Depreciation, Amortization & Impairment: Methods, Journal Entries & Financial Impact

Core Concepts: Definitions and Why They Matter

1. Depreciation, Amortization, and Depletion: What’s the Difference?

classDiagram
    class Asset {
        +Cost
        +Useful Life
        +Salvage Value
    }
    class Depreciation {
        +Applies to: Tangible Non-Current Assets (e.g., machinery, buildings)
        +Method: Straight-line, Reducing Balance, Activity-based
        +Journal Entry: Dr. Depreciation Expense | Cr. Accumulated Depreciation
    }
    class Amortization {
        +Applies to: Intangible Non-Current Assets (e.g., patents, copyrights, goodwill)
        +Method: Straight-line only (unless specified otherwise)
        +Journal Entry: Dr. Amortization Expense | Cr. Accumulated Amortization
    }
    class Depletion {
        +Applies to: Natural Resources (e.g., mines, oil wells)
        +Method: Units-of-Production (activity-based)
        +Journal Entry: Dr. Depletion Expense | Cr. Accumulated Depletion
    }
    Asset --> Depreciation : "Physical Wear & Tear"
    Asset --> Amortization : "Loss of Value Over Time"
    Asset --> Depletion : "Extraction of Natural Resources"

Key Idea:

• Depreciation = Wear and tear of physical assets (e.g., machinery, vehicles, buildings).
• Amortization = Loss of value of intangible assets (e.g., patents, trademarks, software licenses).
• Depletion = Extraction of natural resources (rare in Nepal but relevant for mining companies).

Why It Matters: These concepts ensure that the cost of long-term assets is matched against revenue over their useful life (matching principle). Without depreciation, assets would appear overvalued on the balance sheet, distorting financial health.

2. The Depreciation Process: Step-by-Step

Step 1: Identify the Asset’s Cost and Useful Life

Example: Kathmandu’s "Thamel Retail Shop" buys a new sewing machine for Rs. 500,000 on 1st Baishakh 2078. The machine has:

• Useful life: 5 years
• Salvage value (scrap value): Rs. 50,000

Step 2: Choose a Depreciation Method

Three common methods (we’ll compare them later):

Step 3: Calculate Annual Depreciation

Worked Example: Straight-Line Method for Thamel Retail Shop

Cost of machine: Rs. 500,000
Salvage value: Rs. 50,000
Useful life: 5 years

```figure
{"type":"t-account","title":"Thamel Retail Shop – Machine Account (Full 5-Year Depreciation)","dr":[["To Purchase A/c",500000],["To Accumulated Depreciation (Year 1)",90000],["To Accumulated Depreciation (Year 2)",90000],["To Accumulated Depreciation (Year 3)",90000],["To Accumulated Depreciation (Year 4)",90000],["To Accumulated Depreciation (Year 5)",90000]],"cr":[],"balance":true,"caption":"T-account showing the machine’s cost and accumulated depreciation over 5 years (straight-line method)."}

Annual Depreciation = (500,000 - 50,000) / 5 = Rs. 90,000 per year

**Journal Entry for Year 1 (Baishakh 2078 – Chaitra 2079):**

**Ledger Account (T-Account) for Machine:**

Machine Account:

Accumulated Depreciation Account:

Balance Sheet Impact (After Year 1):

• Machine (Gross Block): Rs. 500,000
• Less: Accumulated Depreciation: (90,000)
• Net Book Value (NBV): Rs. 410,000

3. Comparing Depreciation Methods

Method Comparison Table

Visual: Depreciation Over Time

```figure
{"type":"curves","lines":[{"label":"Straight-Line (Thamel Retail Shop)","from":[0,500000],"to":[5,410000],"style":"linear"},{"label":"Reducing Balance (20% rate)","from":[0,500000],"to":[5,163840],"fns":[{"expr":"500000 * (0.8^x)","label":"NBV = 500,000 × (0.8)^n"}]}],"points":[{"x":0,"y":500000,"label":"Cost"},{"x":5,"y":410000,"label":"SL NBV"},{"x":5,"y":163840,"label":"RB NBV"}],"xlabel":"Years","ylabel":"Net Book Value (Rs.)","caption":"Comparison of straight-line vs. reducing balance depreciation for the Thamel Retail Shop’s sewing machine (Rs. 500,000 cost, 5-year life)."}

(Imagine a graph with:

• Straight-line: A flat line at Rs. 16,000/year.
• Reducing balance: A steep curve starting at Rs. 20,000, tapering to Rs. 3,200 by Year 5.)

4. Amortization: Intangible Assets

Example: Ncell’s Patent for 5G Technology

• Cost of patent: Rs. 10,000,000
• Useful life: 10 years
• Method: Straight-line (unless specified otherwise)

Annual Amortization:

(10,000,000 - 0) / 10 = Rs. 1,000,000 per year

Journal Entry:

| Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
|------------|---------------------------------|----------|----------|
| 2078/04/15 | Amortization Expense (Patent)   | 1,000,000|          |
|            | To Accumulated Amortization     |          | 1,000,000|

Balance Sheet Impact:

• Patent (Gross): Rs. 10,000,000
• Less: Accumulated Amortization: (1,000,000)
• Net Book Value: Rs. 9,000,000

5. Impairment: When Assets Lose Value Unexpectedly

Definition:

Impairment occurs when an asset’s net book value (NBV) > recoverable amount (fair value less costs to sell). This is a one-time write-down, not part of regular depreciation.

