Understanding Depreciation Expense: Importance and Calculation Methods

Understanding Depreciation

Depreciation is a way for businesses to spread out the cost of something they buy—like a machine or a vehicle—over the years they use it. Instead of showing the full cost as an expense in the year they buy it, they record a part of the cost each year. This helps show how the asset loses value over time as it gets used or becomes outdated. It also gives a more accurate picture of profits by matching the cost of the asset with the income it helps generate.

For instance, if you purchase a delivery van for S$50,000 with an expected useful life of 5 years and a residual value of S$5,000, you wouldn’t record the entire S$50,000 as an expense in the year of purchase. Instead, you would allocate the cost over the van’s useful life, recognising a portion of the expense each year.

Why Is Depreciation Important?

1. Depreciation ensures that the value of assets on the balance sheet reflects their current worth, providing stakeholders with a realistic view of the company's financial position.
2. While depreciation itself isn't tax-deductible in Singapore, businesses can claim capital allowances on qualifying assets, effectively reducing taxable income.
3. Tracking depreciation helps in planning for asset replacements and budgeting for future capital expenditures.
4. Understanding how assets depreciate aids in evaluating the cost-benefit of purchasing new equipment versus maintaining existing equipment.

Depreciation vs Amortisation vs Depletion: Know the Difference

Many business owners confuse depreciation with similar accounting concepts—amortisation and depletion. Here's a quick breakdown to avoid that mix-up:

If you're only managing physical assets like vehicles or equipment, you’ll primarily deal with depreciation, but it’s good to understand all three.

However, there are many methods to calculate periodic depreciation expense. Let's look at them one by one.

Common Methods of Calculate Depreciation Expense

1. Straight-Line Depreciation Method

The Straight-Line Depreciation Method is the easiest and most popular method out there to calculate depreciation expense. Here’s how it works:

You spread the cost of the asset evenly over its useful life.

Formula: (Cost of Asset – Salvage value) / Useful Life = Annual Depreciation Expense

Let’s say you buy a machine for S$10,000. You expect it to last 5 years and have a residual value (aka salvage value) of S$2,000.

Your annual depreciation expense would be: (S$10,000 – S$2,000) / 5 = S$1,600 per year

Straight line depreciation is a method to calculate depreciation expense, spreading the cost of an asset evenly over its useful life.

It’s perfect when the asset is expected to perform consistently year over year.

2. Declining Balance Method

The declining balance method to find the annual depreciation expense applies a constant depreciation rate to the asset's book value each year, resulting in higher depreciation expenses in the early years.

Formula: Depreciation Expense = Book Value at Beginning of Year × Depreciation Rate

Example: For an asset costing S$10,000 with a 20% depreciation rate:

• Year 1: 10,000 × 20% = S$2,000
• Year 2: (10,000 - 2,000) × 20% = S$1,600
• And so on.

The declining balance method is suitable for assets that lose value quickly, such as technology equipment.

3. Double Declining Balance Depreciation

An even more accelerated method doubles the straight-line depreciation rate.

Formula: Depreciation Expense = Book Value at Beginning of Year × (2 / Useful Life)

Example: For an asset costing S$10,000 with a useful life of 5 years:

• Depreciation Rate = 2 / 5 = 40%
• Year 1: 10,000 × 40% = S$4,000
• Year 2: (10,000 - 4,000) × 40% = S$2,400
• And so on.

The double declining balance method is helpful for assets that rapidly lose value in the initial years.

4. Units of Production Depreciation Method

This method to calculate depreciation on actual usage, ideal for manufacturing equipment.

Formula: Depreciation Expense = (Cost - Salvage Value) × (Units Produced in Period / Total Estimated Units)

Example: If a machine costing S$50,000 with a salvage value of S$5,000 is expected to produce 100,000 units:

• Depreciation per Unit = (50,000 - 5,000) / 100,000 = S$0.45
• If 10,000 units are produced in a year: 10,000 × 0.45 = S$4,500

Recording Depreciation in Financial Statements

Now that you’ve picked your depreciation method, how do you actually record it for all your major asset purchases?

