What is depreciation?

Okay, the last two posts were about assets, and now I’d like to give a brief introduction to depreciation. As you may know the accruals concept (also known as the matching concept) sets out how revenues and expenditures should be matched against each other – when cash is paid/received is nots relevant. When a business buys a non-current asset, the accruals concept kicks-in. The asset itself is typically used by the business for several years, and thus generates revenue. So applying the accruals/matching concept, the cost of an asset needs to be matched against revenue over several years. How do we do this? Well, we depreciate the asset. This means the cost of the asset is spread over several years.

This raise two questions 1) how much per year and 2) over how many years? This is where certain assumptions are made. First, an estimated useful life of an asset is determined, for example from previous experience of a similar asset. Second, then business will attempt to assume whether the assets contributes to revenue earned equally over time, or more in earlier years for example. In the former case, the business might use what is termed the straight-line method – which charges an equal amount each year. For example, is an asset cost €10,000 and it’s useful life is 5 years, then the depreciation expense in the income statement each year is €2,000. On the statement of financial position, the asset value falls by €2,000 each year. If an asset is assumed to earn more revenue in earlier years, for example a motor van or truck, then the reducing balance method can be used. This method charges more depreciation in the earlier years. For example, if we assume an asset costs €10,000 and is depreciated at 10% reducing balance, here is what will happen:

Cost       €10,000

Year 1      (1,000) x 10%

Balance   9,000

Year 2      (900) x 10%

and so on…

Thus, using the reducing balance method, the asset will still have a value in the accounts for many years, but the depreciation charge will be smaller each year. If you think about the total costs of owning a car/van/truck, the repairs tend to get higher as it gets older, so the reducing balance method reflect this too.