Today we will learn DEPRECIATION which is one of the key subjects in Financial Accounting.
I still remember many students could not understand why we need to deprecate Assets. There are a lot of explanation why we need deprecation, but today I will make it as simple as possible for you to get the image of DEPRECIATION in Accounting.
Assets Are Used in Long Term
When you buy an Asset, for example, a car or machine for your business, you need to pay cash to purchase. As we learned in Balance Sheet Tutorial, cash, cars and machine are all Assets in Accounting. The reason why it is an Asset, not an Expense, is that you will use your car or machine in the long term from the financial period point of view. At the point you purchase cars and machines, your cash goes out. If you book this purchase cost as an Expense, then it will be part of your cost during this financial year. In your business, you will use cars and machines over one year. Therefore, if you book cars and machine as an expense, then you will book purchase cost of cars and machine in the first year. On the other hand, you will not book any value in the following year.
Book Cost Based on Actual Usage of Goods
We gave a very simple example of just using one car and machine. You will most likely purchase the various type of fixed assets for your business. If you just book Assets as Expense, then we will not be able to see the actual situation of the cost from Profit and Loss Statement. As a result, Accounting principle defined depreciation concept so that we can visualise the value of the things that we use in the long term in the financial report. Again, the reason for DEPRECIATION is to book the cost among multiple fiscal years so that the cost is linked to the actual usage of the goods.
Value of Asset Will Decrease From Usage
Some Accounting courses teach you that DEPRECIATION is to deduct the value of the Asset based on the usage on an annual basis. This is the same thing as we learned earlier. When you purchase a car and machine, Accounting rule is to book that as Assets. Assets are booked based on acquisition cost, which means you book the value of Asset as purchase cost. So when you buy a car for $30,000, then your value of the Asset is $30,000. If you don’t depreciate the Asset although you are using it, the value will not be same as when you purchased the car and machine. Asset values will decrease over time. From Balance Sheet point of view, you must deduct the value of Asset according to the annual usage.
What is Useful Life?
By now you know why we have to book cost among financial period and deduct the value of Assets. When you decrease the value of Assets, you need to decide how many years you will use your Asset. For example, if it is a car, you may use for 4 to 5 years. If it is a machine, it may be longer like 8 to 10 years. Depending on the type of Fixed Asset, you will determine the years of usage which is the Useful Life. In general, Useful Life is defined based on the statutory requirement of accounting principles you apply. Each country may have different requirements to define Useful Life. After the Useful Life period, you may want to set the salvage value. Salvage value is the estimated resell value of the Asset at the end of useful life. In Thailand, in most cases, you will book 1THB as salvage value.
Different Ways of Deprecation
1) Straight Line Method
Straight Line Method is the way to deduct the value of Assets by the same amount every financial year. It means that your usage does not have any particular pattern of consumption. Straight Line Method is the most simple way to depreciate your Asset, so unless your Asset has specific usage pattern, this is the most common way of deprecation. Refer to the calculate formula of Straight Line Method. As long as you understand the image of Straight Line Method, you don’t need to remember the calculation formula. Most of you who are reading this will not calculate this as you are not an Account. Although you are an Accountant, Accounting system will calculate depreciation amount. The important aspect is to get the image that the same amount of the cost divided by useful life is the deprecation amount.
2) Reducing Balance Method (Declining Balance)
Reducing Balance Method is the way to deduct the value of Assets by same ratio every financial year. This means that the amount of depreciation will be higher in the beginning and gradually becomes lower every year. When you apply Reducing Balance Method, then the depreciation amount will be larger in the first couple of years compare to Straight Line method. Regarding cash flow or tax point of view, there are benefits. On the other hand, the calculation is more complicated compared to Straight Line Method.
3) Units of Production Method
Manufactruing companies will use Units of Production Method. It is used when Assets such as machines and mold are consumed by the production unit, then Unit of Production Method will be a better choice to deprecate. This is because the life cycle of these Assets is linked closely with the volume of production.
Example of Accounting Entries Based on Straight Line Method
You have purchased one car for $30,000, and one machine for $100,000 by cash.
As an Asset, you will need to book the value of the car and machine based on the purchase price. So the initial accounting entries will be as follows.
As you can see, your cash became a Fixed Asset which value is $130,000 in total.
One year has passed, and you have set the useful life as following. Car: 5 years, Machine: 10 years. Salvage value is 0.
Depreciation for Car
$30,000 / 5 years = $6,000 (Depreciation amount per year)
$100,000 / 10 years = $10,000 (Depreciation amount per year)
Journal entry to book depreciation is as follows.
(DR) Deprecation $6,000 / (CR) Fixed Asset $6,000
When you deduct directly from your Fixed Asset, you are unable to see the original value of the Asset itself. Therefore, we use Accumulated Deprecation (Liability) to visualise the Asset value at the point of acquisition and total depreciation amount. Accumulated Deprecation means the total amount of reduced value by deprecation. In the Balance Sheet, you can see the original value as well as total depreciation value as follows.
This is what you need to know about Assets and Deprecation. First of all the important thing is to understand why we need to depreciate. We explained from an expense point of view and also from Asset point of view. Secondly is about how long you will depreciate which is the usage of the Asset. The method is used to determine the formula of annual depreciation amount. Based on the calculation you can reduce the Asset value as well as post the cost to the income statement.