is charged over the entire useful life.
Depreciation expense decreases at a constant rateas the
life of an asset progresses.
Depreciation charge declines by a constant amountas the
life of the asset progresses.
Depreciation charge varies each period in proportion to
the change in level of activity.

Impact of using different depreciation methods

The total amount of depreciation charged over an asset's entire useful life (i.e. depreciable
amount) is the same irrespective of the choice of depreciation method. The adoption of a
particular depreciation method does however effect the amount of depreciation expense charged
in each year of an asset's life.

Following diagram illustrates the effect of using different depreciation methods on yearly
depreciation expense:
The above illustration is based on the following information:

Cost of fixed asset $100,000

Residual Value Nil
Useful Life 4 Years
Total Machine hours 20,000 (for calculating depreciation using units of activity method)
Rate of depreciation 40% (for calculating depreciation using reducing balance method)

For calculation and working, you may view the depreciation worksheet.

Following can be deduced from the diagram:

Straight Line Depreciation Results in an equal expense of $25,000 each year.

Depreciation charge is reduced by 40% in each period
Reducing Balance Depreciation (i.e. the rate used in this example) until the last year in
which the entire un-depreciated amount is charged off.
Sum of the Year' Digits
Depreciation expense decreases each year by $10,000.
Depreciation
Depreciation charge varies in line with the change in
Units of Activity Depreciation
number of machine hours consumed each year.

Comparison of Depreciation Methods

Advantages Disadvantages
Straight Line Easy to calculate May not reflect the true pattern of
asset's economic benefits.
Useful where the pattern of economic
benefits are hard to determine with
precision.

Suitable for depreciating assets that

provide similar level of economic
benefits throughout their useful life
(e.g. buildings).
Reducing Balance Appropriate where the usefulness of The rate of depreciation selected is
an asset declines over its useful life subject to bias
(e.g. IT equipment).
Sum of the Year' Easier to understand More difficult to calculate.
Digits
The effect of decrease in depreciation
expense compared to reducing balance
method.
Units of Activity Most accurately reflects the pattern of Difficult to determine and measure a
consumption of economic benefits. reasonable basis of activity

Suitable in case of fixed assets that

depreciate in proportion to units of
activity rather than just the passage of
time.

Straight Line Depreciation Method

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Straight Line Depreciation Methods

Explanation
Straight line depreciation method charges cost evenly throughout the useful
life of a fixed asset.

This depreciation method is 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 the pattern of economic benefits expected to be derived
over an asset's useful life.

Formula
Straight line depreciation can be calculated using any of the following
formulas:

( Cost − Residual Value )

● Depreciation per annum=
Useful Life

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

Where:

●Cost is the initial acquisition or construction costs related to the asset as well as
any subsequent capital 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 is not depreciated because it is expected to be recovered at the end of an asset's useful
life.

●Useful Life is the estimated time period that 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 depreciation is the percentage of useful life that is consumed in a single accounting
period. Rate of depreciation can be calculated as follows:
 1
Rate of depreciation= x 100%
Useful Life

e.g. rate of depreciation of an asset having a useful life of 8 years is

12.5% p.a.

1
x 100%=12.5% per year
8

Tip

Remember to adjust the depreciation expense downwards when an asset has

been acquired or disposed off during the accounting period to avoid charging
depreciation for the time the asset was not available for use. See Example 1

Example 1
A 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.

($2000 − $500)
Depreciation expense per annum shall be:= = $500 p.a.
3 Years
 Depreciation expense for the year ended 30 June 2013:

$500 x 6/12 = $250

As $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

($2000 −
$41.67
Monthly depreciation charge =$500) =
p.m.
36 months
Depreciation expense for year ended 30 June
= $41.67 x 6 =$250
2013
Depreciation expense for year ended 30 June
= $41.67 x 12 =$500
2014

Revision in Estimates of Useful life and Residual Value

The 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

estimates prospectively, i.e. the change in depreciation expense is accounted
for in the period in which the revision takes place and subsequent accounting
periods (see Example 2below).

Following formula can be used to calculate straight line depreciation for the
current and subsequent accounting periods in case of a revision:

( Cost - Revised Residual Value - Accumulated Depreciation)

● Depreciation expense= Revised Remaining Useful Life

Where:

●Accumulated depreciation is the total depreciation that has been charged in previous
accounting periods since the capitalization of the asset.
●Revised remaining useful life is the estimated number of useful years or months of the asset
remaining since the last accounting period in which depreciation was charged.

Tip

Depreciation already charged in prior periods is not revised in case of a

revision in the depreciation charge due to a change in estimates.

Refer IAS 8 for treatment of changes in accounting estimates.

Example 2
A 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 acquisition 10 years
Useful Life revised estimate on 1 January 2013 8 years

Calculate depreciation expense for the years ended 31 December 2011,

2012, 2013 & 2014

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

*Cost

**Residual Value

***Useful Life

2012 Depreciation 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)

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

Delining Balance Depreciation Method

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Declining Balance

Reducing 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:

NBV R.V Rate Depreciation Accumalated Depreciation

Year1: (2000 - 500) x 50% = 750 750
Year2: (1250 - 500) x 50% = 375 1125
Year3: (875 - 500) x 50% = 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.

Units of Production Depreciation Method

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Units of Production

Units of Production Depreciation Method, also known as Units of Activity and

Units of Usage Method of Depreciation, calculates depreciation on the basis
of expected output or usage.

For example, a machine may be depreciated on the basis of output produced

during a period in proportion to its total expected production capacity.
Therefore, useful life of an asset under Units of Production Method is stated in
terms of production output or usage rather than years of service.

Depreciation per annum = (Cost - Residual Value) / Useful Life

The Formula for calculation of depreciation under Units of Production Method

is as follows:

Value of Work Certified as complete

Stage of Completion % = x 100
Total Expected Production or Usage

Where:

 Cost includes the initial and any subsequent capital expenditure.

 Residual Value is the estimated scrap value at the end of the useful life
of the asset. Since 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 asset's
cost equaling the residual value.

Example - Units of Production Depreciation

Oil PLC installs a crude oil processing plant costing $12 million with an
estimated capacity to process 50 million barrels of crude oil during its entire
life. Production during the first year of operation is 2 million barrels. Expected
residual value of the processing plant is $2 million.
Depreciation charge for the first year is calculated as follows:

Depreciation Expense = ($12 - $2m) x 2 / 50 = $0.4 million

Example - Units of Usage (Activity) Depreciation

Plastic LTD purchases a steel mould costing $1 million to be used in the
production of plastic glasses. The mould could be used in 8 production
batches after which it will have a scrap value of $.2 million. During the first
year, the company manufactures 2 batches of glasses.

Depreciation charge for the year is calculated as follows:

Depreciation Expense = ($1 - $0.2m) x 2 / 8 = $0.2 million

Considerations - Advantages and Disadvantages

Units of Production Method may be appropriate where there is a high
correlation between activity of an asset and its physical wear and tear. As no
depreciation under this method is charged when an asset remains idle, it is
not appropriate for depreciating assets that suffer a significant decrease in
their earning potential with the passage of time for reasons such as
technological obsolescence.

Sum of the years' digits | Depreciation Method

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Sum of the years' digits

Definition

Sum of the years' digits depreciation method involves

calculating depreciation based on the sum of the number of years in an
asset's useful life.

Explanation

Sum 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 life

For 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 = 10

Step 2: Calculate the depreciable amount

Depreciable 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 life

Step 3: Calculate the un-depreciated useful life

Un-depreciated useful life is equal to the number of years in the asset's useful
life that have not yet 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 life

Depreciation using the sum of the years' digits method can be calculated
using the following formula:

Un-depreciated useful life

Depreciation (Step 3) Depreciable Amount
= x
Expense Sum of the years' digits (Step (Step 2)
1)

Example
Following information relates to a fixed asset:

Cost $100,000
Residual Value $10,000
Useful Life 3 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 digits

Sum of the years' digits = 3 + 2 + 1 = 6

Step 2: Calculate the depreciable amount

Depreciable amount = $100,000 - $10,000 = $90,000

Step 3: Calculate the un-depreciated useful life

Year 1Year 2Year 3

Un- depreciated useful life (years) 3 2 1

Step 4: Calculate depreciation expense

Year 1: Depreciation expense:

3 (Step 3)
= x $90,000 (Step 2)
6 (Step 1)

= $45,000

Year 2: Depreciation expense:

2 (Step 3)
= x $90,000 (Step 2)
6 (Step 1)

= $30,000
Year 3: Depreciation expense:

1 (Step 3)
= x $90,000 (Step 2)
6 (Step 1)

= $15,000

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).

Where an entity has a policy of calculating depreciation on full years basis,

sum of the years' digits depreciation can be calculated as above. If however,
depreciation is to be calculated on monthly basis, it will usually be necessary
to time apportion the depreciation charge between accounting periods since it
is unusual for the date of acquisition of an asset to coincide with the start of an
accounting period (unfortunately).

Try to apply your knowledge to calculate depreciation under the sum of digits
method for an asset acquired mid-way during an accounting period in the
multiple-choice question below.