Depreciation

In accountancy, depreciation refers to the reduction in the value of a tangible asset and the systematic allocation of the cost of that asset over the periods in which it is used. Thus, depreciation has two related aspects.

The first aspect is the actual reduction in the fair value of an asset. For example, factory equipment may lose value every year because it is continuously used and experiences wear. The second aspect is the allocation of the original cost of an asset to the accounting periods in which the asset is used. This allocation is based on the matching principle of accounting.

Therefore, depreciation represents both the decrease in the value of an asset and the accounting method used to write down or allocate the cost of a tangible asset over its useful life. Equipment and other long-term tangible assets are examples of assets whose costs may be depreciated.

Businesses depreciate long-term assets for both accounting and taxation purposes. The reduction in the value of an asset affects the Balance Sheet, while the method used to calculate depreciation affects net income and the Income Statement.

Generally, the cost of a depreciable asset is allocated as depreciation expense among the accounting periods in which the asset is expected to be used.

Accounting Concept of Depreciation

For determining the net income or profit from a business activity, the receipts or revenues from the activity must be reduced by the appropriate costs relating to that activity.

One such cost is the cost of assets that are used in business operations but are not immediately consumed. A long-term asset may provide benefits to the business for several accounting periods. Therefore, its entire cost should not necessarily be treated as an expense in the period in which the asset is purchased.

The cost allocated to a particular accounting period represents the portion of the asset’s cost associated with its use during that period. Initially, the value placed on an asset may be equal to the amount paid to acquire the asset. Subsequently, the accounting value of the asset may or may not be directly related to the amount expected to be received when the asset is finally disposed of.

Depreciation is a method of allocating the net cost of an asset to the accounting periods in which the organisation is expected to obtain benefits from the use of that asset. In simple terms, depreciation is the process of deducting or allocating the cost of an asset over its useful life.

Assets may be classified into different classes, and each class may have a different useful life. An asset whose cost is allocated through depreciation is known as a depreciable asset.

It is important to understand that depreciation is technically a method of cost allocation and not a method of valuation. However, the depreciation recorded by an entity affects the carrying value of the asset presented in the Balance Sheet.

Depreciation and Future Economic Benefits

Any business or income-producing activity that uses tangible assets may incur costs relating to those assets. If an asset is expected to provide economic benefits in future accounting periods, part of its cost should be deferred rather than immediately recognised as a current expense.

The deferred cost is allocated to future accounting periods according to the use of the asset. During each accounting period, the business records a portion of the asset’s cost as depreciation expense.

The depreciation expense recognised in a particular accounting period represents the current period’s allocation of the cost of the asset.

The allocation of depreciation is generally carried out in a rational and systematic manner. This means that the cost of the asset should be distributed over its useful life using an appropriate and consistent method.

Factors Required for Calculation of Depreciation

The calculation and allocation of depreciation generally involves four important factors:

1. Cost of the asset
2. Expected salvage value or residual value
3. Estimated useful life of the asset
4. Method of apportioning the cost over the useful life

The cost of the asset represents the amount associated with acquiring and bringing the asset into use.

The salvage value or residual value represents the expected value of the asset at the end of its useful life.

The estimated useful life represents the period during which the asset is expected to provide benefits to the business.

The method of apportioning cost determines how the depreciable cost of the asset will be allocated over its estimated useful life.

These four factors provide the basic framework for determining depreciation expense.

Depreciable Basis

The depreciable basis is based on the cost of the asset that is to be allocated over its useful life.

The cost of an asset generally includes the amount paid to acquire the asset together with all costs relating to the acquisition of the asset and bringing it into use.

Therefore, the cost of an asset is not necessarily limited to its purchase price. Costs directly associated with acquiring the asset and making it ready for use may also form part of its total cost.

In some countries or for certain accounting purposes, the salvage value may be ignored while determining depreciation.

The accounting or tax rules of certain countries may prescribe the useful life and depreciation method to be used for specific types of assets.

However, in most countries, the useful life of an asset is determined on the basis of business experience. The entity may also select an appropriate depreciation method from the various acceptable methods available.

Impairment of Assets

Accounting rules may require the recognition of an impairment charge or impairment expense when the value of an asset declines unexpectedly.

An impairment differs from the normal systematic allocation of cost through depreciation. Impairment generally arises because of an unexpected decline in the value or recoverability of an asset.

Impairment charges are generally non-recurring and may relate to any type of asset.

Companies may consider writing off part of the value of long-lived assets when certain property, plant, and equipment suffer partial obsolescence. In such circumstances, accountants reduce the carrying amount of the asset.

For example, a company may continue to incur losses relating to a particular product or service. In such circumstances, the company may consider writing down the value of the asset associated with that activity.

Such write-downs are referred to as impairments.

