Friday, September 17, 2010

Accounting for depreciation

Depreciation refers to the method of apportioning the value of an asset over several financial periods.

An asset's value is not expensed off immediately, but over a period of time, depending on the length of it's estimated useful lifespan.

So if we anticipate that a motor vehicle has a useful lifespan of 5 years, we would first capitalize the cost of the motor vehicle and then expense it off over a period of 5 years.  The depreciation rate for the motor vehicle each year would then be 20%.

There are two main methods of depreciating an asset, straight line and reducing balance.

Straight line depreciation method

In the straight line method, we would apply the rate of the depreciation to the initial cost of the asset.  The depreciation expense for each year would therefore be the same.

As an example, if the asset cost RM10,000.00 and the depreciation rate is 20%, we would depreciate the asset RM2,000.00 each financial year, over a period of 5 years.
Reducing balance depreciation method

In the reducing balance method, we apply the depreciation rate to the cost of the asset less the amount already depreciated.

For an asset purchased at RM10,000.00, the depreciation would be calculated as follows:
For the first year, depreciation is calculated at 20% of RM10,000.00.

The second year's depreciation however is calculated at 20% of RM10,000.00 minus the first year's depreciation.

In general, most businesses use the straight line method for depreciating their assets.

Frequency of calculating depreciation

Depending on your reporting requirements, depreciation is calculated either monthly or annually.

Small businesses generally do not bother with depreciation or accrual of expenses, and leave it to the auditor to work this out during the audit.

It is good practice, however, to account for depreciation every month so that your income statement reflects a more accurate position.

Accounting for depreciation

Depreciation is taken up in the accounts through journal entries. 

An account called Accumulated Depreciation, which holds the total depreciation expensed to date is credited, and the Depreciation account is debited.

Each asset account will have a corresponding Accumulated Depreciation account. 

The accounting journal entry for straight line depreciation would look like this:


Depreciation expense account  2,000.00

Accumulated depreciation account (Motor Vehicle)



Depreciation rates

Standard depreciation rates used by most businesses in Malaysia are as follows: