Depreciation – learn how to use and ‘appreciate’ it ….

Introduction

At year-end, company balance sheets should try to show the value of the ‘big ticket’ items i.e. the fixed assets at a prices which represents their value if they were to be sold on to another company  e.g. land, buildings, vehicles etc.

The current values of the fixed assets shown on the balance sheet should therefore reflect two issues:

1. Wear and tear of the asset due to use (and its loss in value)
2. Any increase in the asset over time – e.g. share price of stocks and shares or land and buildings increase or change in value of intellectual capital (trademarks etc.)

The first issue is covered by depreciation.
The second item is covered by appreciation.

Depreciation is a term used in accounting, economics and finance with reference to the fact that assets with finite lives lose value over time. (see full explanation below)

There are two main techniques to calculate depreciation in the accounts of a business – straight line and reducing balance method

(note: some sectors e.g. forestry, mining activities use different methods)

Straight-line Method of Depreciation:

Annual depreciation expense = Cost of Fixed Asset – residual value (scrap)
Useful life of the asset (in years)

For example, a vehicle that depreciates over 5 years, is purchased at a cost of £17,000, and you think it may have a final (residual or scrap) value of £2000, will depreciate at £3,000 per year: (£17,000 − £2,000)/ 5 years = £3,000. This is called an annual straight-line depreciation expense.

In other words, it is the depreciable cost of the asset divided by the number of years of its useful life.

The table below illustrates the straight-line method of depreciation. Book value at the beginning of the first year of depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated depreciation.

Book value = original cost − accumulated depreciation

Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals scrap value.

 Book value at beginning of year Depreciation expense Accumulated depreciation Book value at end of year £17,000 (original cost) £3,000 £3,000 £14,000 £14,000 £3,000 £6,000 £11,000 £11,000 £3,000 £9,000 £8,000 £8,000 £3,000 £12,000 £5,000 £5,000 £3,000 £15,000 £2,000 (scrap value)

Key points

1. The depreciation expense (column 2) is charged as a business expense in the Profit and Loss account for that year and that reduces the profits for that period (£3,000 each year).
2. This represents an expense which does not result in cash flowing out of the business.
3. The balance sheet for the year the expense was charged should show the assets value (as indicated in column 4)
4. The original purpose for charging depreciation was to automatically put aside some cash each year (from current operations) to build up a sufficient cash fund to be able to go out and automatically purchase a new asset to replace the old/scrapped one. In the above example £15,000 plus the scrap value means £17,000 would be available to spend (i.e. to smoothly maintain continuity of operations).

If the vehicle is sold and the sales price exceeded the depreciated value (net book value) then the excess would be considered a gain and subject to an entry in the P/L account profit on disposal of the asset (and a tax will be paid).

Reducing balance method

This method of depreciation method enables the company to provide for a higher depreciation charge in the first year of an asset’s life, with gradually decreasing charges in subsequent years.

This may be a more realistic reflection of an asset’s actual expected benefit from the use of the asset: many assets are most useful when they are new. Cars and IT equipment are good examples as new models and better specification are constantly being introduced.

Under this method the book value at the beginning of each year is multiplied by a suitable depreciation rate e.g. 20%, 30%, 40% etc. or based on industry/sector rates).

Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year

First, select a suitable depreciation rate. If the industry sector uses 40% for the class of asset being depreciated, the table below illustrates the charges that will be made.

 Book value at beginning of year Depreciation rate Depreciation expense Accumulated depreciation Book value at end of year £1,000 (original cost) 40% £400 £400 £600 £600 40% £240 £640 £360 £360 40% £144 £784 £216 £216 40% £86.40 £870.40 £129.60 £129.60 40% £52 £900 £78

Key Points.

1. It is possible to continue to use the asset after its usual 5 year life and the asset can continue to decline in value but will never equal zero (as in the other technique).
2. This method recognises that a new asset e.g. motor vehicle will have much lower operational costs in the early years, but as the asset ages breakdowns and maintenance costs will start to increase (hence this method is good for averaging the cost of the use of the asset over its useful life.

Full Definition of Depreciation

Depreciation is a term used in accounting, economics and finance with reference to the fact that assets with finite lives lose value over time.

In accounting, depreciation is a term used to describe any method of attributing the historical or purchase cost of an asset, across its useful life, roughly corresponding to normal wear and tear. It is of most use when dealing with assets of a short, fixed service life, and which is an example of applying the matching principle as per generally accepted accounting principles. Depreciation in accounting is often mistakenly seen as a basis for recognizing impairment of an asset, but unexpected changes in value, were seen as significant enough to account for, are handled through write-downs or similar techniques which adjust the book value of the asset to reflect its current value.

Therefore, it is important to recognize that depreciation, when used as a technical accounting term, is the allocation of the historical cost of an asset across time periods when the asset is employed to generate revenues. This process of cost allocation may have little or no direct relationship to the market value or current selling price of the asset, it is simply the recognition that a portion of the asset’s cost – the portion that will never be recuperated through re-sale or disposal of the asset has been “used up” in the process of generating revenues for that time period.

The use of depreciation affects the financial statements and the tax liability of companies and individuals. The recording of depreciation will cause an expense to be recognized, thereby lowering stated profits on the income statement, while the net value of the asset (the portion of the historical cost of the asset that remains to provide future value to the company) will decline on the balance sheet. Depreciation reported for accounting and tax purposes may differ substantially.

Depreciation and its related concept, amortization (generally, the depreciation of intangible assets), are both non-cash expenses. Neither depreciation nor amortization will directly affect the cash flow of a company, as both are accounting representations of expenses attributable to a given period. In accounting statements, depreciation may neither figure in the cash flow statement, or may be “added back” to net income (along with other items) to derive the operating cash flow.

Depreciation recognized for tax purposes will, however, affect the cash flow of the company, as tax depreciation will reduce taxable profits; there is generally no requirement that treatment of depreciation for tax and accounting purposes be identical. Where depreciation is shown on accounting statements, the figure usually does not relate to depreciation for tax purposes.

Definition of ‘Appreciation’

An increase in the value of an asset over time. The increase can occur for a number of reasons including increased demand or weakening supply, or as a result of changes in inflation or interest rates. This is the opposite of depreciation, which is a decrease in value over time.

This term can be used to refer to an increase in any type of asset such as a shares, bonds, currency or land and property. For example, the term capital appreciation refers to an increase in the value of financial assets such as stocks and shares, which can occur for reasons such as improved financial performance of the company.

The most common adjustment on the value of an asset in accounting is usually a downward one, known as depreciation, which is typically done as the asset loses economic value through use, such as a piece of machinery being used over its useful life. While appreciation of assets in accounting is less frequent, assets such as trademarks may see an upward value revision due to increased brand recognition.