Depreciation Accounting: Methods, Calculations & Financial Impact

TAKEAWAYS:

• Depreciation allocates the cost of long-term tangible assets (e.g., machinery, vehicles) over their useful life, matching expenses to revenue.
• Three key methods (straight-line, reducing balance, units of production) are used based on asset usage patterns—each has distinct journal entries and financial statement impacts.
• Depreciation reduces net income but increases cash flow by deferring tax payments (via lower taxable income).
• Errors in depreciation calculations distort profit/loss and asset values, requiring rectification via adjusting entries.
• Nepali businesses (e.g., NTC buses, Daraz warehouses, Ncell towers) use depreciation to comply with NFRS and secure loans by showing realistic asset values.
• Exam focus: Numerical problems (e.g., calculating depreciation for a Kathmandu retail shop’s generator) and distinguishing between depreciation vs. impairment.

1. What is Depreciation?

Depreciation is the systematic allocation of an asset’s historical cost (minus salvage value) over its useful life. It reflects the wear and tear, obsolescence, or usage of tangible assets like machinery, vehicles, or buildings.

Why Depreciate?

graph TD
    A["Purpose of Depreciation"] --> B["Match Expenses to Revenue"]
    A --> C["Show True Asset Value"]
    A --> D["Comply with NFRS"]
    A --> E["Tax Benefits"]
    A --> F["Loan Security"]

• Matching Principle: Expenses (depreciation) are recorded in the same period as the revenue generated by the asset.
• True Asset Value: Assets lose value over time; depreciation adjusts their book value (cost – accumulated depreciation).
• NFRS Compliance: Nepal Financial Reporting Standards (NFRS) require depreciation for non-current assets (e.g., NFRS 16).
• Tax Deduction: Depreciation reduces taxable income, deferring tax payments.
• Loan Security: Banks assess asset values for loans; depreciated values reflect reality.

2. Key Terms

3. Methods of Depreciation

Three primary methods are used in Nepalese businesses:

A. Straight-Line Method (SLM)

• Definition: Equal depreciation amount each year.
• Formula: $$\text{Annual Depreciation}=\frac{\text{Cost}-\text{Salvage Value}}{\text{Useful Life (years)}}$$
• When to Use: Assets with steady usage (e.g., office furniture, buildings).
• Journal Entry:

  Dr. Depreciation Expense (P&L)       Rs X
    Cr. Accumulated Depreciation (Balance Sheet) Rs X
  

Example: Kathmandu Retail Shop’s Generator

• Cost: Rs 500,000
• Salvage Value: Rs 50,000
• Useful Life: 10 years
• Annual Depreciation: $$\frac{500,000-50,000}{10}=\text{Rs 45,000/year}$$

T-Account for Year 1:

Generator (Asset)
  500,000 | 45,000
----------|--------
          | 45,000
          |--------
          | 455,000 (Book Value)

Accumulated Depreciation (Contra-Asset)
  45,000 |
----------

B. Reducing Balance Method (RBM)

• Definition: Higher depreciation in early years, tapering off.
• Formula: $$\text{Annual Depreciation}=\text{Book Value at Start}\times \text{Rate}$$ (Rate = $\frac{1-\text{Salvage Value/Cost}}{\text{Useful Life}}$)
• When to Use: Assets that lose value quickly (e.g., computers, Ncell towers).
• Journal Entry: Same as SLM.

Example: Ncell Base Station Tower

• Cost: Rs 2,000,000
• Salvage Value: Rs 200,000
• Useful Life: 5 years
• Rate: $$\frac{1-200,000/2,000,000}{5}=16\%\text{ per year}$$
• Year 1 Depreciation: $$2,000,000\times 16\%=\text{Rs 320,000}$$
• Year 2 Depreciation: $$(2,000,000-320,000)\times 16\%=\text{Rs 268,800}$$

Comparison Table:

C. Units of Production Method (UoP)

• Definition: Depreciation based on actual usage (KMs, hours, units produced).
• Formula: $$\text{Depreciation per Unit}=\frac{\text{Cost}-\text{Salvage Value}}{\text{Total Units of Life}}$$ $$\text{Annual Depreciation}=\text{Depreciation per Unit}\times \text{Units Produced in Year}$$
• When to Use: Assets with variable usage (e.g., NTC buses, Daraz delivery vans).

