What is Depreciation?

Accounting Dictionary > What is Depreciation

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-> Accounting for Depreciation

1. Definitions of Depreciation

•  Depreciation is loss in value of an Asset over time.

•  Depreciation is the monetary or economic value of an asset that is charged against Revenue (ie. expensed) over its expected Useful Economic Life (UEL).

Note: Accounting Depreciation is subjective - it's calculation is based on estimates and assumptions rather than fact. No surprise then, that for Taxable Profit Calculation purposes it is usually replaced with a standardised allowance.

what is depreciationFeeling Depreciated: A dilapidated Zombie faces total write off as it nears the end of its Useful Economic Life (well, Death).

2. Which Assets Get Depreciated?

Depreciation applies to certain Fixed Assets - in particular 'Tangibles' (Buildings, Vehicles, Equipment, Computers, Machinery, Furniture, Zombies etc ). An exception is Land, where the assumption is value will increase.

• Note: the term 'depreciation' can also be used to refer to Foreign Currency assets - where one currency has devalued against another. This is NOT accounted for using a depreciation charge, rather through a one-off periodic adjustment.

3. Why Depreciate Assets?

There are a number of reasons:

1. An asset can be defined as something holding economic value or benefit that is expected to be released in future periods. Those future periods will benefit from that value - eg. through revenue generation, production etc.

  • Charging depreciation adheres to the Fundamental Accounting Principle of matching by recognising and aligning economic benefit with associated cost - regardless of any physical movement of cash. The Depreciation charge represents that cost.

2. Most Tangible Fixed Assets lose value over time - usually from either physical wear and tear or obsolesence from technological advance .

  • The depreciation charge relects that loss in value.

3. These assets will eventually need replacing. Charging depreciation enables the retention of Cash within the business and adherence to the principle of Capital Maintenance:

  • Depreciation represents a Cash Fund being set aside for asset replacement

Although the Depreciation charge itself is not cash, because it reduces profit it reduces the cash that can be paid out as dividends. Over the Useful Economic Life (UEL) of the asset the total of that retained Cash must equal the value 'lost'.

4. Calculating Depreciation

The TOTAL depreciation charged for an asset will always be the same:

Total Depreciation = Cost of Asset  - Residual Value

Cost = Purchase price

Residual Value (RV) = Value at the end of its estimated Useful Economic Life  (aka Scrap or Salvage value). This is often Zero.

eg.  Cost = £10k, RV = £2k,  so Total Depreciation = £8k

Useful Economic Life (UEL) = length of time the asset is expected to be held to generate value.

What can vary is the depreciation charged to each accounting period (the depreciation profile) within an asset's UEL...

5. Depreciation Methods

A number of methods can be used to calculate the depreciation profile.

The approach adopted should be the one that best reflects or matches the value being generated by the asset (ie. to present true and fair).

There are 2 main approaches:

    1. Straight-Line Depreciation:   this assumes even run-down, the same anount being charged to each period:

eg. in above example:  Total Charge = £8k   UEL = 5 Years  Charge = £1.6k to each of Periods 1-5

This method best suits assets like IT equipment, furniture.

  2. Front-loaded Depreciation:  this assumes greatest reduction in value occurs early on in the asset's life. There are a number of methods (eg. 'sum of digits', ' reducing balance'), but we will not go in to the detail here (we need to keep you awake!).

This method best suits assets like vehicles where there is a significant value reduction early on.

6. Accounting for Depreciation: Double Entry

-> Worked Example of Double Entry Accounting

The accounting entries for depreciation are straight forward - a single entry reducing asset value and charging an expense - posted in the General Ledger:

Debit (Dr.):      Depreciation Charge - Asset X (Profit and Loss)

   Credit (Cr.):       Accumulated Depreciation - Asset X (Balance Sheet)

Note:  the entries have NO IMPACT ON ASSET COST. Depreciation is accumulated within a separate Balance Sheet Ledger Account that is tied to the Asset Cost Account. When reporting these two accounts are presented in sequence to arrive at a 'Net Value' - the NET BOOK VALUE of the asset.

7. Depreciation: Accounting Source and Timing

Timing: Accounting entries for Depreciation charges will be posted to the General Ledger monthly as part of the Financial Month End closing processes.

Accounting Source: depending on the systems the Accounting Entries will be posted either manually via a Manual General Ledger Journal  (off the back of a spreadsheet, database or standalone system) or systemmatically via an interface with an integrated Fixed Asset Register or Module.

Click here for a simple worked example of Accounting for Depreciation

8. Depreciation and Reporting

Because of the subjective nature of depreciation charges, an organisations Published Financial Accounts must list out depreciation rates, methods and Useful Economic Life for each Fixed Asset class.

9. Depreciation and Tax

As has been seen, in any one period the Accounting Depreciation charge is subjective - it being based on a variety of assumptions rather than objective fact - and can therefore vary for equivalent assets across different organisations.

The tax man is very aware of this! Therefore, for tax calculation purposes, the Depreciation charge in the Financial Accounts is usually ignored and replaced with a prescribed standardised 'depreciation allowance' (eg. 'Capital Allowance').

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