Each year we send away our year-end ledger details to the public accountant and, in due course, a set of financial statements is prepared.
In addition to the operational transactions that our bookkeeper/accountant has input, these statements will contain some additional expenses.
These are generally known as ‘book’ or ‘year-end’ entries and the final Profit & Loss Account will include ‘book’ items such as amortisation, depreciation, bad debts written-off, movements in employee provisions, and profits/losses on asset disposals. This article considers the subject of depreciation.
Definitions
The layperson’s description of depreciation typically relates to the loss in value of assets because they are now one year older and have incurred wear and tear.
The accounting definition is a little more complex, as described shortly.
Firstly, in accounting terms when an asset is purchased there is no charge to the Profit & Loss Account. One asset: cash, is exchanged for another asset: a machine. Or a liability: a lease, is incurred in buying an asset: a machine. Each of these is a Balance Sheet item.
The accounting concept of depreciation in the Profit & Loss Account is as follows:
- Like cash, the new productive asset represents future benefit to the business
- The asset will be used over a number of years
- The cost of the asset should be linked to the revenues that are generated by using it over those years
- The Profit & Loss Account must bear the proportion of the asset’s future benefit that is used up each year.
Depreciation is not a financial cost, such as labour or chemicals. However, it is an economic cost and, therefore, is just as valid a business expense as any other, and its cost must be met by business performance.
Those growers who have studied Ag Department gross margin analyses will note that the hourly cost of machinery is typically included as a production cost. That hourly rate will include an allowance for depreciation.
‘Amortisation’ describes the depreciation of intangible items, for example, goodwill or formation expenses.
Calculation
Theoretically, care should be applied to determine the economic life of an asset, and its residual value on disposal.
Annual depreciation expense equates to: asset cost, less residual value, divided by economic life.
There may also be one process for determining accounting depreciation, and another for determining tax depreciation.
In reality, accountants may usually rely on the tax version of depreciation, as determined by the Australian Taxation Office.
In each case, there will ultimately be a profit or loss on disposal of the asset depending on the residual value received compared to the depreciated value.
Two main methodologies are applied
Straight-line depreciation charges the Profit & Loss Account with the same value each year for a given asset.
Reducing balance depreciation (also known as accelerated depreciation) charges more to the Profit & Loss Account in the early years of use and lower values in later years.
continued next month
For more information, see Tree Fruit August 2014
