Depreciation & Asset Valuation: Methods, Journal Entries & Impact

TAKEAWAYS:

• Depreciation is the systematic allocation of an asset’s cost over its useful life, not a measure of physical wear.
• Straight-line, reducing balance, and units-of-production are the three primary methods, each suited to different asset types.
• Journal entries for depreciation affect Profit & Loss Account (expense) and Accumulated Depreciation (contra-asset).
• Net Book Value (NBV) = Cost – Accumulated Depreciation; it’s used for financial statements and loan collateral.
• Partial-year depreciation adjusts for assets acquired or disposed mid-period.
• Disposal of assets requires calculating profit/loss on sale and updating accumulated depreciation.

1. Why Depreciate? The Business Case

Assets like machinery, vehicles, and buildings lose value due to wear, tear, obsolescence, or usage. Depreciation:

• Matches expenses to revenue (accrual principle).
• Shows true profitability by reducing asset value over time.
• Complies with accounting standards (IAS 16, Nepal’s GAAP).

A typical asset subject to depreciation (e.g., a Daraz warehouse forklift). (Image: Queensland State Archives, PDM-owner, via Wikimedia Commons) Depreciation does not mean the asset is sold—it’s an accounting adjustment.

2. Definitions & Key Terms

3. Methods of Depreciation

Three widely used methods, each with pros/cons:

A. Straight-Line Method (SLM)

• How it works: Equal annual depreciation. $$\text{Annual Depreciation}=\frac{\text{Cost}-\text{Salvage Value}}{\text{Useful Life}}$$
• Example: A Rs 250,000 machine with 5-year life and Rs 10,000 salvage value: $$\text{Depreciation/year}=\frac{250,000-10,000}{5}=\text{Rs 48,000/year}$$

B. Reducing Balance Method (RBM)

• How it works: Higher depreciation in early years (accelerated). $$\text{Annual Depreciation}=\text{NBV}\times \frac{1}{\text{Useful Life}}\times 2$$ (Nepal uses 2× straight-line rate for RBM.)
• Example: Same machine, 20% rate (1/5 × 2):
  • Year 1: 250,000 × 20% = Rs 50,000
  • Year 2: (250,000 – 50,000) × 20% = Rs 40,000

C. Units of Production Method (UOPM)

• How it works: Depreciation based on actual usage (e.g., km driven for a car). $$\text{Depreciation per unit}=\frac{\text{Cost}-\text{Salvage Value}}{\text{Total Units}}$$
• Example: A car costing Rs 3,010,000 with 300,000 km life and 10,000 salvage value:
  • Depreciation/km = (3,010,000 – 10,000)/300,000 = Rs 10 per km.
  • If driven 50,000 km in Year 1: Rs 500,000 depreciation.

Comparison Table:

4. Journal Entries for Depreciation

Depreciation is recorded annually in the Profit & Loss Account (expense) and Accumulated Depreciation (contra-asset).

Example: Straight-Line Depreciation for a Machine

Given:

• Machine purchased on 1 Baisakh 2076 for Rs 250,000.
• Useful life: 5 years; salvage value: Rs 10,000.
• Depreciation rate: 20% per year (SLM).

Journal Entry (Year 1):

Date       Particulars                     | Dr (Rs) | Cr (Rs)
2076-12-31 Depreciation A/c                | 48,000  |
         To Accumulated Depreciation-Machine |         | 48,000

Explanation:

• Dr Depreciation A/c: Expense increases profit (reduces net income).
• Cr Accumulated Depreciation: Reduces asset’s NBV.

Ledger Posting (T-Account):

Accumulated Depreciation - Machine
2076-12-31: 48,000
2077-12-31: 48,000
2078-12-31: 48,000
Total: 144,000

Machine Account:

Cost: 250,000
Less: Accumulated Depreciation: (144,000)
NBV: 106,000

5. Partial-Year Depreciation

If an asset is acquired or disposed mid-year, adjust the depreciation period proportionally.

Example: A Rs 150,000 machine bought on 1 Kartik 2077 (5-month delay) with 5-year life.

• Full-year depreciation: Rs 150,000 / 5 = Rs 30,000/year.
• Partial-year depreciation: (30,000 × 5/12) = Rs 12,500 (for 2077).

Journal Entry:

Date       Particulars                     | Dr (Rs) | Cr (Rs)
2077-12-31 Depreciation A/c                | 12,500  |
         To Accumulated Depreciation-Machine |         | 12,500

6. Disposal of Depreciable Assets

When an asset is sold, calculate:

1. Accumulated Depreciation up to disposal date.
2. Book Value (NBV) = Cost – Accumulated Depreciation.
3. Profit/Loss on Sale = Sale Price – NBV.

flowchart TD
  A["Asset Sold for Rs 120,000"] --> B["Calculate Accumulated Depreciation: Rs 144,000"]
  B --> C["Compute NBV: Rs 250,000 - Rs 144,000 = Rs 106,000"]
  C --> D["Determine Profit/Loss: Rs 120,000 - Rs 106,000 = Rs 14,000"]
  D --> E["Record Profit in P&L A/c"]
  D --> F["Update Accumulated Depreciation"]
  F --> G["Remove Asset from Balance Sheet"]

Example: Sell the Rs 250,000 machine (NBV: Rs 106,000) for Rs 120,000 on 1 Chaitra 2079.

1. Accumulated Depreciation: 48,000 × 3 years = Rs 144,000.
2. NBV: 250,000 – 144,000 = Rs 106,000.
3. Profit/Loss: 120,000 – 106,000 = Rs 14,000 profit.

