Depreciation of Assets

Depreciation is a term used to describe the falling value of a tangible asset that occurs as a result of damage, age, obsolescence and/or loss of market value.

The word "Tangible" literally means that the asset can be touched, seen, measured in 3 dimensions. Cars, machinery, furniture, buildings and tools are all examples of "Tangible" assets.

Some assets are "Intangible" and this means you cannot see or touch them. The asset know as "Goodwill" is an example of an "Intangible" asset.

Let's look at an example of depreciation. We'll use the asset "Motor Vehicles" for this example.

A business buys a motor vehicle on 1st January 2007 for $20,000. At the end of 2007, the vehicle is valued at $16,000. The asset has therefore reduced in value by $4,000.

This fall in value is termed depreciation and it is a business and tax-deductible expense.

If the vehicle is retained through all of 2008 and depreciates another $4,000 then at the end of 2008 the total of depreciation accumulated is $8,000 ($4,000 in 2007, $4,000 in 2008).

Businesses are required to show on their Balance Sheet:

(1) the original cost of the asset

(2) the total amount the asset has depreciated (the accumulated depreciation); and

(3) the "net book value" of the asset remaining.

Students often confuse and do not understand the difference between (a) the annual charge for depreciation and (b) the total accumulated depreciation.

In the above example, the car has been depreciated by $4,000 each year. So, the Profit and Loss Statement for 2008 will show an expense for Depreciation of $4,000. On the other hand the Balance Sheet at the end of 2008 will show Accumulated Depreciated to be $8,000. This is because the asset is now two years old and has depreciated $4,000 each year.

At the end of 2008 the Net Book Value of the car will be $12,000. This is calculated by the original cost ($20,000) less the total Accumulated Depreciation ($8,000).

It is important to know that a failure to show the correct amount of depreciation would be tantamount to falsely stating the value of the company's assets. If company executives engage deliberately falsifying the value of assets by understating or overstating depreciation then they commit FRAUD and can suffer major consequences such as imprisonment in the worst cases.

There are two methods for calculating depreciation:

Straight line method

If an asset costs $100 and the rate of depreciation is 20% per year, the amount of depreciation each year will be $20.00 (the purchase price [$100] * the rate of depreciation [20%]).

Reducing balance method

 If an asset costs $100 and the rate of depreciation is 20% per year, in the first year the depreciation will be $20, in the second year $16.00, in the third year $12.80, and so on as per example below:

A

Purchase price

$100.00

A

B

Depreciation for the year - 20%

$20.00

A * 20%  = B

C

Net Book Value at the end of the Year 1

$80.00

A - B = C

D

Depreciation for the year - 20%

$16.00

C * 20% = D

E

Net Book Value at the end of the Year 2

$64.00

C - D = E

F

Depreciation for the year - 20%

$12.80

E * 20% = F

G

Net Book Value at the end of the Year 3

$51.20

E - F = G

 

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