Example: Daraz’s Warehouse Fire (Hypothetical)

• Cost of warehouse: Rs. 50,000,000
• Accumulated depreciation (5 years, straight-line): Rs. 20,000,000
• NBV before impairment: Rs. 30,000,000
• Fair value after fire (insurance estimate): Rs. 15,000,000

Impairment Loss:

NBV (30,000,000) - Fair Value (15,000,000) = Rs. 15,000,000 loss

Journal Entry:

| Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
|------------|---------------------------------|----------|----------|
| 2078/10/10 | Impairment Loss (Warehouse)     | 15,000,000|          |
|            | To Warehouse (Reduction)        |          | 15,000,000|

Impact on Financial Statements:

• Income Statement: Rs. 15,000,000 impairment loss (reduces net profit).
• Balance Sheet: Warehouse’s NBV drops to Rs. 15,000,000.

6. The Accounting Cycle: Depreciation’s Role

7. Real-World Applications in Nepal

Example 1: NTC’s Telecommunication Towers

• Asset: Telecommunication towers (cost: Rs. 20,000,000 each).
• Method: Straight-line (20-year useful life).
• Why? Towers depreciate slowly and uniformly over time.
• Impact: NTC reports Rs. 1,000,000/year depreciation per tower in its financial statements.

Example 2: Pathao’s Delivery Vans

• Asset: Electric vans (cost: Rs. 5,000,000 each).
• Method: Activity-based (depreciated by km driven).
• Why? Vans wear out faster with high usage. Pathao tracks km per van and depreciates accordingly.
• Journal Entry Snippet:

  Dr. Depreciation Expense (Van) | Cr. Accumulated Depreciation
  Amount = (5,000,000 - 500,000) / 100,000 km × 50,000 km = Rs. 2,250,000
  

Example 3: Banks’ Loan Processing Software (Amortization)

• Asset: Custom software license (cost: Rs. 2,000,000).
• Method: Straight-line (5-year useful life).
• Why? Software becomes obsolete or requires updates over time.
• Impact: Global IME Bank reports Rs. 400,000/year amortization for its core banking software.

8. Common Mistakes to Avoid

1. Ignoring Salvage Value: Always subtract salvage value before calculating depreciation.

   • ❌ Wrong: Rs. 500,000 / 5 = Rs. 100,000 (ignores Rs. 50,000 salvage).
   • ✅ Correct: (500,000 - 50,000) / 5 = Rs. 90,000.

2. Mixing Up Accumulated Depreciation and Depreciation Expense:

   • Accumulated Depreciation = Contra-asset (reduces asset value on balance sheet).
   • Depreciation Expense = Income statement expense (reduces net profit).

3. Forgetting Partial-Year Depreciation:

   • If an asset is purchased mid-year, depreciate only for the used months.
   • Example: Machine bought on 1st Chaitra 2078 (used for 9 months in Year 1).

     Annual Depreciation: Rs. 90,000
     Year 1 Depreciation: 90,000 × (9/12) = Rs. 67,500
     

Exam Tip: How This Unit is Tested

1. Numerical Problems (50% of Marks)

• What to Expect:

  • Calculate depreciation using all three methods (straight-line, reducing balance, activity-based).
  • Prepare journal entries and ledger accounts.
  • Compute net book value (NBV) after depreciation/amortization.
  • Impairment scenarios (calculate loss and adjust NBV).

• Example Question:

  "A company buys machinery for Rs. 800,000 on 1st Baishakh 2078. Its useful life is 5 years with a salvage value of Rs. 50,000. Calculate depreciation for Year 1 and Year 2 using: (a) Straight-line method (b) Reducing balance method (20% rate) Show journal entries for Year 1."

• How to Score Full Marks:

  • Show all steps (formulas, calculations, and reasoning).
  • Label every T-account and journal entry clearly.
  • Reconcile NBV at year-end (e.g., "After Year 2, NBV = Rs. X").

2. Theory Questions (30% of Marks)

• Common Topics:

  • Define depreciation vs. amortization vs. impairment.
  • Explain the matching principle and why depreciation is necessary.
  • Compare advantages/disadvantages of different methods.
  • Describe the impact of depreciation on financial statements (income statement vs. balance sheet).

• Example Question:

  "Why does a company choose the reducing balance method over straight-line for computers? Discuss with examples."

• How to Score Full Marks:

  • Use real-world examples (e.g., "Nepal’s IT firms depreciate laptops faster early because technology becomes obsolete quickly").
  • Link to accounting principles (e.g., "Reducing balance matches higher expenses in early years when assets are more productive").

3. Practical Scenarios (20% of Marks)

• What to Expect:

  • Bank reconciliation with depreciation adjustments.
  • Financial statement preparation (show how depreciation affects profit and asset value).
  • Impairment adjustments (e.g., "A machine’s fair value drops due to obsolescence").

• Example Question:

  "From the following trial balance, prepare the income statement and balance sheet, adjusting for depreciation and impairment. Assume:

  • Machinery (cost Rs. 1,000,000, accumulated depreciation Rs. 200,000) is impaired by Rs. 150,000.
  • Patents (cost Rs. 500,000) have 5 years remaining life."

• How to Score Full Marks:

  • Prepare adjusted trial balance first.
  • Show impairment journal entry separately.
  • Highlight changes in NBV on the balance sheet and impact on net profit.

Final Checklist for Exam Readiness

Pro Tip: Always round to the nearest rupee in calculations and cross-verify totals in ledgers. Examiners deduct marks for arithmetic errors!