Depreciation: Methods, Calculation, and Financial Impact

What is Depreciation?

Depreciation is the systematic allocation of the cost of a non-current (fixed) asset over its useful life. It reflects the wear and tear, obsolescence, or exhaustion of an asset’s economic benefits. Unlike expenses (e.g., salaries), depreciation is not a cash outflow but a non-cash expense that reduces the asset’s book value over time.

Why Depreciate Assets?

Depreciation is crucial because:

1. Matching Principle: Expenses (depreciation) must match the revenue generated by the asset.
2. Accurate Financial Reporting: Shows the true value of assets on the balance sheet.
3. Tax Benefits: Reduces taxable income (in Nepal, depreciation is allowed as a deduction under the Income Tax Act).
4. Fund Replacement: Accumulated depreciation funds help replace old assets.

---

Key Terms

---

Depreciation Methods

Three primary methods are used in Nepalese businesses (and globally). Each affects financial statements differently.

1. Straight-Line Method (SLM)

Formula: $$\text{Annual Depreciation}=\frac{\text{Cost of Asset}-\text{Salvage Value}}{\text{Useful Life (in years)}}$$

Example: A Kathmandu retail shop buys a delivery van for NPR 2,500,000 with a salvage value of NPR 500,000 and a useful life of 5 years. $$\text{Annual Depreciation}=\frac{2,500,000-500,000}{5}=\text{NPR 400,000/year}$$

Journal Entry (Year 1):

| Date       | Particulars                          | L.F. | Dr. (NPR) | Cr. (NPR) |
|------------|---------------------------------------|------|-----------|-----------|
| 2023-01-01 | Depreciation Expense (Van)            |      | 400,000   |           |
|            | Accumulated Depreciation (Van)       |      |           | 400,000   |

Ledger Posting (T-Account):

Depreciation Expense (P&L Account)
| Dr. 400,000 (2023)
| Cr. [Balance Sheet]

Accumulated Depreciation (Contra-Asset)
| Cr. 400,000 (2023)
| Dr. [Balance Sheet]

Mermaid Diagram: Straight-Line Depreciation Over 5 Years

Advantages:

• Simple to calculate and understand.
• Equal expense allocation over the asset’s life.

Disadvantages:

• Does not account for varying usage patterns (e.g., a machine used more in early years).
• Understates expenses in early years if the asset wears out faster initially.

---

2. Reducing Balance Method (RBM)

Formula: $$\text{Annual Depreciation}=\text{Book Value at Beginning of Year}\times \text{Depreciation Rate}$$ Where: $$\text{Depreciation Rate}=\frac{1-\sqrt[n]{\frac{\text{Salvage Value}}{\text{Cost}}}}{\text{Useful Life (n)}}$$

Example: Same van (Cost = 2,500,000; Salvage = 500,000; Life = 5 years). First, calculate the rate: $$\text{Rate}=\frac{1-\sqrt[5]{\frac{500,000}{2,500,000}}}{1}=45.64\%\text{ (approx)}$$ Year 1 Depreciation: $$2,500,000\times 0.4564=\text{NPR 1,141,000}$$ Year 2 Depreciation: $$(2,500,000-1,141,000)\times 0.4564=\text{NPR 590,000}$$

Journal Entry (Year 1):

| Date       | Particulars                          | L.F. | Dr. (NPR) | Cr. (NPR) |
|------------|---------------------------------------|------|-----------|-----------|
| 2023-01-01 | Depreciation Expense (Van)            |      | 1,141,000 |           |
|            | Accumulated Depreciation (Van)       |      |           | 1,141,000 |

Mermaid Diagram: Reducing Balance Depreciation Over 5 Years

Advantages:

• Higher depreciation in early years (matches higher usage/wear).
• Better for assets that lose value quickly (e.g., technology).

Disadvantages:

• Complex calculations.
• Salvage value may not be reached exactly (rounding errors).

