Under both IFRS (International Financial Reporting Standards) and GAAP (Generally Accepted Accounting Practice), the capital expenditure can not be recognized as an expense when the asset is bought. It is considered as more appropriate to spread the cost of the asset over its useful life. Therefore, Accounting Standards allow companies to depreciate the assets they have bought over their useful life. This tutorial explains what depreciation is, why it is used, what are the depreciation methods that accounting standards allow and what are the journal entries that are posted to account for depreciation.
What is depreciation
Depreciation is used to spread the cost of the asset over its useful life and to account for the fact that assets become obsolete and need to be replaced as time passes. In other words, companies are not allowed to recognize capital expenditure as an expense and instead, they use a (consistent) depreciation method to gradually include this expense in the income statement.
Both IFRS and GAAP only allow two specific depreciation methods which are:
- Straight Line Depreciation and
- Declining (or Reducing) Balance Depreciation
Declining Balance Depreciation Formula
The declining or the reducing balance depreciation method recognizes that a higher cost should be allocated to the first periods and lower costs are recognized as time passes. The formula that is used to calculate the declining balance depreciation is :
For example, let’s assume that a company bought an asset for $10,000 and the accounting policy allows declining balance depreciation of 10% per year. The depreciation that will be recognized is as follows:
First Year: Opening book value * Depreciation Percentage
$10,000 * 10%=$1000 depreciation and closing carrying value of $10,000-$1,000=$9,000
Second Year: Opening Book Value * Percentage or
$9,000 * 10%= $900 depreciation and $8,100 carrying value.
Bear in mind that the scrap value of the asset is ignored when the declining balance method is used.
Straight Line Depreciation Formula
When the straight line method is used, the scrap value should be deducted from the purchase price. Therefore, the straight line depreciation method formula is as follows:
For example, if a company buys an asset for $10,000 and the asset is expected to be used for four years before it will be sold for $2,000, the depreciation will be :
(10,000-2,000)/4=$2,000 per annum.
Depreciation Tax Shield
Tax rules for depreciation are different from the accounting rules. The depreciation tax shield refers to the expense that can be recognized as an allowable tax expense every year. On the other hand, tax rules change and what is allowable or dis-allowable expenditure depends on the asset and its usage. It is considered as more appropriate not to go into tax details in this tutorial but what is important is that the tax refers to the depreciation that is allowed (usually the declining balance is allowed) for tax purposes.
Journal Entry for Depreciation
The journal entries that are posted to account for depreciation are straightforward. The first thing that you should remember is that the cost of an asset that is recorded in the accounting books does not change. Instead, a second account is created which is called accumulated depreciation. The carrying value that is included in the balance sheet is the net result of the cost of the asset and the accumulated depreciation.
Using the first example (the declining balance example), during the first year the following journal entries should be posted:
Debit Depreciation Expense $1,000
Credit Accumulated Depreciation $1,000
The carrying value of the asset will be cost-accumulated depreciation or $9,000.
For the second year, the following entries will be posted:
Debit Depreciation Expense $900
Credit Accumulated Depreciation $900
The carrying value will be $10,000 (cost)-1,900 (accumulated depreciation)=$8,100
Depreciation and Amortization
There are no practical differences between the methods that are used to calculate depreciation and amortization. Amortization is used for all intangible assets (patents, brand names, exclusive contracts etc.) while depreciation is used for tangible assets. It is often hard to estimate the useful life of an intangible asset while some assets (such as goodwill) should not be amortized under IFRS, but should be reviewed for impairment instead.