Depreciation of fixed assets: methods and how it is recorded

Depreciation of fixed assets: methods and how it is recorded

Buying an oven, a pickup truck or a server is not an expense of the month in which the invoice arrives: it is an asset that produces income for years, and its cost is spread over that time. That spread is depreciation, an accounting expense that lowers profit but does not take a single peso out of the bank account. Mixing up the two throws the income statement off balance and, along the way, the tax return as well.

This article explains what is depreciated and what is not, the three methods a small business actually uses, how useful life is chosen, how the monthly charge is built, the month-to-month journal entry, the early sale of the asset, and the effect on profit, taxable income and cash flow, with a replicable example.

What depreciating means and why it is not a cash expense

Depreciating means distributing the cost of a fixed asset over the periods in which it provides service. The asset wears out or becomes obsolete, and that consumption is an expense of the period in which it happens, not of the period in which it was paid for. That is why it shows up month after month with no bank movement: the money left when the machine was bought.

In the cash flow statement, the purchase is a heavy outflow in a single month and depreciation does not appear. In the income statement the opposite happens: the purchase is invisible and depreciation arrives in instalments. Both views are correct. Profit falls; cash does not move.

Which assets are depreciated and which are not

You depreciate what has a limited useful life, is used in the operation and generates benefits for more than one period. Anything that fails one of the three conditions is handled differently, and that is where the errors that later have to be reversed are born.

Land is not depreciated: it does not wear out and its useful life cannot be estimated. A building is, even though the plot it stands on is not. When a warehouse is purchased, it pays to separate in the invoice how much is the plot and how much is the construction; if everything goes in as a single block, you end up depreciating the ground or failing to depreciate the wall.

An asset under installation is not depreciated yet either. Depreciation starts when the asset is available for use, not when the invoice arrives. While it is being installed, the cost accumulates in an asset-in-transit account.

Leasehold improvements are depreciated over the shorter of their useful life and the remaining lease term, unless renewal is reasonably certain. An electrical panel for premises you will leave in three years should not be depreciated over ten.

The three methods a small business uses: straight line, declining balance and units produced

Straight line spreads the depreciable base in equal charges and anyone can verify it. If the asset's pattern of use is steady, it is also the most faithful: a desk or the facade of a shop wears out more or less the same every month.

Declining balance applies a fixed rate to the carrying amount, not to the original cost. Because the carrying amount falls every year, the charge falls too: a heavy expense at the start and a soft one at the end. It is justified when the asset loses value quickly or maintenance costs rise. The usual rate is double the straight-line rate, and the charge can never push the carrying amount below the residual value.

Units produced ties depreciation to actual use. A rate per unit is calculated by dividing the base by the estimated capacity, and every month it is multiplied by what was actually produced. It is the most honest method for an oven or a printing press.

None of them changes the total depreciated: they change the spread and, with it, each year's profit. That is why the method is not a bookkeeping detail but a decision a bank or the tax authority will look at.

All three columns belong to the same oven, with a full annual charge under declining balance. Prorated over the ten months of the first year, that method would give 8,000,000 and the year 3 balance would change; the lifetime total does not move.

Useful life: accounting life is estimated by the company, tax life is set by the rules

Accounting useful life is not written on the asset. It is the company's estimate of how long it will use the asset, and it must rest on something: the history of similar equipment, the manufacturer's recommendation, operating conditions, the replacement plan. Two companies with the same machine can have different useful lives if one runs a single shift and the other runs three.

Tax life is a different matter. Tax rules allow the deduction if the asset is used in the income-producing activity, is recorded in the accounting, the depreciation is booked and it does not go beyond the tax cost. There are also accelerated depreciation schemes as incentives, with conditions and validity periods that change with each reform.

In recent years the deduction has been aligned with accounting depreciation, which reduced the reconciliation that used to be mandatory. The differences did not disappear: they appear in assets that do not produce income, in goods received in payment, in revaluations and in accelerated depreciation. When the bases separate, the difference must be tracked and deferred tax recorded.

Residual value and salvage value: the difference almost nobody separates

Residual value is what the company expects to obtain for the asset at the end of its useful life, net of the costs of selling it, in the condition it will be in at that point. It is not today's market price. It is a forward estimate and it can be zero without any problem.

The depreciable base is cost minus that residual value. If the oven costs 48,000,000 and is expected to sell for 3,000,000 after ten years, what gets spread is 45,000,000. The residual is not depreciated because the company expects to recover it through the sale, not through use.

Salvage value is a project appraisal concept. It estimates how much cash will come in at the end of the project and usually includes the land or the working capital that is released. Mixing the two leads to opposite errors: depreciating too little by loading a generous salvage figure, or too much by setting residual value at zero on an asset that will indeed be sold.

