Understanding of Depreciation and Amortization on the Income Statement

Overview:

Depreciation and amortization expenses are the expenses records in the income statement over the period due to charging on the uses of tangible and intangible non-current assets based on the depreciation method under the company accounting policies.

The depreciation methods of the tangible and intangible assets are really depending on the types of assets, the ways how the company uses the assets, and useful life.

Both tangible and intangible assets are normal depreciation on a monthly basis and then record those charged amounts in the income statement as expenses and records in the balance sheet in the accumulated depreciation expenses, reducing the book values of non-current assets.

Explanation:

The concept of depreciation is that assets should not record as expenses immediately at the time they are purchased if the useful life of assets is more than one year. Therefore, the qualified assets are initially recorded in the balance sheet under the non-current assets, and then the value of those assets is reduced over time due to the depreciation expenses.

Those assets should be charged as expenses based on the proportion that they are consumed, use, and useful life. Depreciation applies to fixed assets only. For current assets like inventories are transferred into the income statement as expenses or cost of sales that the time they are used or sold.

How is the Depreciation Record in the Income Statement?

Similar to the other expenses items, depreciation expenses are also increasing in debit and are recording in cost of goods sold which is part of the production costs if assets are specifically involved in the productions. If the assets are not involved in the production, then the depreciation is recorded in the general and administrative expenses in the income statement.

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The Journal entry to record depreciation is as follow;

Dr Depreciation expenses X,XXX

Cr Accumulated depreciation X,XXX

Based on the journal entry above, the depreciation expenses are debited to the income statement account and it is considered as the operating expenses or cost of goods sold. The contra entry is to the accumulated depreciation account of the fixed assets. This will reduce that asset from cost to net book value.

Methods:

Based on IAS 16,  the depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.

As per IAS 16 mention, three depreciation methods include the straight-line method, the diminishing balance method, and the units of production method. However, it also mentions that various methods could be used as long as it respects the pattern of assets.

Straight line method:

The straight-line depreciation method is one of the most popular methods that charge the same amount over the useful life of assets. This method is quite easy to compare to the others method.

An example of the Straight-line depreciation method would be that the company has a car value of 10,000. It is the company policy to depreciation its assets based on Straight-line depreciation. For such assets, the depreciation rate assumes 20%. Therefore, the depreciation per year would be USD 2,000 equally.

Diminishing balance method:

Using the diminishing balance method, the depreciation amount for the first year will be high and decrease in the subsequent year. The concept is the assets are more productive in the first years and subsequently less productive. By using the same example, the basic depreciation is based on the net book value of assets.

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Therefore, the first year’s depreciation expenses are the same but the second year will be based on the next book value of USD8,000 (USD10,000 – USD2,000). The depreciation in the second year is 1,600 (8,000 * 0.2). based on this figure, you could see the depreciation in the second year is less than the first year.

Units of production method:

The units of production method are the types of depreciation method allowed by IFRS. In this method, the assets will be depreciated based on, for example, the unit of products that assets contribute for the period compared to the total products that are expected to be contributed.

This method is a bit complicated as you require estimating the production units that assets could run for in the whole useful lift. For example, the car could run for 10,000 kilometers per its useful lift, which has already run for 2,500 kilometers this year. Therefore, the depreciation for first year would be USD 2,500 [(2,500*10,000)10,000].

Declining or reducing balance method

The declining and reducing balance method is the same thing. In this method, depreciation will be charged on the rate provided to assets at the net book value after eliminating residual value.

This type of depreciation method is a bit difficult compared to the straight line, and it is applicable to certain types of fixed assets where the value of used or the benefit from the use are high at first and then subsequently reduces from time to time.

This kind of depreciation keeps charging forever if you don’t determine the residual value and number of years to be used.

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Double declining balance method

Double declining is similar to declining above, but the rate is a bit different. For decline, the rate is provided to fixed assets based on their class. However, for double declining, the depreciation rate is based on the rate in a straight line.

For example, the computers will be depreciated at 25% using the straight-line method for four years. And if we change to use double declining, the depreciation rate will be double from 25% to 50% at the first year to its net book value.