Depreciation Accounting: Methods, Journal Entries & Real-World Impact

TAKEAWAYS

• Depreciation allocates the cost of a tangible asset over its useful life, matching expenses to revenue (matching concept).
• Three methods (straight-line, diminishing balance, sum-of-years’ digits) calculate depreciation differently—choose based on asset usage patterns.
• Journal entries for depreciation always debit Depreciation Expense and credit Accumulated Depreciation (a contra-asset account).
• Disposing of an asset requires calculating book value, comparing it to sale proceeds, and recognizing gain/loss on disposal.
• Depreciation reduces taxable income (advantage) but does not reflect market value (disadvantage).
• Real-world examples: NTC’s telecom towers (straight-line), Ncell’s servers (diminishing balance), Daraz’s delivery vans (sum-of-years’ digits).

1. What is Depreciation?

Depreciation is the systematic allocation of the cost of a tangible non-current asset (e.g., machinery, vehicles, buildings) over its useful life. It reflects the wear and tear, obsolescence, or exhaustion of an asset’s economic benefits.

Why Depreciate?

• Matching Concept: Expenses (depreciation) are matched with revenues generated by the asset.
• Tax Benefits: Reduces taxable income (e.g., businesses like Ncell claim depreciation to lower tax liabilities).
• Accurate Financial Statements: Shows the true value of assets on the balance sheet (not original cost).
• Fund Replacement: Accumulated depreciation funds can replace old assets (e.g., NTC sets aside money to upgrade telecom infrastructure).

Causes of Depreciation

mindmap
  root((Depreciation Causes))
    Physical Wear and Tear
      Example: A truck’s engine wears out over time.
    Obsolescence
      Example: Old computers become outdated (e.g., **Daraz’s** inventory management systems).
    Inefficiency
      Example: A machine slows down production over years.
    Depletion
      Example: A quarry’s stone reserves diminish.

2. Depreciable vs. Non-Depreciable Assets

Not all assets depreciate. Use this table to decide:

Key Rule: Land never depreciates (it may appreciate in value).

3. Depreciation Methods (With Nepali Business Examples)

Choose a method based on how the asset’s value declines. Below are the three most common methods, with real-world ties to Nepali companies.

A. Straight-Line Method (SLM)

Formula: $$\text{Annual Depreciation}=\frac{\text{Cost}-\text{Scrap Value}}{\text{Useful Life}}$$

When to Use:

• Assets lose value evenly over time (e.g., NTC’s telecom towers, Ncell’s base stations).
• Simple to calculate and understand.

Example: NTC’s Telecom Tower

• Cost: Rs. 10,00,000
• Scrap Value: Rs. 2,00,000
• Useful Life: 10 years
• Annual Depreciation: $$\frac{10,00,000-2,00,000}{10}=\text{Rs. 80,000/year}$$

Journal Entry (Year 1):

| Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
|------------|---------------------------------|----------|----------|
| 31 Dec 2079| Depreciation Expense (SLM)      | 80,000   |          |
|            | To Accumulated Depreciation     |          | 80,000   |

T-Account for Machinery (NTC Tower):

Machinery A/c
| Dr (Cost) | Cr (Depreciation) |
|-----------|-------------------|
| 10,00,000 | 80,000 (Yr 1)     |
|           | 80,000 (Yr 2)     |
|           | ...               |
|           | 80,000 (Yr 10)    |
| **Total** | **10,00,000**     | **8,00,000** |

Accumulated Depreciation A/c
| Dr | Cr (Depreciation) |
|----|-------------------|
|    | 80,000 (Yr 1)     |
|    | 80,000 (Yr 2)     |
|    | ...               |
|    | 80,000 (Yr 10)    |
|    | **8,00,000**      |

B. Diminishing Balance Method (DBM)

Formula: $$\text{Annual Depreciation}=\text{Book Value at Start}\times \text{Rate}$$ Rate = $\frac{1-\text{Scrap Value}/\text{Cost}}{\text{Useful Life}}$

When to Use:

• Assets lose value faster early on (e.g., Ncell’s servers, Khalti’s ATMs).
• Higher depreciation in early years (reflects rapid obsolescence).

