Depreciation

Learning Objective: Calculate depreciation using different methods

When a delivery company in Kathmandu buys a truck for Rs. 25,00,000, that truck does not maintain its full value forever. Every year, due to wear and tear, the truck loses some value. This gradual decrease in the value of a fixed asset over its useful life is called depreciation.

Why Depreciation Matters

• Accurate profit calculation: Without depreciation, profits would be overstated because the cost of using assets is ignored.
• True asset valuation: The balance sheet should show assets at their realistic value, not original cost.
• Tax benefits: Depreciation is a deductible expense in Nepal's income tax calculations.
• Replacement planning: Setting aside depreciation helps a business save for future asset replacement.

Methods of Depreciation

1. Straight-Line Method (SLM)

The simplest method -- the same amount of depreciation is charged every year.

Formula: Annual Depreciation = (Cost - Scrap Value) / Useful Life

Example: A printing machine costs Rs. 5,00,000, has a scrap value of Rs. 50,000, and a useful life of 9 years.

Annual Depreciation = (5,00,000 - 50,000) / 9 = Rs. 50,000 per year

| Year | Opening Value (Rs.) | Depreciation (Rs.) | Closing Value (Rs.) | |------|-------------------|-------------------|-------------------| | 1 | 5,00,000 | 50,000 | 4,50,000 | | 2 | 4,50,000 | 50,000 | 4,00,000 | | 3 | 4,00,000 | 50,000 | 3,50,000 |

2. Reducing Balance Method (Diminishing Balance)

Depreciation is calculated as a fixed percentage of the book value (not original cost) each year. This means higher depreciation in early years, which gradually decreases.

Formula: Depreciation = Book Value at Beginning of Year x Rate%

Example: Furniture worth Rs. 1,00,000 depreciated at 10% per year.

| Year | Opening Value (Rs.) | Depreciation (Rs.) | Closing Value (Rs.) | |------|-------------------|-------------------|-------------------| | 1 | 1,00,000 | 10,000 | 90,000 | | 2 | 90,000 | 9,000 | 81,000 | | 3 | 81,000 | 8,100 | 72,900 |

Notice how the depreciation amount decreases each year.

Journal Entries for Depreciation

To record annual depreciation:

| Date | Particulars | Debit (Rs.) | Credit (Rs.) | |------|------------|-------------|--------------| | Year-end | Depreciation A/c ...Dr. | 50,000 | | | | To Machinery A/c | | 50,000 | | | (Being depreciation charged on machinery) | | |

Key Term: Book Value (or Written Down Value) is the original cost of an asset minus the total depreciation charged so far. It represents the asset's current value in the books.

Summary

• Depreciation is the systematic allocation of an asset's cost over its useful life.
• The Straight-Line Method charges equal depreciation each year.
• The Reducing Balance Method charges higher depreciation in early years and less in later years.
• Depreciation is recorded as an expense, reducing both profit and asset value.