Reading 3.6. UNSW Business School, Depreciation of property, plant and equipment, UNSW Sydney.

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1 WARNING This material has been reproduced and communicated to you by or on behalf of the University of New South Wales in accordance with Section 113P of the Copyright Act 1968 (Act). The material in this communication may be subject to copyright under the Act. Any further reproduction or communication of this material by you may be the subject of copyright protection under the Act. Do not remove this notice. Reading 3.6 UNSW Business School, Depreciation of property, plant and equipment, UNSW Sydney.

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3 Depreciation of property, plant and equipment Depreciation of assets concerns how the cost of an asset is allocated as an expense to each period in the asset s life. The idea arises due to the matching principle underlying accrual accounting the asset is (presumably) acquired to assist in the earning of future revenues. Through matching, we want to record (or recognise) as an expense that part of the asset s cost that was used up in a particular period in earning revenue for that period. The general term for this procedure (for physical assets) is depreciation. Note: It is important to recognise that depreciation is an accounting term used to describe the amount of physical assets used up during the period. That is, it is just like using up prepaid rent or any other prepaid expense seen at other times during the course. It does not refer to a reduction in the value of an asset. The bookkeeping effect of depreciation is to reduce net book value of property, plant and equipment (PP&E), an asset, and reduce shareholders equity (through the depreciation expense). Also, recall that the reduction in the net book value of PP&E is usually recorded in a separate account called accumulated depreciation. This is best viewed as part of the net PP&E account just used to record the accumulated effect of recognising depreciation over the life of the asset. The measurement challenge with depreciation is to determine how much of the asset has been used up in any particular period. This is done by choosing one of a number of systematic depreciation methods that allocate the cost of asset over its useful life. Two common methods used are straight-line depreciation and reducing-balance depreciation. Straight-line depreciation This method simply spreads the cost of a PP&E asset evenly across its useful life so that the depreciation expense for a particular PP&E asset is the same in each period. Depreciation each period is calculated as (Cost Salvage value)/useful life. To illustrate, consider an asset purchased for $100,000 with an estimated useful life of eight years and an expected salvage value of $20,000. Using the straight-line approach would yield an annual depreciation expense of ($100,000 $20,000)/8, or $10,000. The effect on the accounts in each of the eight years of the asset s useful life would be: Depreciation expense $10,000 Accumulated depreciation $10,000 Reading 3.6: Depreciation of property, plant and equipment 1

4 A balance sheet extract in Year 1 would show the following: Less: Accumulated depreciation ($10,000) Book value $90,000 A balance sheet extract in Year 2 would show the following: Less: Accumulated depreciation ($20,000) Book value $80,000 Reducing balance depreciation Under this method, depreciation expense is calculated as a fixed percentage of the net book value of the asset at the beginning of the period. This method results in larger depreciation expenses in the earlier years of an asset s life. An example of this approach is shown below. Consider an asset purchased for $100,000 that is depreciated using the reducing balance method at an annual rate of 25%. In the first year, the depreciation expense will be $25,000 (i.e. 25% of $100,000). Depreciation expense $25,000 Accumulated depreciation $25,000 A balance sheet extract in Year 1 would show the following: Less: Accumulated depreciation ($25,000) Book value $75,000 This means that at the end of the first year, the asset will have a net book value of $75,000 (i.e. original cost of $100,000 less $25,000 accumulated depreciation). 2 Accounting and Financial Management

5 For Year 2, depreciation expense will then be 25% of $75,000, which equals $18,750. The balance in accumulated depreciation will then be $25,000 + $18,750 = $43,750. So, the net book value of the asset will be $100,000 $43,750 = $56,250. Depreciation expense $18,750 Accumulated depreciation $18,750 A balance sheet extract in Year 2 would show the following: Less: Accumulated depreciation ($43,750) Book value $56,250 Depreciation in the third year will be 25% of $56,250, or $14,063, and so on. Reading 3.6: Depreciation of property, plant and equipment 3