How to calculate monthly depreciation without mismatches

The calculation has four steps. First, set the base: cost excluding Colombian VAT (IVA) when that VAT is recoverable, plus freight, insurance, installation and the adaptations needed for the asset to work. If the VAT is not recoverable, it is capitalised. Second, subtract the residual value. Third, convert useful life to months. Fourth, divide.

The calendar error is the most common one. If the asset went into use in March, that year does not carry twelve charges but only the months in which it was available. With the oven in the example, available on 1 March, the first year has ten months.

Two details throw reconciliations off. Rounding: if the charge is not exact, the last month is adjusted so the accumulated total closes against the base. And changes in estimate: if useful life or residual value is revised, the adjustment runs forward on the remaining carrying amount, without redoing prior years.

The monthly journal entry and the accumulated depreciation account

The entry has two lines and does not touch the bank. Depreciation expense is debited and accumulated depreciation is credited, a credit-nature account inside property, plant and equipment. In the balance sheet it is deducted from cost and produces the carrying amount: the original cost is preserved and the wear is shown separately.

The other side of the entry depends on where the asset is used. If the machine works in administration, the expense goes to operating expenses. If it works in production, it is a production cost and must form part of the product cost: sending all of it to expenses understates work in progress and distorts gross margin. If it is used to sell, it goes to selling expenses.

What happens when the asset is sold or retired early

Selling a fixed asset is not a matter of booking the price as income and moving on. The original cost is removed, accumulated depreciation is removed, and the difference between the price and the carrying amount is a gain or a loss, on a line separate from operating revenue. If the oven is sold at the end of year 2 for 42,000,000, there is a gain of 2,250,000; for 37,000,000, a loss of 2,750,000.

If the asset carried recoverable VAT, the sale generates VAT on the price, and that VAT is not profit: it is invoiced, declared and paid. When the asset was acquired without the right to recover VAT, the treatment changes and it is worth confirming before issuing the invoice.

Retirement due to loss or obsolescence requires support: a management minute, a technical report, a police report where there is theft, and removal from the physical inventory. Without support, the loss is questioned in an audit and the expense is rejected. Dismantling costs may require a provision from the purchase date, not when the invoice for the work arrives.

Depreciation and IFRS: reviewing useful life and testing for impairment

Under IFRS, depreciation is not calculated once and repeated to the end. Useful life, residual value and method are reviewed at least at the end of each period, and the change is applied prospectively, affecting the period in which it is reviewed and the following ones. The past is not corrected.

The review makes practical sense. A vehicle bought for five years that has done four with 300,000 kilometres does not have the remaining life the original plan assumed. If it is not reviewed, the expense is understated and the asset overstated.

Impairment is a separate test and a separate expense. The carrying amount is compared with the recoverable amount, the higher of net selling price and value in use. If the recoverable amount is lower, the loss is recognised and the asset continues to be depreciated on the new amount. Depreciation and impairment measure different things and do not replace each other.

The IFRS for SMEs addresses the topic in its property, plant and equipment section. Under full IFRS, significant components must be depreciated separately: the engine of a truck and its body do not wear the same way and should not share a useful life when the difference is material.

Effect on the income statement, on tax and on cash flow

In the income statement, depreciation is an expense and reduces profit before tax. The tax effect is indirect: if profit falls, taxable income falls and the tax falls, provided the deduction is accepted. That saving is not automatic; it depends on there being taxable income and on the deduction being properly supported.

In the cash flow statement there is no disbursement, so depreciation is added back when the flow is built from profit. A common error in small business projections is subtracting it twice, as an expense and as an outflow, which makes the project look less profitable than it is.

Some effects are less visible. The carrying amount falls, and with it the ratios calculated on assets: return on assets, debt coverage with collateral. A bank asking for an unencumbered asset as security looks at the carrying amount, not the purchase price.

Common mistakes

Depreciation mistakes are almost never about arithmetic. They are about the start date, a badly built base and classification.

What depreciation does not fix

Depreciation spreads a cost; it does not make it disappear. An asset that stopped producing income keeps consuming maintenance, spare parts, energy and floor space, and those costs do leave the bank account every month. If the machine is idle and depreciation keeps running, the problem is not accounting: it is operations.

Nor does it replace the accountant. Method, useful life and residual value are estimates with a tax effect, and reconciling the accounting and tax bases requires knowing the rules in force and the particular case. If the company has revalued assets, goods received in payment, leases or belongs to a business group, this does not apply as written: review it with whoever signs the financial statements.

What can be done without waiting for year end is to put the base in order: one record per asset with availability date, cost net of VAT, residual value, useful life, method and destination account. With that record the monthly charge takes care of itself. In Kardex Tauro that control lives alongside inventory and invoicing, so an asset that comes in through a purchase is not lost in a separate spreadsheet.

Keep reading

• Selling price: how to set it without giving away your margin
• Annual budget for a small business: how to build it and control it