Example: Ncell’s Server (10% Rate)

• Cost: Rs. 5,00,000
• Scrap Value: Rs. 50,000
• Rate: $$\frac{1-50,000/5,00,000}{5}=18\%\text{ (approx)}$$ (Note: TU exams often use a fixed rate like 10% or 20%.)

Year-by-Year Calculation:

Journal Entry (Year 1):

| Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
|------------|---------------------------------|----------|----------|
| 31 Dec 2079| Depreciation Expense (DBM)      | 50,000   |          |
|            | To Accumulated Depreciation     |          | 50,000   |

T-Account for Server (Ncell):

Server A/c
| Dr (Cost) | Cr (Depreciation) |
|-----------|-------------------|
| 5,00,000  | 50,000 (Yr 1)     |
|           | 45,000 (Yr 2)     |
|           | ...               |
| **Total** | **5,00,000**      | **~4,50,000** |

Accumulated Depreciation A/c
| Dr | Cr (Depreciation) |
|----|-------------------|
|    | 50,000 (Yr 1)     |
|    | 45,000 (Yr 2)     |
|    | ...               |
|    | **~4,50,000**     |

C. Sum-of-Years’ Digits (SYD)

Formula: $$\text{Annual Depreciation}=\frac{\text{Remaining Life}}{\text{Sum of Years’ Digits}}\times (\text{Cost}-\text{Scrap Value})$$ Sum of Years' Digits = $n(n+1)/2$ (where $n$ = useful life).

When to Use:

• Assets depreciate faster early, slower later (e.g., Daraz’s delivery vans, Pathao’s bikes).

Example: Daraz Delivery Van (5-Year Life)

• Cost: Rs. 2,00,000
• Scrap Value: Rs. 20,000
• Sum of Years' Digits: $5+4+3+2+1=15$

Journal Entry (Year 1):

| Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
|------------|---------------------------------|----------|----------|
| 31 Dec 2079| Depreciation Expense (SYD)      | 60,000   |          |
|            | To Accumulated Depreciation     |          | 60,000   |

4. Comparison of Depreciation Methods

5. Disposal of Assets (Sale or Scrap)

When an asset is sold or scrapped, follow these steps:

1. Calculate Book Value = Cost – Accumulated Depreciation.
2. Compare book value with sale proceeds.
3. Recognize Gain/Loss:
   • If Sale Proceeds > Book Value → Gain on Sale (credit).
   • If Sale Proceeds < Book Value → Loss on Sale (debit).

Example: Kathmandu Retail Shop’s Old Printer

• Cost: Rs. 50,000
• Accumulated Depreciation (after 3 years, SLM): Rs. 30,000
• Book Value: Rs. 20,000
• Sold for: Rs. 15,000

Journal Entries:

1. Depreciation for the Year (if partial year):

   | Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
   |------------|---------------------------------|----------|----------|
   | 30 Jun 2079| Depreciation Expense (Printer)  | 5,000    |          |
   |            | To Accumulated Depreciation     |          | 5,000    |
   

   (Assuming 6 months depreciation at Rs. 10,000/year.)

2. Sale of Printer:

   | Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
   |------------|---------------------------------|----------|----------|
   | 1 Jul 2079| Bank A/c                        | 15,000   |          |
   |            | Loss on Sale of Printer         | 5,000    |          |
   |            | To Printer A/c                 |          | 20,000   |
   

   • Explanation:
     • Bank: Rs. 15,000 (cash received).
     • Loss on Sale: Rs. 5,000 (Book Value Rs. 20,000 – Sale Proceeds Rs. 15,000).
     • Printer A/c: Removed from books (cost Rs. 50,000 – accumulated depreciation Rs. 35,000 = Rs. 15,000, but adjusted for partial year).

T-Account for Printer Disposal:

Printer A/c
| Dr (Cost) | Cr (Depreciation) | Cr (Disposal) |
|-----------|-------------------|----------------|
| 50,000    | 35,000            | 15,000         |

Accumulated Depreciation A/c
| Dr (Disposal) | Cr (Depreciation) |
|----------------|-------------------|
| 35,000        | 35,000            |

6. Depreciation in Financial Statements

Depreciation affects three key statements:

A. Income Statement

• Depreciation Expense appears under Operating Expenses, reducing net profit. Example (Nepal Bank Ltd.):

  | Particulars               | Amount (Rs.) |
  |----------------------------|--------------|
  | Revenue                    | 10,00,00,000 |
  | Less: Operating Expenses  |              |
  |   - Salaries               | 2,00,00,000  |
  |   - Depreciation (SLM)     | 50,00,000    | *(Machinery, buildings)* |
  | Net Profit                 | 7,50,00,000  |
  

B. Balance Sheet

1. Asset Side:

   • Cost of Asset (e.g., Machinery Rs. 10,00,000).
   • Less: Accumulated Depreciation (e.g., Rs. 8,00,000).
   • Net Book Value = Rs. 2,00,000.

2. Liabilities Side:

   • No direct impact, but retained earnings are lower due to depreciation expense.

Example (Kathmandu Supermart):

| Assets                     | Amount (Rs.) |
|----------------------------|--------------|
| Fixed Assets:              |              |
|   - Machinery              | 10,00,000    |
|   Less: Accumulated Dep.   | (8,00,000)   |
|   Net Book Value           | 2,00,000     |

C. Cash Flow Statement

• Depreciation is a non-cash expense, so it’s added back to net profit in the operating activities section. Example:

  | Particulars               | Amount (Rs.) |
  |----------------------------|--------------|
  | Net Profit                | 7,50,00,000  |
  | Add: Depreciation         | 50,00,000    |
  | Cash Flow from Operations | 8,00,00,000  |
  

In the Real World

Depreciation isn’t just theory—it’s how Nepali businesses save money, plan replacements, and comply with tax laws. Here’s how:

1. Ncell’s 4G Towers

   • Method: Straight-line (SLM).
   • Why? Towers lose value evenly over 10–15 years. Ncell claims Rs. 80,000–1,00,000/year per tower as depreciation, reducing taxable income.
   • Impact: Funds future upgrades (e.g., 5G rollout).

2. Daraz’s Delivery Fleet

   • Method: Sum-of-Years’ Digits (SYD).
   • Why? Vans depreciate faster in the first 2 years (high mileage, wear). Daraz writes off more depreciation early, reflecting higher replacement costs.
   • Impact: Helps budget for new vans every 3–4 years.

3. Khalti’s ATMs

   • Method: Diminishing Balance (DBM).
   • Why? ATMs become obsolete quickly (new tech, security upgrades). Khalti uses a 20% rate, so early years see higher depreciation (e.g., Rs. 40,000/year vs. Rs. 10,000 later).
   • Impact: Justifies frequent ATM upgrades to prevent fraud risks.

4. NTC’s Undersea Cables

   • Method: Straight-line (adjusted for inflation).
   • Why? Cables have a long life (20+ years) and wear uniformly. NTC uses a reduced rate (e.g., 3%/year) to spread costs over decades.
   • Impact: Ensures stable internet infrastructure without sudden cost spikes.

7. Worked Example: Full Depreciation Schedule (Nepali Business)

Scenario: Kathmandu Electronics buys a computerized embroidery machine on 1 Baishak 2073 for Rs. 8,00,000. Installation costs Rs. 50,000. The machine has:

• Useful Life: 5 years
• Scrap Value: Rs. 1,00,000
• Method: Diminishing Balance at 20%/year

Step 1: Calculate Depreciable Amount $$\text{Total Cost}=8,00,000+50,000=\text{Rs. 8,50,000}$$ $$\text{Depreciable Amount}=8,50,000-1,00,000=\text{Rs. 7,50,000}$$

Step 2: Annual Depreciation Schedule (Note: In DBM, we depreciate the book value, not the depreciable amount.)

Step 3: Journal Entries for Each Year (Assume fiscal year ends on Chaitra 31.)

