Depreciation and Accumulated Depreciation

Explanation

Depreciation is the systematic allocation of the cost of a depreciable non-current asset over its useful life. It is not an outflow of cash but a non-cash expense that recognises that assets such as vehicles, machinery, fittings and furniture lose value as they are used. Accumulated depreciation is the running total of all depreciation expense charged on an asset from the date it was acquired up to the current balance date. The difference: annual depreciation is the expense for a single accounting period only, while accumulated depreciation is the build-up of depreciation across several years. Accumulated depreciation is a contra-asset account that reduces the cost of the asset to give the net book value (NBV).

There are several reasons assets are depreciated. First, physical deterioration through wear and tear as the asset is used in the business operations. Second, obsolescence, when an asset becomes outdated due to newer, more efficient technology. Third, effluxion of time for assets with a fixed usable period such as leases. Fourth, depreciation upholds the matching principle, where the cost of the asset is matched against the revenue the asset helps to generate over its useful life. Note that land is normally not depreciated because its useful life is regarded as unlimited, except for leasehold land.

The two main methods studied are the straight line method and the reducing balance method. The straight line method charges an equal amount of depreciation each year throughout the asset's life. Its formula is (cost of asset minus residual/scrap value) divided by useful life, or as a fixed percentage on cost. The reducing balance method charges a fixed percentage on the net book value (the balance), which falls each year, so the depreciation amount is high in the early years and gets smaller in later years. The straight line method suits assets that give even benefits such as furniture, while the reducing balance method suits assets that are more productive in their early years such as vehicles and machinery.

Recording depreciation involves the same double entry regardless of the calculation method. At the balance date the depreciation expense is recorded as: Debit Depreciation Expense and Credit Accumulated Depreciation. The Depreciation Expense account is a nominal (expense) account that is closed to the Income Statement at period end, while the Accumulated Depreciation account is a contra-asset account whose balance is carried forward and grows each year. To calculate, students must identify the given method, take the correct cost or net book value, apply the rate or formula, and be careful with part-year depreciation adjustments when an asset is bought mid-year (as directed by the question).

Depreciation affects the financial statements in two places. In the Income Statement, the current year's depreciation expense is recorded as an expense (usually under operating expenses), thereby reducing net profit. In the Statement of Financial Position, under non-current assets, the cost of the asset is shown, then the accumulated depreciation up to the balance date is deducted to arrive at the net book value. Only the current year's depreciation expense goes into the Income Statement, but the whole accumulated depreciation (including prior years) is deducted in the Statement of Financial Position. A common misconception is deducting the full accumulated depreciation in the Income Statement; this is wrong and must be avoided.

Worked examples

Practice

Exam tips

Key terms

Depreciation (Susut nilai)

The systematic allocation of the cost of a non-current asset over its useful life; a non-cash expense.

Accumulated depreciation (Susut nilai terkumpul)

The running total of all depreciation charged on an asset from acquisition to the balance date; a contra-asset account.

Straight line method (Kaedah garis lurus)

A method that charges an equal amount of depreciation each year over the asset's life.

Reducing balance method (Kaedah baki berkurangan)

A method that applies a fixed percentage on the net book value, giving depreciation that decreases each year.

Source: DSKP KSSM Prinsip Perakaunan Tingkatan 4

Other Content Standards in this chapter