Businesses use fixed assets such as plant, property and equipment in generating revenues and as infrastructure for the business. Fixed assets are not charged to the profit and loss account rather they are reported on the balance sheet and they stay on the balance sheet.
The purpose of depreciation is to charge an element of the fixed assets annually to the profit and loss account to reflect the usage of the assets during the year. Depreciation will continue to be charged to the profit loss account until the carrying value of the fixed assets have been fully depreciated that is if the net book value of the fixed asset becomes zero. Depreciation should cease once the net book value or carrying amount of a fixed asset becomes zero.
The basics or nuts and bolts of depreciation
Below are some of the basic details that helps in the understanding of the concept of depreciation;
- The depreciable amount or the amount that will be subjected to depreciation is cost of the fixed asset less estimated residual value. This depreciable amount will be charged over the life of the fixed asset based on depreciation method such as reducing balance method, straight line or sum of digits. The depreciation method chosen by a business should reflect the pattern in which the fixed asset's economic benefits accrue to the business
- Depreciation is charged on the cost of the business’ long-lived assets or fixed assets other than land over their useful lives. The cost of fixed assets is made up of the purchase price plus any costs of bringing the fixed asset to the present location and condition. In some cases significant costs to be incurred at the end of an asset's useful life such as decommissioning of the mine can either be reflected by reducing the estimated residual value or by charging the amount as a depreciation expense over the life of the asset.
- Fixed assets are normally carried on the balance sheet and the historical cost however some businesses elect to revalue their fixed assets. When a business elects to revalue fixed assets then depreciation should be based on the re-valued amount.
- A business may be allowed to review the useful economic life of an assets and the business thinks it is appropriate for it to change the useful life then the changes it makes should be reflected in the current year financial statement and should use the new methodology consistently in future. Accounts may need to be changed retrospectively also.
Depreciation is a charge that is released through the profit and loss account as an expense charge for fixed assets usage and for wear and tear. The charge spreads the costs of fixed asset usage over the useful economic life of the fixed assets and will continue to be charged to the profit loss account until the carrying value of the fixed assets becomes zero. Depreciation ceases to be charged once the net book value of the fixed asset becomes zero.
Munya Mtetwa - Munya is an ACCA and IFA qualified accountant with over ten years financial management and accounting experience acquired in a plethora of ...
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