Events and Circumstances Indicating Impairment

Certain events or changes in circumstances may indicate that an asset has become impaired. These may include:

• A significant decrease in the fair value of an asset.
• A change in the manner in which the asset is used.
• An accumulation of costs that were not originally expected in acquiring or constructing the asset.
• A projection of future losses associated with the particular asset.

Such events or circumstances may indicate that the company will not be able to recover the carrying amount of the asset.

Recoverability Test for Impairment

When events or changes in circumstances indicate possible impairment, the company may use a recoverability test to determine whether the asset is impaired.

The first step is to estimate the future cash flows expected from the asset. These cash flows include the expected cash flows from the use of the asset until its final disposal.

The estimated future cash flows are then compared with the carrying amount of the asset.

If the sum of expected future cash flows is less than the carrying amount of the asset, the asset is considered impaired.

Therefore, the recoverability test evaluates whether the expected future benefits from an asset are sufficient to recover its recorded carrying amount.

Depreciation, Depletion and Amortization

Depreciation, depletion, and amortization are similar accounting concepts, but they generally apply to different types of assets.

Depreciation relates to the allocation of the cost of tangible assets over their useful lives.

Depletion is a similar concept applied to natural resources, including resources such as oil.

Amortization is a similar concept applied to intangible assets.

Therefore, the nature of the asset determines whether the allocation of cost is generally described as depreciation, depletion, or amortization.

Effect of Depreciation on Cash

Depreciation expense does not require a current cash payment or cash outflow. It is an accounting expense representing the allocation of the cost of an asset to a particular accounting period.

Although depreciation is charged as an expense to the Profit and Loss Account, the recording of depreciation itself does not involve the payment of cash during the current period.

Therefore, depreciation is described as a non-cash expense.

If an enterprise is operating in a manner that covers its expenses, such as operating at a profit, depreciation is not considered a direct source of cash. Instead, because it is a non-cash expense, depreciation is added back in the Statement of Cash Flows while reconciling net income with cash generated from operating activities.

Thus, depreciation reduces accounting profit but does not directly result in a current cash outflow.

Accumulated Depreciation

Accumulated depreciation represents the total depreciation recorded on an asset over time.

Depreciation expense is recorded in the Income Statement of a business. However, the accumulated impact of depreciation is generally recorded in a separate account and disclosed in the Balance Sheet under fixed assets.

The account used to record the accumulated depreciation is known as the Accumulated Depreciation Account.

Accumulated depreciation is a contra-account. A contra-account shows a negative amount that is directly associated with another account. In this case, accumulated depreciation is directly associated with the relevant fixed asset.

The accumulated depreciation account reduces the carrying value of the related asset in the Balance Sheet.

Recording Depreciation against Assets

Depreciation expense may be charged directly against the relevant asset. In such a case, the value of fixed assets shown in the Balance Sheet declines as depreciation is recorded.

The value of fixed assets may therefore decrease even when the business has not purchased new assets or disposed of existing assets.

Theoretically, the reduced accounting value of the assets may approximately reflect their fair value.

Alternatively, depreciation expense may be charged against the Accumulated Depreciation Account.

Showing accumulated depreciation separately in the Balance Sheet helps preserve the historical cost of the asset. The original cost of the asset remains separately identifiable, while accumulated depreciation shows the total amount of cost allocated as depreciation.

If there are no investments in or disposals of fixed assets during the year, the historical cost of the assets may remain the same in the Balance Sheets of the current year and previous year. The change in the carrying amount of the assets is reflected through accumulated depreciation.

Difference between Depreciation and Impairment

Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It is normally recorded periodically because the asset is expected to provide benefits over several accounting periods.

Impairment, on the other hand, arises when the value or recoverability of an asset declines unexpectedly. An impairment charge is generally non-recurring and results from particular events or changes in circumstances.

Thus, depreciation is a planned and systematic allocation of cost, whereas impairment relates to an unexpected decline in the recoverable value of an asset.

Exam Focus

Depreciation is the systematic allocation of the cost of a tangible asset over its useful life and also reflects the decrease in the value of the asset. It is based on the matching principle, under which the cost of an asset is allocated to the periods benefiting from its use.

Depreciation is technically a method of allocation and not a method of valuation. The four important factors in determining depreciation are the cost of the asset, residual or salvage value, estimated useful life, and method of allocating cost over the useful life.

The cost of an asset generally includes the purchase amount and all costs associated with acquiring and bringing the asset into use.

An asset is considered impaired when the sum of expected future cash flows is less than its carrying amount. Depreciation applies to tangible assets, depletion applies to natural resources, and amortization applies to intangible assets.

Depreciation is a non-cash expense. It reduces accounting profit but does not require a current cash outflow. Therefore, it is generally added back in the Statement of Cash Flows while reconciling net income with cash from operating activities.

Accumulated depreciation is a contra-account associated with fixed assets. Separate presentation of accumulated depreciation helps preserve the historical cost of assets in the Balance Sheet while showing the cumulative depreciation recorded against them.