The accounting for depreciation provides a number of challenges for the accounting student. These include the available methods, ensuring calculations are correct, and dealing with journal entries concerning the expensing of depreciation and the impact upon non-current (or fixed) assets.
We welcome your feedback and questions, as with all of our accounting tutorials, so please get in touch.
Definition of Depreciation
This is where I see so many accounting textbooks and websites get this wrong. Depreciation is NOT a measure to reflect:
- a fall in asset value;
- an apportionment of the cost of the asset purchase across some predetermined period of time; nor
- the matching of the revenue if generates to it being “expensed” each year.
The approach to depreciation nowadays doesn’t have anything to do with reflecting correct asset values, expensing of assets, or matching expenses and revenues.
So we know what depreciation isn’t, so what is it? For that, we turn to the International Financial Reporting Standards (IFRS) Conceptual Framework. The framework defines depreciation as an expense that reflects the consumption of economic benefits that the reporting entity controls from the respective asset.
Now we know what depreciation is, let us move onto the numbers and the two standard methods used in accounting for depreciation.
Methods of Calculating Depreciation
You will have to learn two methods of calculating depreciation, but not to worry about them as they are pretty straightforward.
The straight-line method writes off a fixed percentage of the asset purchase cost each year. For example, if the consumption of economic benefits from an asset is expected to last five years, you would expense 20 per cent of the asset cost in each of those five years.
This is also referred to as the economic life of the asset. Often “economic benefits” and “economic life” are used interchangeably. Although, of course, the former is referring to the monetary value being gained from an asset. At the same time, the latter is referring to a period of time. It’s a cute difference, but important.
Of course, different classes or types of non-current assets are depreciated, reflecting the different rates at which economic benefits flow to the reporting entity controlling them. This control point is an important, quick sideline to mention. Under the IFRS conceptual framework we mentioned earlier, the focus is not on what a reporting entity owns per se but rather what it can control. In particular, the control of the economic benefits from an asset. We touch on this in our article dealing with non-current assets.
But moving on. Straight-line depreciation is calculated by:
(cost of the asset – estimated disposal proceeds) / years of economic life
For example. Let’s say ABC Ltd acquired a new digger:
- purchase cost $850,000
- economic life of 5 years (an equivalent 20 per cent rate)
- estimated disposal value $150,000
(850,000 – 150,000) / 5 years = 140,000 per year
Reducing Balance Method
Like the straight-line methods, a set percentage of economic benefits is expensed each year. However, unlike the straight-line methods, and as the name suggests, this percentage is taken from the reduced balance from the year before.
This method is also often referred to as the diminishing balance method.
So let’s take the example we used above for ABC Ltd. We will depreciate the new digger at 33 per cent over five years but using the reducing balance.
|Year 1||Depreciation Expense||280,500|
|New Closing Value Year 1||569,500|
|Year 2||Depreciation Expense||187,935|
|New Closing Value Year 2||381,565|
|Year 3||Depreciation Expense||125,916|
|New Closing Value Year 3||255,649|
|Year 4||Depreciation Expense||84,364|
|New Closing Value Year 4||171,285|
|Year 5||Depreciation Expense||56,524|
|New Closing Value Year 5||114,761|
From a quick review, one can see that the depreciation expense is lower under the straight-line method compared to the reducing balance method in the early years. But as the asset’s economic life progresses, the depreciation expense is greater in the later years. For example in the last year, year 5, the straight-line method expenses $83,476 more ($140,000 – $56,524 = $83,476).
Comparison of the Two Depreciation Methods
So let us quickly compare the two methods and when one might be more suitable than the other (of course, when dealing with tax depreciation schedules, there is generally little to no flexibility in the method or rates applied).
|Straight-Line Method||Reducing Balance Method|
|Amount of Depreciation||The same dollar value is expensed each year.||We claimed a higher amount of depreciation in the earlier years and a lower amount in the latter years.|
|Depreciation Percentage||A lower depreciation rate is required to achieve the same residual value.||A higher level of depreciation is required to achieve the same residual value. Unlike the straight-line method, we cannot accomplish a nil residual value.|
|Suitability||For those non-current assets that have a relatively even spread on the consumption of their economic benefits—for example, office equipment and fixtures and fittings.||For those non-current assets that have a higher consumption of economic benefits earlier in their useful life. For example, vehicles and heavy machinery.|
Accounting Journal Entries for Depreciation
Now that we have a good grounding in the theory behind the accounting for depreciation of non-current assets, it’s time to look at the journal entries involved. If we use ABC Ltd’s machinery purchase mentioned above, we can work through initially the journal entries and then, in the next section, work through the financial statement disclosures.