---

3. Sum-of-Years’ Digits (SYD) Method

Formula: $$\text{Annual Depreciation}=\frac{\text{Useful Life}-\text{Year}+1}{\text{Sum of Years’ Digits}}\times (\text{Cost}-\text{Salvage Value})$$ Where: $$\text{Sum of Years’ Digits}=\frac{n(n+1)}{2}\text{(for n years)}$$

Example: Same van (Life = 5 years). Sum of digits = 1+2+3+4+5 = 15. Year 1 Depreciation: $$\frac{5}{15}\times (2,500,000-500,000)=\text{NPR 666,667}$$ Year 2 Depreciation: $$\frac{4}{15}\times 2,000,000=\text{NPR 533,333}$$

Journal Entry (Year 1):

| Date       | Particulars                          | L.F. | Dr. (NPR) | Cr. (NPR) |
|------------|---------------------------------------|------|-----------|-----------|
| 2023-01-01 | Depreciation Expense (Van)            |      | 666,667   |           |
|            | Accumulated Depreciation (Van)       |      |           | 666,667   |

Mermaid Diagram: SYD Depreciation Over 5 Years

Advantages:

• Higher depreciation in early years (like RBM but more precise).
• Ensures salvage value is reached exactly.

Disadvantages:

• More complex than SLM.
• Less common in Nepal (often used for tax purposes in some countries).

---

Comparison of Depreciation Methods

---

Depreciation in Financial Statements

Depreciation affects three key financial statements:

1. Income Statement

• Depreciation Expense reduces net profit. Example: If a business has revenue of NPR 5,000,000 and expenses (excluding depreciation) of NPR 3,000,000, adding NPR 400,000 (SLM depreciation) gives: $$\text{Net Profit}=5,000,000-3,000,000-400,000=\text{NPR 1,600,000}$$

2. Balance Sheet

• Asset Value: Reduces the book value of the asset.
• Accumulated Depreciation: Increases as a contra-asset (deducted from the asset’s cost). Example: After Year 1:

  | Asset               | Cost (NPR) | Accumulated Depreciation (NPR) | Net Book Value (NPR) |
  |---------------------|------------|---------------------------------|----------------------|
  | Delivery Van        | 2,500,000  | 400,000                        | 2,100,000            |
  

3. Cash Flow Statement

• Depreciation is a non-cash expense, so it is added back to net profit in the operating activities section. Example: If net profit is NPR 1,600,000 and depreciation is NPR 400,000, cash flow from operations is: $$1,600,000+400,000=\text{NPR 2,000,000}$$

---

Disposal of Depreciable Assets

When an asset is sold or scrapped, the following steps are taken:

Step 1: Update Depreciation

Bring accumulated depreciation up to the date of disposal.

Step 2: Calculate Gain or Loss

$$\text{Book Value at Disposal}=\text{Cost}-\text{Accumulated Depreciation}$$ $$\text{Gain/Loss}=\text{Selling Price}-\text{Book Value}$$

Step 3: Journal Entries

Example: A computer costing NPR 200,000 with salvage value NPR 20,000 and life 4 years is sold for NPR 80,000 after 3 years.

• Annual Depreciation (SLM): $(200,000-20,000)/4=\text{NPR 45,000/year}$
• Accumulated Depreciation after 3 years: $3\times 45,000=\text{NPR 135,000}$
• Book Value: $200,000-135,000=\text{NPR 65,000}$
• Gain/Loss: $80,000-65,000=\text{NPR 15,000 (Gain)}$

Journal Entries:

| Date       | Particulars                          | L.F. | Dr. (NPR) | Cr. (NPR) |
|------------|---------------------------------------|------|-----------|-----------|
| 2023-12-31 | Accumulated Depreciation (Computer)   |      | 45,000    |           |
|            | Depreciation Expense (Computer)      |      |           | 45,000    |
| 2024-01-01 | Bank A/c                              |      | 80,000    |           |
|            | Computer A/c                         |      | 200,000   |           |
|            | Accumulated Depreciation (Computer)   |      |           | 180,000   |
|            | Gain on Disposal of Asset            |      |           | 15,000    |

---

In the Real World

Depreciation is critical in Nepal’s business landscape. Here’s how companies apply it:

1. Ncell (Nepal Telecom)

   • Asset: Cell towers and network equipment.
   • Method: Straight-line method (for tax compliance and simplicity).
   • Why? Towers have a long useful life (10–15 years) with relatively stable usage. Ncell reports depreciation to reduce taxable income while reflecting the true value of its infrastructure.

