Introduction to Depreciation and Provision for Depreciation
Introduction:
This note will discuss the meaning of depreciation, its essence, and its causes.
Meaning of Depreciation:
Black’s Law Dictionary defines depreciation as:
A decline in an asset's value because of use, wear, obsolescence, or age
For example, when you buy a new phone and immediately want to resell it, the value for which it will be resold will be much higher than if you want to sell it after five years of use. The fact of this decline in value as a result of use or age is what is referred to as depreciation.
According to IAS 16 Property, Plant and Equipment, depreciation is:
The systematic allocation of the depreciable amount of an asset over its useful life.
This definition is cited in the Course Manual on Legal Accountancy. The definition reveals two important terms (depreciable amount and useful life) that need clarification.
1. Depreciable Amount:
IAS 16 defines this as
The cost of an asset, or other amount substituted for cost, less its residual value.
This definition has again introduced another unfamiliar term, which is residual value (also known as scrap value). IAS 16 defines this as:
The estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.
Summarily, the depreciable amount is the cost of an asset minus the price it will be sold for if it were to be sold. If the cost of an asset is Ghc 100,000, and its residual value is Ghc 70,000, the depreciable amount will be Ghc 30,000.
Depreciable amount = Ghc 100,000 – Ghc 70,000
Depreciable amount = Ghc 30,000
2. Useful Life:
IAS 16 defines this as:
(a) the period over which an asset is expected to be available for use by an entity; or
(b) the number of production or similar units expected to be obtained from the asset by an entity.
This is also referred to as lifespan, economic or effective life.
Understanding the IAS Definition of Depreciation:
In light of the above definitions of depreciable amount and useful life, we may now reevaluate the definition of the IAS of depreciation as:
The systematic allocation of the depreciable amount of an asset over its useful life.
From the definition of depreciable amount, it was clear that the asset lost Ghc 30,000 value over the period from which it was acquired and the period from which it was (to be) disposed off (its useful life). Depreciation is simply a system for us to allocate the loss of the GHC 30,000 value from the period of acquiring the asset to the period of disposing of it.
The way this loss of Ghc 30,000 is allocated depends on the method of depreciation that is used. For instance, if we use the straight-line method of allocating the depreciable amount of Ghc 30,000, the asset will lose the same value each year, resulting in equal annual depreciation expenses from acquisition to disposal. If we use the reducing balance method of allocating the depreciable amount of Ghc 30,000, the asset will depreciate more in the earlier years and less in later years. Other methods of allocating the depreciable amount will be discussed in subsequent notes.
Essence of Making Provisions for Depreciation:
It will be remembered that in preparing the statement of financial position (balance sheet), the assets of the business and their value are recorded. Given our newfound understanding that an asset loses value every year, it is not accurate to only record the cost of acquiring the asset as the value of the asset without accounting for decreases in the value of the asset as a result of use, passage of time, among others.
Making provision for depreciation is the way by which we can account for the losses in the value of an asset. For example, if an asset is acquired in 2025 for Ghc 100,000, and we estimate that in 2030 it will have a residual value of Ghc 70,000, we need to be able to allocate the Ghc 30,000 decrease in the asset's value over the five-year period (2025-2030). In our statement of financial position for the first year, we need to be able to determine how much of the GHC 30,000 total loss of value occurred in the first year. Same for the second to fifth year. At the end of the fifth year, the value of our asset, as it shows in the statement of financial position, should be Ghc 70,000, not the original purchase price of Ghc 100,000.
Note that depreciation is calculated for fixed assets because they are the assets that are acquired for long-term use, and their benefits exceed twelve months.
Causes of Depreciation:
1. Physical factors such as wear and tear, accidental damage to the equipment, rust, and decay. For instance, a vehicle used for commercial transportation will experience depreciation due to continuous use, leading to wear and tear of its engine, tires, and body. Similarly, industrial machinery may suffer rust and decay over time due to exposure to moisture or harsh environmental conditions.
2. Passage of Time: The value of some assets, such as a lease, copyright, patent, or even an iPhone, reduces over time. For example, even without using your new iPhone X, the mere passage of time will cause it to depreciate (lose value).
3. Economic Factors such as technological advancement and change in market demand can cause an asset to lose its value over time. For instance, it is estimated that 256 gigabytes of storage will cost about 20 billion dollars in the 1950s. Now, this costs less than Ghc 500 cedis due to advancements in technology. Similarly, traditional film cameras lost significant value with the rise of digital photography.
4. Legal and Regulatory Factors: For instance, laws that criminalise or regulate the use of some assets can cause the loss of value of those assets, as people are unwilling to buy them at a higher price. For instance, a law that prohibits the use of old diesel-powered generators will cause the price of such generators to substantively reduce.