What is Depreciation in Accounting? | Types, Uses and Methods of Depreciation

There is no single equipment that does not suffer from wear and tear as time passes. It will not be in line with accounting ethics and completely wrong for accountants not to take the wear and tear suffered by company’s assets at the time of preparing the financial statement.

Tangible Non-Current Assets (NCA) like buildings, machineries, vehicles, fixtures have finite life – meaning that they don’t last forever. Any NCA or fixed asset that is sold less than it was purchased has suffered depreciation.

Contrary to popular opinion amongst traditional business managers, depreciation is not a charge or money set aside to replace an asset. Asset replacement plan is a separate component of assets management process that every successful business has in one form or the other.

Depreciation accounting ensures that the full overhead cost of running a business is captured as companies are not allowed to expense the cost of capital expenditure in one period.

Depreciation is that a proportion of the original cost of purchasing a fixed asset that is charged to the profit and loss every period – usually every year.

Most tax jurisdiction in the world encourages an accelerated depreciation where an assets useful life is consumed faster. We will talk more on this when we discuss capital allowance in the context of tax avoidance through tax planning.

What is depreciation?

Oxford Dictionary of Accounting defines depreciation as “measure of the cost or revalued amount of the economic benefits of a tangible fixed asset that have been consumed during a financial period”

IAS 16 Property, Plants and Equipment (PPE) defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its life.’

This is to say that depreciation is a gradual continuous fall in the value of Non-Current Assets (formerly fixed assets) due to passage of time, wear & tear, advancement in technology and contractual requirements.

IAS 16 also defines useful life as: “

1. The period of time over which an asset is expected to be used by an entity, or
2. The number of production or similar units expected to be obtained from the asset by an entity “

Depreciations are accounting estimates that are prone to errors hence, requires accounting adjustments at period end to normalize things. Accounting standard requires that companies review their depreciation estimated useful life yearly so as to ensure that the estimates still makes economic sense.

The only time one can accurately say what value a fixed asset has lost is during disposal i.e a fixed asset bought for N500,000 and disposed for N210,000 after 3 years has suffered a depreciation of N290,000 for the 3 years it was in use.

What are the constituents in the depreciation formula?

There are three factors that must be determined in order for one to calculate depreciation:

1. Cost
2. Economic life
3. Residual value

What are the causes of depreciation?

Depreciation are caused by the followings:

1. Physical deterioration by way of wear & tear through usage and through the effect of natural occurrences like rust, decay, rot, erosion, etc
2. Economic factors like obsolescence, change in people’s taste, inadequacy, etc
3. Passage of time
4. Changes in regulations
5. Depletion

What is a provision for depreciation?

The fact that most things about depreciation revolves around estimates makes it imperative to make provisions. Remember that provisions are made for events or tasks with some levels of uncertainties about the timing and amount involved.

What are depreciable assets?

Depreciable assets are those assets that can be depreciated with the following features:

• They are acquired primarily for use in production of goods and services
• They have a useful life of more than one year
• They are not part of company’s normal inventories
• They have a limited useful life

What is a depreciable amount?

Depreciable amount or value refers to the cost of an asset or net book value (NBV) of an asset less residual value. NBV simply means cost of an asset less accumulated depreciation. The depreciable amount is usually found in the fixed asset register.

What are the methods of depreciation?

We have many depreciation methods in practice but our focus in this article would be on the few most popular and somewhat generally accepted methods of depreciation. They are

10 methods of depreciation

1. Straight line method of depreciation: under this method as the name implies, this is a very straight method where the cost of an asset less its scrap value is divided by the number of useful lives of the depreciating asset.

• Diminishing or reducing balance method of depreciation: here, a fixed percentage is applied on the NBV. The annual depreciation charges fall every year under this method.

• Sum of the year digit method of depreciation: the idea here is to sum up the digits representing each year throughout the useful life of the asset, then using this figure as a base, apportion the total depreciation by dividing the figure represented by the farthest year with the total sum from summing up the digits, the multiply by the depreciable amount.

• Annuity and sinking fund method of depreciation: these two methods of depreciation are similar. here, an amount representing the asset is regarded as being capable of earning a fixed rate of interest. The forgone interest as a result of investing the said amount in an asset is taken to be the depreciation for the period. This is achieved with help from annuity table.

