Depreciation is an area of accounting that most people have some difficulty getting their heads around, notes Ginny Brink.
Put simply, it is about buying something for £x, expecting that it will last, say, four years. You pay all the money out for the item in the year you buy it, but in the accounts you spread the cost over four years. In effect you tell the accounts that you are spending a certain amount each year for four years. Once the four years are up you will have paid off the item. This is known as being ?written off?.
Thus, depreciation is the measure of the wearing out, using up or other reduction in the useful economic life (the period you will get benefit) of a fixed asset. This can be from use, passage of time or becoming out of date. It is an accounting adjustment, reducing the value of a fixed asset while at the same time reducing the amount of net profit on the income and expenditure account ? without involving the actual movement of cash.
In order for the financial statements to reflect all the costs of an organisation (?loss of value? is a cost), it is necessary to calculate depreciation. The purpose of the depreciation process is to gradually remove the cost of an asset on the balance sheet and show it as a cost on the profit and loss account. To do this, a portion of the cost of these items is charged to each year that they have a useful life. This process is called capitalising and depreciating fixed assets.
To calculate depreciation charges for each fixed asset, you must know:
? What the asset is considered to be worth. This could be the cost at the time of purchase (including all costs to make the asset operational); the cost of its production (if you made it); or the new figure after revaluation.
? How long the asset can reasonably be expected to last before it needs to be replaced.
? The estimated residual value of the asset at the end of its useful economic life, i.e. the money you can realise at the end of its useful life, based on prices prevailing when you bought it, or the revaluation of the asset.
There are two commonly accepted methods of calculating depreciation. Most charitable organisations adopt the straight-line method. This assumes that the net cost of an asset should be written off in equal amounts over each year of its life. Assume you buy a photocopier for £6,000 and it has an expected life of four years. Its scrap value is estimated to be £4,000. Your depreciation allowance per year will be: £6,000 minus £4,000 divided by 4, making £500.
Alternatively, the reducing balance method assumes that the depreciation charge in the early years of an asset?s life should be higher than in later years. The asset must therefore be written off using the same percentage rate each year. Assume you buy a vehicle for £28,000 and it has an expected life of four years. A 40% charge is to be made each year. Table 1 shows how to calculate the book value of the vehicle at the end of every year.
It is very useful to set up a depreciation schedule to give you an at-a-glance reading of the value of your fixed assets. Spreadsheets can be helpful in this process ? you can enter the depreciation calculations as formulae and let the spreadsheet do all the work for you. This allows you to simply add items as you purchase them. Make sure you marry your inventory with the schedule so that it includes serial numbers, ID codes and a note on where the delivery notes, guarantees and invoices are filed.
Since depreciation is a non-cash purchase (that is, cash is usually paid out in the year the asset is acquired, but the expense is distributed over several years), it is important to plan for the replacement of the fixed assets as they wear out or become obsolete. For example, some organisations set aside an amount of cash equal to the amount of their yearly depreciation expense so that money will be available to purchase a new asset once the current one is fully depreciated. Check with your accountant what an acceptable depreciation rate might be for each asset and what you need to disclose in your books.
Ginny Brink is Information Officer at Voluntary Arts Network. t: 029 2039 5395;
e: ginny@voluntaryarts.org
This article is an adaptation of VAN briefing no 52 ?How do we deal with goods and services part 2? in which depreciation and the background to it are explained in some detail. For the full briefing, visit the website at w: http://www.voluntaryarts.org.