Accounting Depreciation Methods – Step-by-Step Guide

Under both IFRS and GAAP, capital expenditure cannot be recognised as an expense when an asset is bought. But instead, this expenditure is spread over the cost of an asset’s 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, the accounting depreciation methods that standards allow, and the posted journal entries to account for depreciation.

What is Depreciation?

Depreciation is used to spread the asset’s cost over its useful life and to account for assets becoming obsolete and needing to be replaced as time passes. In other words, companies are not allowed to recognise capital expenditure as an expense. Instead, they use a (consistent) depreciation method to include this expense in the income statement gradually.

Depreciation Methods

Both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (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 recognises that a higher cost should be allocated to the first periods, and lower costs are recognised as time passes. The formula that is used to calculate the declining balance depreciation is :

Depreciation = Percentage * Opening Book Value

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 recognised is as follows:

First Year: Opening book value * Depreciation Percentage

Or

$10,000 * 10% = $1000

So the closing closing carrying value would be: $10,000 – $1,000 = $9,000. And in the second year of depreciation, we would do the same calculation, but this time with the new opening book value, $9,000. So the calculation would be:

$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, you should deduct the scrap value from the purchase price. Therefore, the straight-line depreciation method formula is as follows:

Depreciation = (Purchase Price – Scrap Value) / Useful Life

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 sell it 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 recognised as an allowable tax expense every year. On the other hand, tax rules change, and what is allowable or disallowable expenditure depends on the asset and its usage. It is considered more appropriate not to go into tax details in this tutorial. What is essential is that the tax refers to the depreciation 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. You should remember that the cost of an asset recorded in the accounting books does not change. Instead, a second account is created, which is called accumulated depreciation. The carrying value included in the balance sheet is the net result of the asset’s cost and the accumulated depreciation.

Using the first example (the declining balance example), during the first year, you should post the following journal entries:

The carrying value of the asset will be cost-accumulated depreciation or $9,000. For the second year, you will post the following entries:

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 amortisation. Amortisation 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 amortised under IFRS but should be reviewed for impairment instead.