The first entry below is for the initial recording of the asset purchase. In this case, ABC paid cash for the purchase of $850,000 on April 1, year X1.
|April 1||Plant Machinery||850,000|
In using the accumulated depreciation account, which we’ll get to next, the asset account is not touched with depreciation entries. It is much cleaner to operate these entries through the contra account, and so the asset account is kept clear of these.
Conveniently the machinery was purchased on April 1, the beginning of ABC’s financial year. We will be using straight-line depreciation at 20 per cent per annum for this exercise and assume a residual balance of the digger of $150,000.
So as we did above, we would do the following calculation:
($850,000 – $150,000) = $700,000 X 20% = $140,000 depreciation pa
At the end of the year, X1 ABC’s accounting team would post the following entry:
|March 31||Machinery Depreciation||140,000|
|Machinery Accumulated Depreciation||140,000|
The debit creates the depreciation expense for the year, which we will see in the statement of financial performance (also called the income statement or profit and loss statement). At the same time, the credit increases the asset contra account of accumulated depreciation, which will flow through to the balance sheet (statement of financial position).
Before we move on to look at the disclosure side of things, it’s worth a quick detour to fixed asset registers and why they can be helpful.
Fixed Asset (Non-Current) Registers
We will probably get round to a separate accounting tutorial on this, but in the meantime, it is worth a few words on this. From our example above, maintaining track of depreciation and the accumulated balance each year would be pretty straightforward with one fixed asset. However, one can easily imagine that as the number of assets increases, this tracking becomes more difficult.
So what businesses can operate is a fixed asset register. This takes a lot of the detail out of the general ledger system and enables the accounting to deal with individual assets rather than grouping them. For example, the individual detail in the above journal entry would be kept in the register instead of operating a separate depreciation and accumulated account for each machine in the general ledger. This could mean the business may operate just one account for the expense and contra account, or perhaps each for each class of non-current assets.
Ok, onto the financial disclosures and the accounting for depreciation.
Accounting for Depreciation Financial Statement Disclosures
Accounting Depreciation Policies
Not the place most people think to start, but we wanted to highlight this part as it is often overlooked. When you read a set of financial statements, the attached accounting policies form part of the accounts. One of the policies will be how the reporting entity treats depreciation. It will generally set out the method (straight-line, reducing balance), the percentage rate, estimated useful life assessments and whether depreciation is applied for a whole or partial year. For example, if an asset is purchased part-way through a year, does the business apportion depreciation or apply for it for a full period?
As an example, below is an example from one of my client’s tax accounts. It is a simple policy but provides the reader with enough information about how depreciation is treated in the accounts.
Whereas, if you go to a company like Air New Zealand, you will see a more detailed policy as they have a more complex operation to account for. Below is an extract from their 2020 annual accounts as an example.
Statement of Financial Performance
The income statement (or statement of financial performance) reflects the annual depreciation expense – i.e. it picks up the debit of the journal entry we produced above. Below is an extract from year X1 for ABC Ltd. In our case with using the straight-line method, the depreciation expense is the same each year for the machinery.
Suppose ABC had more classes of fixed assets, then a depreciation sub-line could be provided for each. But in our case, there is only one.
Statement of Financial Position
We now move onto the balance sheet. The extract below from ABC’s 31 March X1 accounts shows the accumulated depreciation to date, picking up the credit from our journal entry each year.
As this is year one of having the machinery in the accounts, the figure, of course, is the same as that on the income statement (as shown above). But over the next five years of accounts, the accumulated figure would, of course, grow. So by the end of year five, assuming no changes in accounting policy, the accumulated depreciation figure would be $700,000. And so providing us with a net book value of $150,000, which, as you remember, is the estimated residual figure we used in calculating our depreciation per annum to apply.
The last point we want to cover with you is the fact depreciation is a non-cash expense. Unless a business is operating a cash basis accounting system, under an accrual system, we account for the movement of cash and non-cash transactions alike. Remember, our purpose under an accrual system is to track the movement of economic benefits – whatever form they take.
Recording depreciation in the income statement provides the readers with a better picture of the firm’s economic profits or losses – just not its inflow and outflow of cash (which are covered in the statement of cash flows).
Before we conclude this article, we wanted to mention a couple of other articles we have written that also deal with depreciation. The first article looks at why the accumulated depreciation account is a permanent account on the general ledger – rather than being closed out each year. And the second provides some more step-by-step guidance in working through depreciation examples.
So we have learnt that the accounting for depreciation reflects the consumption of economic benefits that a firm can control from assets. And that under today’s conceptual frameworks, assets are just bundles of economic benefits that a firm can control (in accounting, control is more important than legal ownership).
We then looked at the straight-line versus reducing balance depreciation methods and when we may wish to use one rather than the other, and the effect of this on our financial statements.
And finally, we covered an example with a simple straight-line depreciation calculation for some machinery and how this would look in a firm’s set of accounts.
We trust this article has helped you better understand depreciation and how it is applied in an accrual accounting system.