2. Daraz (Nepal’s Amazon)

   • Asset: Warehouse machinery (conveyor belts, sorting robots).
   • Method: Reducing balance method for high-tech assets.
   • Why? Machinery wears out faster in the first few years. Daraz accelerates depreciation to match higher early-year expenses, improving cash flow projections for investors.

3. Nepal Rastra Bank (NRB) and Commercial Banks

   • Asset: ATMs and core banking servers.
   • Method: Sum-of-Years’ Digits (SYD) for IT assets.
   • Why? Banks use SYD to recognize higher depreciation in early years when IT systems are most critical. This aligns with the matching principle—higher expenses when systems generate the most revenue.
   • Real Example: A bank buys a server for NPR 5,000,000 (salvage = NPR 500,000, life = 5 years). Using SYD:
     • Year 1: $(5/15)\times 4,500,000=\text{NPR 1,500,000}$
     • Year 2: $(4/15)\times 4,500,000=\text{NPR 1,200,000}$ This ensures the bank’s financial statements reflect the rapid obsolescence of technology.

4. Khalti (Digital Payment Platform)

   • Asset: Point-of-Sale (POS) terminals for merchants.
   • Method: Straight-line method (simpler for small assets).
   • Why? POS terminals have a uniform usage pattern (e.g., 3–4 years). Khalti uses SLM to simplify accounting and comply with Nepal’s Income Tax Regulations.

5. Nepal Electricity Authority (NEA) / NTC

   • Asset: Power generation plants (hydroelectric turbines).
   • Method: Straight-line method with partial-year conventions.
   • Why? Large infrastructure projects (e.g., a 100 MW plant costing NPR 20 billion) depreciate evenly over 30–40 years. NTC uses SLM to spread costs evenly, aiding long-term budgeting for maintenance and upgrades.

---

Worked Example: Depreciation for a Kathmandu Retail Shop

Scenario: Mr. Sharma owns a retail shop in Thapathali, Kathmandu. He buys a refrigerator for NPR 150,000 on 1 January 2023. The refrigerator has:

• Salvage value: NPR 10,000
• Useful life: 5 years
• Method: Straight-line and reducing balance (compare both).

Step 1: Straight-Line Method

$$\text{Annual Depreciation}=\frac{150,000-10,000}{5}=\text{NPR 28,000/year}$$

Journal Entry (Year 1):

| Date       | Particulars                          | L.F. | Dr. (NPR) | Cr. (NPR) |
|------------|---------------------------------------|------|-----------|-----------|
| 2023-01-01 | Depreciation Expense (Refrigerator)   |      | 28,000    |           |
|            | Accumulated Depreciation (Refrigerator)|      |           | 28,000    |

Balance Sheet (End of Year 1):

| Asset               | Cost (NPR) | Accumulated Depreciation (NPR) | Net Book Value (NPR) |
|---------------------|------------|---------------------------------|----------------------|
| Refrigerator        | 150,000    | 28,000                         | 122,000              |

Step 2: Reducing Balance Method

First, calculate the rate: $$\text{Rate}=\frac{1-\sqrt[5]{\frac{10,000}{150,000}}}{1}=52.76\%\text{ (approx)}$$ Year 1 Depreciation: $$150,000\times 0.5276=\text{NPR 79,140}$$

Journal Entry (Year 1):

| Date       | Particulars                          | L.F. | Dr. (NPR) | Cr. (NPR) |
|------------|---------------------------------------|------|-----------|-----------|
| 2023-01-01 | Depreciation Expense (Refrigerator)   |      | 79,140    |           |
|            | Accumulated Depreciation (Refrigerator)|      |           | 79,140    |

Balance Sheet (End of Year 1):

| Asset               | Cost (NPR) | Accumulated Depreciation (NPR) | Net Book Value (NPR) |
|---------------------|------------|---------------------------------|----------------------|
| Refrigerator        | 150,000    | 79,140                         | 70,860               |

Comparison:

• SLM: Lower early-year expenses (NPR 28,000 vs. NPR 79,140).
• RBM: Higher early-year expenses, matching the rapid wear and tear of refrigerators (compressors fail more often in the first few years).

