Depreciation

Explanation

By their nature, investment assets (machinery and equipment, buildings, etc.) are subject to wear over the years.

This decrease in the value of assets is called “Wear and Tear” or “Depreciation”. In other words, depreciation represents the cost of using assets during the period.

Assume that the company bought a new car for $70,000, and sold it for $50,000 two years later. In this case, the company suffered $20,000 in depreciation.

Obviously, there is no exact formula or method for calculating the annual amount of wear and tear. Nevertheless, over the years, accountants have devised rules (with a number of variations) for calculating the annual wear and tear in terms of assets.

The most popular method is called the straight-line method. It is based on two assumptions:

Each type of asset has a given constant life span.
Examples:

• 10 years for machinery and equipment.

• 8 years for office furniture.

• 3 years for computers.

Wear on assets is gradual, amounting to the same sum each year.9

Example: A new machine is purchased for $100,000 at the beginning of the year, and it is expected to wear out completely after 10 years. Wear and tear on the machine is assumed to be $10,000 each year (10% of the purchase price):

It is assumed that 10% of the machine’s capacity deteriorates each year, and that in the second year, the machine contributes only 90% of its production as compared to when it was new, and 50% after 5 years, etc., so that at the end of 9 years, its production capability totals only 10% of its original production capability.

In practice, the machine may work 15 years, or 5 years. Its production may not decrease by 10% every year – it may decrease by more, or by less. This, however, makes no difference, for two main reasons:

1. The calculation is according to the average. There are many machines of various types that the company bought. Some will provide a pleasant surprise, while others will prove a disappointment. According to prior experience, however, the assumption is that the average wear for the machine will be similar to the description above.

2. There is no simpler solution.

Wear and tear is not necessarily physical deterioration that causes a machine to break down completely. It can be technological wear, due to the entry into the market of more effective machinery or computers with greater production capacity and speed. Companies still using the old equipment will tend to lag behind.

“Virtual” Depreciation

When a company buys a fixed asset (machinery, equipment, etc.), the money paid for it is not considered an expense. It is considered an investment because the cost of the purchase is designed for use over a number of years.

The company therefore lists the amount of wear and tear each year as expense, as if it had bought the asset through equal annual installment payments spread across the life of the asset, which equals the annual wear and tear. This “virtual” expense does not reflect actual cash expense.

It is listed in the profit and loss statement under the “depreciation expense” item. Accountants usually call this item provision for depreciation instead of depreciation expense, because the word provision reflects a situation in which no cash is actually spent.

The logic behind this method of listing is highlighted in the following example.  

Assume that Napoli Pizza Company makes a stable $10,000 profit each year. At the beginning of 2008, the company bought a new oven with a 10-year life span for $15,000 in cash. If the company lists the purchase of the oven as expense in 2008, it will represent a $5,000 loss in that year, and it might be assumed that the company’s situation had greatly worsened in 2008.

Fortunately, the accounting system “helps” the company by enabling it to distribute the cost of the buying the oven over the entire period that the company is expected to benefit from it (10 years, for example). The company will therefore list a $1,500 provision for depreciation each year and finish listing the full provision for the oven after 10 years.

Registration in the ledger account for the purchase of the oven and the provision for its depreciation will 

The balance sheets will indicate as follows:  

Beginning of Year 1 (Purchase of the Machine)

Machine Ledger Account (Asset Ledger Account)

Cash Ledger Account (Asset Ledger Account)

End of Year 1

Machine Ledger Account (Asset Ledger Account)

Depreciation Ledger Account (Expenditure Ledger Account)

End of Year 2

Machine Ledger Account (Asset Ledger Account)

Depreciation Ledger Account (Expenditure Ledger Account)

Beginning of Year 1 (purchase of the machine)

Napoli Pizza’s Balance Sheet as of January 1, 2008 ($)

*The cash item was $35,000 before the purchase of the machine, and decreased by $15,000 to $20,000 following the purchase of the machine.

The balance sheets will indicate as follows: 

End of Year 1

Napoli Pizza’s Balance Sheet as of December 31, 2008 ($)

Explanation:

On the assets side

The value of the machine decreased by $1,500 (from $15,000 to $13,500), compared with the preceding year, as a result of provision for depreciation. 

Cash grew by $10,000 as a result of the annual profit.

On the Liabilities Side:

The retained earnings item grew by $8,500 (from $30,000 to $38,500), compared with the end of the preceding year, as a result of a $10,000 profit, minus $1,500 in depreciation expenses reported in 2008.

(It was assumed that there were no changes in the other items during the year).

End of Year 2

Napoli Pizza’s Balance Sheet as of December 31, 2009 ($)

The process of listing the purchase of the oven in the financial statements is as follows:

When the company bought the oven, it listed it as an asset on the left side of the balance sheet, at the purchase price of ($15,000). After 1 year (and in each of the following years), the company lists a tenth of the value of the oven’s value ($1,500) as “depreciation expense” in the profit and loss statement, while lowering the value of the oven in the balance sheet by the same amount, leaving it at $13,500 (90% of its initial value) at the end of the first year, at $12,000 (80% of its initial value) after two years, and at 0 (worthless) after 10 years.