Example: Nepal Yatayat Minibus

• Cost: Rs 880,000
• Salvage Value: Rs 80,000
• Useful Life: 160,000 KMs
• Depreciation per KM: $$\frac{880,000-80,000}{160,000}=\text{Rs 5/KM}$$
• Year 1 (15,000 KMs): $$15,000\times 5=\text{Rs 75,000}$$
• Year 2 (24,000 KMs): $$24,000\times 5=\text{Rs 120,000}$$

Mermaid Flowchart: Depreciation Calculation Process

flowchart TD
    A["Start"] --> B["Identify Asset & Method"]
    B --> C{"SLM?"}
    C -->|"Yes"| D["Calculate: (Cost - Salvage)/Life"]
    C -->|"No"| E{"Reducing Balance?"}
    E -->|"Yes"| F["Calculate: Book Value × Rate"]
    E -->|"No"| G["Units of Production?"]
    G -->|"Yes"| H["Calculate: (Cost - Salvage)/Total Units × Actual Units"]
    G -->|"No"| I["Error"]
    D --> J["Record Depreciation Expense"]
    F --> J
    H --> J
    J --> K["Update Accumulated Depreciation"]
    K --> L["End"]

4. Depreciation in Financial Statements

Depreciation affects three key statements:

A. Income Statement (Profit & Loss)

• Depreciation Expense reduces net profit.

  Revenue: Rs 1,000,000
  Less: Expenses (including Depreciation Rs 45,000)
  Net Profit: Rs 855,000
  

B. Statement of Financial Position (Balance Sheet)

• Asset Side:

  Fixed Assets:
    Generator: Rs 500,000
    Less: Accumulated Depreciation (Rs 45,000)
    Net Book Value: Rs 455,000
  

C. Cash Flow Statement

• No cash outflow occurs for depreciation (non-cash expense), but it reduces tax payments (indirect cash inflow).

5. Depreciation vs. Impairment

6. Errors in Depreciation and Rectification

Common Errors:

1. Omission: Forgetting to record depreciation.
2. Wrong Method: Using SLM for a computer (should be RBM).
3. Incorrect Life/Salvage Value: Over/underestimating useful life.

Rectification Journal Entry: If depreciation of Rs 20,000 was omitted for 2 years:

Dr. Depreciation Expense (P&L)       Rs 40,000
    Cr. Accumulated Depreciation (Balance Sheet) Rs 40,000

7. Depreciation and Taxation in Nepal

• NFRS Requirement: Depreciation must be calculated as per NFRS 16.
• Tax Deduction: Depreciation reduces taxable income (e.g., 15% corporate tax rate).
• Prescribed Rates: Nepal’s Income Tax Act prescribes depreciation rates for different assets (e.g., 20% for buildings, 30% for machinery).

Example: Khalti’s Server Costing Rs 5,000,000

• Tax Depreciation (30% RBM):
  • Year 1: Rs 1,500,000
  • Year 2: Rs 1,050,000
• Taxable Income Reduction: Rs 2,550,000 in first 2 years.

In the Real World

1. NTC Buses

   • Method Used: Units of Production (depreciated per KM driven).
   • Why? Buses are used unevenly; depreciation matches actual usage.
   • Impact: Helps NTC budget for fleet replacements and secure loans based on accurate asset values.

2. Daraz Warehouses

   • Method Used: Straight-Line Method for buildings, Reducing Balance for forklifts.
   • Why? Buildings have steady wear, while machinery obsolesces faster.
   • Impact: Depreciation reduces taxable profits, improving Daraz’s cash flow for expansion.