Journal Entries:

1. Update Depreciation (if not yet recorded for 2078):
   Depreciation A/c (48,000) | Accumulated Depreciation (48,000)

2. Dispose of Asset:
   Bank A/c (120,000) | Machine A/c (250,000)
   Profit on Sale A/c (14,000) | Accumulated Depreciation (144,000)

Ledger Posting (Machine Account):

Cost: 250,000
Less: Accumulated Depreciation: (192,000)
NBV: 58,000
Sale: 120,000
Profit: 14,000

7. In the Real World

Depreciation affects every business—from micro-enterprises to multinational corporations. Here’s how Nepali companies use it:

A. NTC’s Telecommunication Towers

• Idea: NTC depreciates its cell towers (cost: Rs 5M–10M each) using straight-line method over 10–15 years.
• Why? Towers lose signal strength over time, and NTC must replace them. Depreciation spreads the cost across years, reducing annual expenses and improving financial health.
• Real Impact: Helps NTC justify higher tariffs to regulators by showing "wear-and-tear" costs.

B. Daraz’s Warehouse Equipment

• Idea: Forklifts and conveyor belts in Daraz’s warehouses are depreciated using reducing balance method (higher expense early, when usage is highest).
• Why? Daraz replaces equipment frequently due to high turnover. RBM matches higher early costs with peak operational activity.
• Worked Example: A Rs 2M forklift with 5-year life and Rs 200,000 salvage value:
  • Year 1: 2M × 20% = Rs 400,000 depreciation.
  • Year 5: (2M – accumulated depreciation) × 20% ≈ Rs 128,000. Daraz uses this to budget for replacements.

C. Pathao’s Delivery Vehicles

• Idea: Pathao depreciates its fleet (motorcycles, cars) using units-of-production method, tracking km driven.
• Why? Vehicles in Kathmandu’s traffic wear out faster. Depreciation per km adjusts for actual usage (e.g., Rs 5/km for a motorcycle).
• Real Impact: Pathao’s financial statements reflect true vehicle costs, helping it negotiate loans with banks like NMB.

8. Depreciation’s Impact on Profit

Depreciation reduces taxable income and affects financial ratios:

Example: A Rs 250,000 machine with:

• SLM: Rs 48,000/year → Profit = Rs 500,000 – 48,000 = Rs 452,000.
• RBM: Rs 50,000 (Year 1) → Profit = Rs 500,000 – 50,000 = Rs 450,000.

Why it matters: Banks like Global IMEbank use depreciation data to assess a business’s cash flow stability before lending.

9. Exam Tip: Common Pitfalls

1. Miscounting useful life: Always check the asset’s expected lifespan (e.g., 5 years for furniture, 10 years for buildings).
2. Ignoring salvage value: Subtract it from cost before calculating depreciation.
3. Partial-year errors: Use the formula (Depreciation × Months Owned/12) for mid-year transactions.
4. Disposal mistakes: Forget to close the asset account and update accumulated depreciation at disposal.
5. Method confusion: Match the method to the asset (e.g., RBM for tech, SLM for furniture).

Past Exam Question (Adapted): A company bought a machine for Rs 200,000 on 1 Chaitra 2077 with a 5-year life and Rs 20,000 salvage value. Calculate depreciation for 2077–2081 using SLM and RBM (20% rate). Solution:

10. Worked Example: Kathmandu Retail Shop

Scenario: Sagar’s Stationery buys a printer for Rs 80,000 on 1 Baisakh 2076. Life: 4 years; salvage: Rs 10,000. Depreciate using SLM and RBM (25% rate).

Step 1: Calculate Annual Depreciation

• SLM: $$\frac{80,000-10,000}{4}=\text{Rs 19,000/year}$$
• RBM: $$\text{Year 1: }80,000\times 25\%=\text{Rs 20,000}$$ $$\text{Year 2: }(80,000-20,000)\times 25\%=\text{Rs 15,000}$$

Step 2: Journal Entries (SLM)

Step 3: Ledger Posting (Printer Account)

Cost: 80,000
Less: Accumulated Depreciation (SLM): (38,000)
NBV: 42,000

Step 4: Disposal (Sold for Rs 35,000 on 1 Chaitra 2079)

1. Update Depreciation for 2078: Rs 19,000.
2. NBV: 80,000 – (19,000 × 2) = Rs 42,000.
3. Profit/Loss: 35,000 – 42,000 = Rs 7,000 loss.

Final Journal Entry:

Bank A/c (35,000) | Printer A/c (80,000)
Loss on Sale A/c (7,000) | Accumulated Depreciation (38,000)

11. Visualizing the Accounting Cycle

sequenceDiagram
  participant Transaction
  participant Journal
  participant Ledger
  participant TrialBalance
  participant FinancialStatements
  Transaction->>Journal: Record in Journal
  Journal->>Ledger: Post to T-Accounts
  Ledger->>TrialBalance: Prepare Trial Balance
  TrialBalance->>FinancialStatements: Generate Income Statement & Balance Sheet
  FinancialStatements->>Depreciation: Adjust for Depreciation Expense
  FinancialStatements->>Depreciation: Update Accumulated Depreciation
  note right of FinancialStatements: Depreciation affects both P&L and Balance Sheet

In the real world

• eSewa: Uses straight-line depreciation for its server infrastructure (e.g., Rs 500,000 server with 5-year life → Rs 100,000/year expense) to match IT costs with revenue generated from digital transactions.
• Daraz Warehouse Forklifts: Apply units-of-production depreciation (e.g., Rs 2,000,000 forklift with 50,000 km life → Rs 40/km; depreciated based on actual km driven monthly).
• Nepal Rastra Bank (NRB): Requires banks like Nabil Bank to use reducing balance method for high-value assets (e.g., ATMs) to reflect faster obsolescence in early years, ensuring accurate risk assessment for loan collateral.