Depreciation and revaluation

by Admin
Updated: July 11, 2018

Depreciation and revaluation are methods of allocating costs and values of assets over time

When the useful life of an asset is longer than the accounting period (a company’s financial year), it is necessary to apportion the cost of the asset to each accounting period appropriately. Depreciation (including amortization and depletion) are methods for achieving this. Revaluation is used when the actual value of an asset is significantly different from its book value and a correction needs to be made.

Depreciation and revaluation are used for allocating costs over time. It is possible for them to match the true value of the assets but this is highly dependent on the methods and not something to be trusted. They are accounting devices and can be manipulated.

Depreciation, amortization and depletion

Depreciation, amortization and depletion use essentially the same process applied to different things:

  • Depreciation is the catch-all term. Specifically, it is applied to fixed assets (buildings, equipment etc.)
  • Amortization is depreciation applied to intangible assets (rights, intellectual property etc.)
  • Depletion is depreciation applied to non-renewable natural resources (precious metals, oil etc.)

Principles

Depreciation spreads the way the cost of an asset is charged to the business and reduces operating profit accordingly.

  • Representative depreciation would attempt to accurately reflect the consumption of the asset.
  • Accelerated depreciation would attempt to maximize tax efficiency and support cash flow.

Methods

Note that the calculations used for each method may vary and tax authorities place restrictions on the methods used.

  1. Accelerated: The portion of total asset cost applied during the first accounting period is highest and becomes less for subsequent periods. Common for fixed assets:
    e.g. a vehicle which costs $50,000 and loses a lot of its value as soon as it is used for the first time but it is expected to have terminal value might be depreciated at 50% per year ($25,000 is applied in year 1, $12,500 in year 2 etc. to a final value of $781.25 at the end of year 5).
  2. Linear (a.k.a. Straight-line): The cost of the asset is divided by its lifetime and applied to each accounting period in equal amounts. Common for amortization:
    e.g. rights acquired for $50,000 that expire after 5 years are depreciated to zero at $10,000 per year.
  3. Variable: The portion of the total asset cost during any accounting period is proportional to an estimate of the consumption of its value. Common for depletion:
    e.g. $50,000 spent opening a mine (capital cost) which yields 10% of its total capacity in year 1 is depreciated by 10% to $45,000 and if it yields 20% in year 2 it is depreciated by a further $10,000 and so on.

Salvage value

Also known as residual value or scrap value, the salvage value is value an assets has at the end of its useful life (according to the accounts). It is often, but not always, assumed to be zero.

When accelerated depreciation is used, the end-of-year value never reaches zero so not special allowance needs to be made under normal circumstances. However, when applying linear depreciation to something that will have significant salvage value, only the loss in value should be depreciated.

Revaluation

If the real (sale) value of an asset changes to the extent that it is significantly different from its book value, it may be necessary to revalue it.

e.g. a building acquired for $100,000 that has been depreciated at $5,000 per year for 10 years will have a book value of $50,000 but might actually be worth $120,000.

When the revaluation is positive it is distinguished on the balance sheet from other equity as the Revaluation Reserve. When negative, it is debited against any existing revaluation reserve and any negative balance is treated as a loss.

A revaluation to compensate for insufficient depreciation because of some catastrophic change is an impairment and can be applied immediately to the income (profit & loss) statement.

More info

Depreciation article at investopedia.com.

Salvage value at accountingtools.com.

Revaluation at accountingexplained.com.

Internal links

Compound interest and inflation Balance sheet Buying a business Go to Articles
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