Depreciation
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Depreciation is the systematic allocation of the depreciable amount of a tangible non-current asset over its useful economic life. It is not a fund or money set aside — it is an accounting entry that reduces the book value of an asset and is charged as an expense in the income statement. Depreciation reflects the wearing out, consumption, or loss of value of an asset, not its market value.
The depreciable amount is the cost of the asset minus its estimated residual value (scrap value) at the end of its useful life. Useful life is the period over which the asset is expected to be available for use by the entity.
Three Principal Methods of Depreciation:
1. Straight-Line Method (also called Fixed Installment Method): $$\text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}}$$
For example, a machine costs ₦550,000, residual value ₦50,000, useful life 5 years: $$\text{Annual Depreciation} = \frac{550{,}000 - 50{,}000}{5} = ₦100{,}000\text{ per year}$$
2. Reducing Balance Method (also called Diminishing Balance or Written-Down Value): $$\text{Depreciation} = \text{Rate} \times \text{Reducing Book Value}$$
Using a rate of 40%: Year 1: 40% × ₦550,000 = ₦220,000; Year 2: 40% × ₦330,000 = ₦132,000
3. Sum-of-Digits Method (accelerated method): If useful life = 5 years, sum of digits = 5+4+3+2+1 = 15. Year 1 depreciation = 5/15 × (Cost − Residual value)
⚡ Exam Tip: ICAN consistently asks candidates to compare straight-line and reducing balance methods — straight-line gives equal annual charges, while reducing balance gives higher charges in early years and lower later. Reducing balance is appropriate for assets that lose value faster initially (computers, motor vehicles).
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Depreciation — ICAN (Nigeria) Study Guide
IAS 16 — Property, Plant and Equipment
Under IAS 16, an entity must choose either the cost model or the revaluation model as its accounting policy for property, plant and equipment after initial recognition. Under the cost model, the asset is carried at cost less accumulated depreciation and impairment. Under the revaluation model, the asset is carried at a revalued amount (fair value at date of revaluation) less subsequent accumulated depreciation.
When an asset is revalued, the entire class of assets to which that asset belongs must be revalued. Revaluation gains are usually credited to revaluation surplus (under equity), except to the extent that the gain reverses a revaluation loss previously recognised in profit or loss.
Journal Entries for Depreciation:
At the end of each year:
- Dr. Depreciation Expense a/c (income statement) [amount]
- Cr. Accumulated Depreciation a/c (balance sheet — contra asset)
Asset Disposal
When an asset is sold:
- Calculate depreciation to date of sale
- Calculate book value (Cost − Accumulated Depreciation)
- Compare proceeds with book value:
- Proceeds > Book Value = Profit on disposal (credit P&L)
- Proceeds < Book Value = Loss on disposal (debit P&L)
Example: Machine cost ₦200,000, accumulated depreciation ₦160,000, sold for ₦50,000:
- Book value = ₦200,000 − ₦160,000 = ₦40,000
- Proceeds (₦50,000) > Book value (₦40,000) = Profit of ₦10,000
Journal entries:
- Dr. Bank ₦50,000
- Dr. Accumulated Depreciation ₦160,000
- Cr. Machine a/c ₦200,000
- Cr. Profit on Disposal ₦10,000
Depreciation and the Financial Statements:
In the balance sheet: Accumulated Depreciation is deducted from the asset’s cost (same line item or as a separate contra asset). In the income statement: Depreciation expense appears as an operating expense.
⚡ Common Mistakes: Forgetting to provide for depreciation in the year of disposal (depreciation should be charged for the portion of the year the asset was used), and confusing residual value with scrap value — they are the same concept.
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Depreciation — Comprehensive ICAN (Nigeria) Notes
Conceptual Foundations of Depreciation
Depreciation is one of the most frequently misunderstood topics in accounting. It is fundamentally an allocation concept, not a valuation concept. The depreciable amount must be allocated on a systematic basis over the asset’s useful life. The method chosen should reflect the pattern in which the asset’s economic benefits are consumed.
Straight-Line Method — Detailed Analysis:
Produces the same depreciation charge each year. Best suited for assets whose economic benefits are consumed evenly over time (e.g., leasehold buildings, some types of equipment). The formula is straightforward, but candidates must be careful to:
- Use residual value in the denominator, not full cost
- Calculate partial-year depreciation on a pro-rata basis when an asset is acquired or disposed of mid-year
Pro-rata example: Asset purchased 1 April 20X1, financial year ends 31 December. Depreciation ₦90,000 per year.
- Year 1: 9/12 × ₦90,000 = ₦67,500 (April to December)
- Year 2–4: Full years = ₦90,000 each
- Year 5: 3/12 × ₦90,000 = ₦22,500
Reducing Balance Method — Detailed Analysis:
The rate is typically applied to the opening book value (cost less accumulated depreciation to date). The method produces a declining charge — higher in early years when the asset is more productive, lower later. This is particularly appropriate for assets that generate more economic benefits early in their life (e.g., computers, mobile phones, motor vehicles).
The rate can be derived from the formula: $$(1 - \sqrt[n]{\frac{\text{Residual Value}}{\text{Cost}}}) \times 100$$
where n = useful life in years. For a 4-year life with residual = 10% of cost: Rate = (1 − ∜0.10) × 100 ≈ 37.8%.
Sum-of-Digits Method — Detailed Analysis:
An accelerated method where the fraction of depreciable cost recognised each year decreases over time. For a 5-year asset:
- Total digits = 1+2+3+4+5 = 15
- Year 1: 5/15 × depreciable cost
- Year 2: 4/15 × depreciable cost
- Year 3: 3/15 × depreciable cost
- Year 4: 2/15 × depreciable cost
- Year 5: 1/15 × depreciable cost
Units of Production Method:
For assets whose wear and tear is better measured by output than time: $$\text{Depreciation per unit} = \frac{\text{Cost} - \text{Residual Value}}{\text{Total Estimated Units of Production}}$$
Example: Machine cost ₦300,000, residual ₦30,000, estimated production 90,000 units over 5 years. Depreciation per unit = ₦3 per unit. If Year 1 production = 25,000 units → depreciation = ₦75,000.
Revaluation Method:
Under the revaluation model, when an asset is revalued upward:
- Dr. Asset a/c (increase in value)
- Cr. Revaluation Surplus a/c (equity — unless reversing a prior downward revaluation loss taken to P&L)
If an upward revaluation reverses a previously recognised impairment loss on the same asset: Dr. Asset a/c, Cr. P&L (other income — impairment gain).
Component Depreciation (IAS 16 Amendment):
When significant parts of a non-current asset have different useful lives, each part must be depreciated separately. For example, an aircraft may be depreciated over 20 years, but its engines depreciated over 8 years each. When an engine is replaced, the new engine is capitalised as a separate component.
Disclosure Requirements under IAS 16:
The financial statements must disclose for each class of PPE: the measurement basis, depreciation methods used, useful lives or depreciation rates, gross carrying amount and accumulated depreciation, and reconciliation of carrying amount at beginning and end of period.
⚡ ICAN Exam Pattern: Depreciation questions frequently combine the calculation of depreciation (straight-line, reducing balance, or sum-of-digits) with asset disposal, revaluation, and inclusion in financial statements. Always attempt partial-year depreciation questions in the year of acquisition and year of disposal — ICAN examiners penalise the omission of these adjustments. A 15-mark question typically involves: calculating depreciation under two methods (6 marks), preparing ledger accounts for accumulated depreciation and asset disposal (5 marks), and showing extracts from financial statements (4 marks).
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