Year 1 (2073):

| Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
|------------|---------------------------------|----------|----------|
| 31 Chaitra 2073 | Depreciation Expense (Machine) | 1,70,000 |          |
|            | To Accumulated Depreciation     |          | 1,70,000 |

Year 2 (2074):

| Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
|------------|---------------------------------|----------|----------|
| 31 Chaitra 2074 | Depreciation Expense (Machine) | 1,36,000 |          |
|            | To Accumulated Depreciation     |          | 1,36,000 |

Step 4: Disposal After 3 Years (Sold for Rs. 3,00,000)

• Book Value (End of Year 3): Rs. 4,35,200
• Sale Proceeds: Rs. 3,00,000
• Loss on Sale: Rs. 1,35,200

Journal Entries:

1. Depreciation for Year 3:

   | Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
   |------------|---------------------------------|----------|----------|
   | 31 Chaitra 2075 | Depreciation Expense (Machine) | 1,08,800 |          |
   |            | To Accumulated Depreciation     |          | 1,08,800 |
   

2. Sale of Machine:

   | Date       | Particulars                     | Dr (Rs.) | Cr (Rs.) |
   |------------|---------------------------------|----------|----------|
   | 15 Baishak 2076 | Bank A/c                        | 3,00,000 |          |
   |            | Loss on Sale of Machine         | 1,35,200 |          |
   |            | To Machine A/c                  |          | 4,35,200 |
   

T-Account for Machine Disposal:

Machine A/c
| Dr (Cost) | Cr (Depreciation) | Cr (Disposal) |
|-----------|-------------------|----------------|
| 8,50,000  | 4,14,800          | 4,35,200       |

Accumulated Depreciation A/c
| Dr (Disposal) | Cr (Depreciation) |
|----------------|-------------------|
| 4,14,800       | 4,14,800          |

Exam Tip: How to Score Full Marks

1. Always Show Calculations

   • Examiners deduct marks if you skip steps. For example:
     • SLM: Show the formula and plug in numbers.
     • DBM: Calculate the rate explicitly (e.g., "Rate = 20% as per question").
     • SYD: Write the sum of years’ digits (e.g., "5+4+3+2+1 = 15").

2. Use T-Accounts for Disposal

   • Questions often ask for final entries after disposal. Always:
     • Calculate book value.
     • Compare with sale proceeds.
     • Pass the difference to gain/loss on sale.

3. Match Methods to Scenarios

   • Straight-line: Buildings, land improvements.
   • Diminishing Balance: Tech assets (computers, servers).
   • SYD: Vehicles, machinery with uneven usage.

4. Partial Year Depreciation

   • If an asset is bought/sold mid-year, depreciate for the fraction of the year. Example: Bought on 1 Baishak, sold on 1 Kartik → 5 months depreciation. $$\text{Depreciation}=\text{Annual Depreciation}\times \frac{5}{12}$$

5. Common Mistakes to Avoid

   • ❌ Forgetting to add installation costs to the asset’s cost.
   • ❌ Using scrap value in DBM/SYD calculations (only SLM uses it directly).
   • ❌ Not closing the asset account on disposal (debit/credit the full cost).

6. Practice Past Exam Questions

   • Question Type 1: Calculate depreciation for multiple years (e.g., 2017–2021). Tip: Use a table like the Kathmandu Electronics example above.
   • Question Type 2: Disposal scenarios (sale, scrap, retirement). Tip: Always show book value and gain/loss calculation.
   • Question Type 3: Method comparison (e.g., "Why would Ncell use DBM?"). Tip: Link to real-world usage patterns (e.g., tech obsolescence).

Final Checklist for Depreciation Questions

Visual Summary of the Accounting Cycle for Depreciation:

flowchart TD
    A["Purchase Asset\n(Dr Asset, Cr Bank/Cash)"] --> B["Record Depreciation\n(Dr Dep Exp, Cr Acc Dep)\n(Annually)"]
    B --> C["Prepare Financial Statements\n(Income Statement: Dep Exp\nBalance Sheet: Net Book Value)"]
    C --> D["Disposal/Sale\n(Dr Bank, Dr/Loss or Cr/Gain, Cr Asset)"]
    D --> E["Close Books\n(Update Accumulated Depreciation)"]