3. Ncell Tower Infrastructure

   • Method Used: Reducing Balance Method (high initial depreciation due to rapid tech changes).
   • Why? Towers become obsolete quickly; RBM reflects higher early-year losses.
   • Impact: Justifies capital expenditures to banks and investors by showing realistic asset values.

Worked Example: Full Depreciation Calculation for a Nepali Business

Scenario: Thapathali Bakery purchases a mixer for Rs 250,000 on Baisakh 1, 2080. The mixer has:

• Salvage Value: Rs 10,000
• Useful Life: 5 years (or 10,000 operating hours)
• Actual Usage:
  • 2080: 2,000 hours
  • 2081: 3,000 hours

Required: Calculate depreciation for 2080 and 2081 using:

1. Straight-Line Method (by years)
2. Units of Production Method (by hours)

Solution 1: Straight-Line Method

• Annual Depreciation: $$\frac{250,000-10,000}{5}=\text{Rs 48,000/year}$$
• Journal Entry for 2080:

  Dr. Depreciation Expense (P&L)       Rs 48,000
      Cr. Accumulated Depreciation       Rs 48,000
  

• Balance Sheet (End of 2080):

  Mixer: Rs 250,000
  Less: Accumulated Depreciation (Rs 48,000)
  Net Book Value: Rs 202,000
  

Solution 2: Units of Production Method

• Depreciation per Hour: $$\frac{250,000-10,000}{10,000}=\text{Rs 24/hour}$$
• 2080 Depreciation (2,000 hours): $$2,000\times 24=\text{Rs 48,000}$$
• 2081 Depreciation (3,000 hours): $$3,000\times 24=\text{Rs 72,000}$$
• Journal Entry for 2081:

  Dr. Depreciation Expense (P&L)       Rs 72,000
      Cr. Accumulated Depreciation       Rs 72,000
  

• Balance Sheet (End of 2081):

  Mixer: Rs 250,000
  Less: Accumulated Depreciation (Rs 120,000)
  Net Book Value: Rs 130,000
  

Comparison:

Note: UoP shows higher depreciation in 2081 because the mixer was used more intensively.

Exam Tip

1. Numerical Problems (50% of Marks)

   • Always show calculations step-by-step. Use the formula box for clarity.
   • Example Question:

     "A company buys machinery for Rs 1,200,000 with a salvage value of Rs 200,000 and a life of 10 years. Calculate depreciation for Year 3 using SLM and RBM (rate = 15%)."

   • Solution:
     • SLM: (1,200,000 – 200,000)/10 = Rs 100,000/year.
     • RBM Year 3: (1,200,000 – 180,000 – 153,000) × 15% = Rs 125,550.

2. Journal Entries (20% of Marks)

   • Always debit "Depreciation Expense" and credit "Accumulated Depreciation."
   • Partial Year Adjustment: If an asset is purchased mid-year, depreciate for the portion of the year used.

3. Conceptual Questions (30% of Marks)

   • Key Points to Mention:
     • Depreciation is a non-cash expense.
     • It reduces taxable income but does not affect cash flow directly.
     • Errors in depreciation distort profit and asset values.
   • Example Answer:

     "Depreciation is essential for decision-making because it:

     • Shows the true cost of using an asset over time.
     • Helps in pricing products/services by including asset usage costs.
     • Ensures compliance with NFRS and tax laws.
     • Provides accurate financial statements for investors and lenders."

4. Real-World Application (Bonus Marks)

   • Link calculations to Nepali businesses (e.g., "Like NTC, Thapathali Bakery uses UoP to match depreciation with actual mixer usage.").

Final Checklist for Exams: ✅ Understand the asset’s useful life and salvage value. ✅ Choose the correct method (SLM for steady usage, RBM for rapid obsolescence, UoP for variable usage). ✅ Show all steps in calculations (examiners reward clarity). ✅ Distinguish between depreciation and impairment. ✅ Practice past exam questions (especially those involving partial years or method changes).