The only difference between the sinking fund and annuity method of depreciation is that while no interest is added to the original cost of asset under the sinking fund method, interest element is added back to the cost of asset under the annuity method of depreciation

• Replacement method of depreciation: this is an anticipatory style of accounting for depreciation where an estimate of what it will cost to replace the asset of concern is made. This method is used when a company values its asset using replacement valuation method or technique.

The application of the replacement method of depreciation is to add an agreed percentage of the difference between the two figures, then add it to depreciation expense that has been obtained using any other method.

• Revaluation method of depreciation: under the revaluation method, the value of the asset at the beginning of the year is added to the cost of the assets purchased during the year, then deduct the value of the asset at year end. Any figure arrived at is the depreciation for the year. This is best for assets like loose tools.

• Machine-hour method of depreciation:  this is sometimes called the service hour method, the machine-hour system is based on an estimate of the asset’s service potential. Accounting period is not considered under this method of depreciation rather the number of working hours is used as a basis of calculating depreciation.

Proportion of actual number of hours worked to the total potential hours available. This is a common method of depreciation in the airline industry where airplanes are depreciated on the basis of flying time.

• Depletion unit method of depreciation: assets with ‘wasting character’ like mining sites, quarries, oil well, and other natural reserves are depreciated through this means. Accountants simply write off certain amount from these assets and charge same to the profit and loss for the period – the amount is usually provided by expert qualified valuers.

• Amortization method of depreciation: amortization method of depreciation is where the provision for the consumption of asset with legal life such as leases, patents, trademark and copyrights are made. Amortization is suitable for these kinds of assets because they have connection with time horizon.

1. Insurance policy system of depreciation: this method is an extension of sinking fund method of depreciation, but instead of charging this cost to the P&L directly, it is used to pay insurance premium for the asset then posting the cost accordingly to the p&l.

What is Residual value or Salvage value?

Residual or salvage value also known as scrap value is the estimated recoverable amount at the end of the estimated useful life of the asset.

What are the types of depreciation accounting?

There are basically two types of depreciation accounting. One of the types of depreciation accounting has long fallen out of favour. We will nonetheless briefly discuss it here for completeness.

Old method of depreciation accounting (depreciation recorded in asset account): under this old way of depreciation accounting, the amount charged as provision for depreciation is shown on the face of the asset’s accounts. Accounts that must be prepared under this method are:

1. Assets accounts
2. Depreciation accounts
3. Statement of profit and loss (Profit and loss accounts)
4. Statement of financial position (Balance sheet)

The accounting procedure for this old style of depreciation accounting are as follows:

1. Debit the asset account with the cost of the asset
2. Credit the assets account with depreciation amount charged
3. Debit the depreciation account with depreciation charge
4. Debit the P&L with depreciation charge
5. Credit the depreciation account with depreciation charge

Newer method of depreciation accounting (depreciation recorded in provision for depreciation account): the more recent method of depreciation is a system that creates a separate depreciation account. This style of accounting for depreciation is more transparent and revealing. Hence, the reason why organizations abandoned the old method for it.

The following accounts must be prepared in this newer way:

• Asset account
• Provision for depreciation account
• Profit and Loss Account
• Balance sheet effect or extract

What is the usefulness and uses of depreciation?

• Proper cost allocation
• Complying with matching concept in accounting
• Eliminates the effects of one-off payment on a period

Myths and misconceptions about depreciation

The following are some myths about depreciation:

1. Depreciations are accurate – No, they are not, they simply estimates
2. Depreciations are charged to replace asset – NO, they are not, they are charged to truly and fairly represent economic activities

Appreciation in value of asset

You may be wondering about what happens when our assets gains value. Well, the fact that accountants are pessimistic by nature dictates that accountants do nothing to record the effects of appreciation in value of an asset. Historical concept and prudence forbid us from thinking positively as accountants. Lol I hope have been able to answer most of your questions relating to what is depreciation in accounting?

If by chance I manage to skip any aspect of your question regarding this topic please do not hesitate to contact me either through the contact form on the contact page or through email at the footer of this page.