---

Depreciation and Taxes in Nepal

In Nepal, depreciation is a deductible expense under the Income Tax Act, 2058. Key points:

1. Allowed Rates:
   • Buildings: 2–5% per year (SLM).
   • Machinery/Equipment: 10–20% per year (often RBM or SYD).
   • Vehicles: 15–25% per year (depends on usage).
2. Depreciation Pool:
   • Businesses can group assets (e.g., all computers) and depreciate them at a pooled rate (simplifies accounting).
3. Tax Benefit:
   • Depreciation reduces taxable income. For example, if a business has a profit of NPR 500,000 and depreciation of NPR 100,000, taxable income becomes NPR 400,000.

Example: A Kathmandu restaurant buys a deep fryer for NPR 80,000 (salvage = NPR 5,000, life = 4 years).

• Annual Depreciation (SLM): $(80,000-5,000)/4=\text{NPR 18,750}$
• Tax Savings: If the corporate tax rate is 25%, the restaurant saves: $$18,750\times 0.25=\text{NPR 4,687.50 per year in taxes}$$

---

Common Mistakes to Avoid

1. Ignoring Salvage Value:

   • Always subtract salvage value from the cost before calculating depreciation.
   • Wrong: Depreciating the full cost over the life.
   • Right: Depreciate $(Cost-SalvageValue)$.

2. Mismatched Methods:

   • Using SLM for a computer (should be RBM/SYD) or RBM for a building (should be SLM).

3. Forgetting Partial-Year Depreciation:

   • If an asset is purchased mid-year, depreciate only for the portion of the year used.
   • Example: A machine bought on 1 July 2023 should be depreciated for 6/12 months in Year 1.

4. Not Updating Accumulated Depreciation:

   • Always ensure accumulated depreciation is updated to the disposal date before calculating gain/loss.

5. Confusing Depreciation with Maintenance Costs:

   • Depreciation: Non-cash, systematic allocation.
   • Maintenance: Actual cash expenses (e.g., repairing a machine).

---

The Accounting Cycle and Depreciation

Depreciation is part of the accounting cycle. Here’s how it flows:

Key Point: Depreciation is an adjusting entry made at the end of the accounting period to ensure the matching principle is followed.

---

Exam Tip

Depreciation is a high-scoring topic in PU exams. Focus on these areas:

1. Definitions and Concepts (5–10 marks)

• Define depreciation, accumulated depreciation, book value, and salvage value.
• Explain the matching principle and going concern concept in relation to depreciation.

2. Calculations (15–20 marks)

• Always show your work for SLM, RBM, and SYD.
• Partial-year depreciation: If an asset is bought in June, depreciate for 6 months.
• Disposal entries: Calculate gain/loss and prepare journal entries.

3. Journal Entries and Ledger Postings (10–15 marks)

• Depreciation Journal Entry:

  Dr. Depreciation Expense
  Cr. Accumulated Depreciation
  

• Disposal Journal Entry: Include gain/loss if applicable.

4. Financial Statement Impact (5–10 marks)

• How depreciation affects the income statement, balance sheet, and cash flow statement.
• Example: If net profit is NPR 1,000,000 and depreciation is NPR 200,000, explain how this appears in the cash flow statement (add back depreciation).

5. Real-World Applications (5 marks)

• Relate depreciation to Nepali businesses (e.g., Daraz’s warehouse machinery, Ncell’s towers).
• Discuss tax implications (e.g., how depreciation reduces taxable income).

Common Exam Questions:

1. Calculate depreciation using all three methods for a given asset.
2. Prepare journal entries for depreciation and disposal.
3. Explain the impact of depreciation on financial statements.
4. Compare SLM and RBM with advantages/disadvantages.
5. Scenario-based: "A shopkeeper buys a sewing machine for NPR 50,000. Calculate depreciation for 3 years using SLM and RBM. Show the balance sheet impact."

Pro Tips:

• Memorize formulas but always derive them in exams (e.g., SYD rate).
• Label clearly: Use terms like "Dr.", "Cr.", "Accumulated Depreciation" in journal entries.
• Show totals: In ledger accounts, ensure debit = credit.
• Use real numbers: If the exam gives a cost in NPR, keep answers in NPR (no need to convert to USD).

---