Here's the easy breakdown:

• Determine the cost of the asset.
• Estimate the residual or salvage value.
• Select a method of depreciation.
• Book the depreciation annually.

At the end of each year, debit depreciation expense and credit accumulated depreciation, appears as a contra-asset account on your balance sheet.

Accumulated depreciation is the total of an asset's cost expensed to date and reported on the balance sheet.

With accumulated depreciation, you continue to monitor the initial value of your asset and also indicate how much of that value has "expired."

Depreciation and Business Valuation

If you are raising capital or selling your business, depreciation can have a direct impact on your valuation. Here's why:

• Understated Net Income: Increased depreciation reduces profit, which may lower valuation based on earnings (such as EBITDA).
• Overstated Asset Value: By bypassing periodic depreciation, your balance sheet can present overstated fixed asset value, alarming investors.
• Free Cash Flow Impact: Because depreciation is non cash, it's back-calculated when determining free cash flow, one of the most applied measures of valuation.

Tip: Have open depreciation policies and audit trails. Prospective investors will thank you, particularly if you're about to initiate a due diligence exercise.

Depreciation and Tax Implications in Singapore

Here's the thing you actually care about: saving tax.

Depreciation in itself isn't tax-deductible in Singapore, but don't worry. The IRAS offers you something called capital allowances instead.

These let you take away a proportion of the expense of qualifying assets over time. It's like tax-sanctioned depreciation.

For instance, if you purchase a new van for your company, you can claim a fraction of the price as a capital allowance over a number of years based on the depreciation expense recorded.

The schedule and rate are based on the type of asset and whether or not you claim accelerated claims (such as the Section 19A 100% write-off in the first year).

So yes, depreciation has tax benefits—but the details are up to your claim strategy. Always worth talking with your accountant.

How IRAS Treats Depreciation in Your Income Statement: Capital Allowances

In Singapore, tax depreciation of fixed assets takes a different form—capital allowances.

Here’s a simplified view:

IRAS provides several schemes for claiming capital allowances:

Write-off Over One Year: Applicable for low-cost assets (≤ S$5,000 per item), up to a total of S$30,000 annually.

• Best for: SMEs purchasing laptops, small tools, etc.

Write-off Over Three Years: Default option. Assets are written off equally over 3 years (1/3 per year).

• Best for: General machinery, office equipment, vehicles.

Write-off Over Prescribed Working Life: Used for specific assets (like buildings or certain infrastructure). Spread over 6–16 years depending on asset type.

• Best for: Long-term industrial investments.

Preparing of a Depreciation Schedule

A depreciation schedule is a table that shows depreciation expense by asset over its useful life. It assists in:

• Tracing asset value over time
• Asset replacement planning
• Preparation of accurate financial statements

Example:

Forecasting Depreciation Expenses

Accurate forecasting of depreciation expenses is vital for budgeting and financial planning. Consider:

• Asset Purchase Plans: Anticipate new acquisitions and their depreciation impact.
• Asset Disposal: Plan for the retirement or sale of assets.
• Maintenance Costs: Older assets may incur higher maintenance costs, affecting overall expenses.

By forecasting depreciation, businesses can better manage cash flow and make informed investment decisions.

Asset Valuation and Impairment

Over time, assets may lose value faster than anticipated due to damage, obsolescence, or market changes. In such cases, an impairment loss is recognised, reducing the asset's book value on the balance sheet.

Regularly reviewing asset values ensures that financial statements reflect the true worth of assets, aiding in accurate reporting and decision-making.

Let Us See An Example: Depreciating a Work Laptop

Let’s say you run a digital agency in Singapore and buy a laptop for your new content manager.

• Cost: S$3,000
• Useful life: 3 years
• Salvage value: S$300

Using straight-line depreciation, you record:

(S$3,000 – S$300) / 3 = S$900 depreciation per year

Every year, you reduce the laptop’s book value by S$900. It helps match the cost of that laptop with the income your content manager helps generate.

Bonus: You might also qualify for capital allowances on this laptop when filing taxes.

Mid-Year Purchases: How to Handle Partial-Year Depreciation

If you buy an asset in the middle of your fiscal year, do you claim a full year of depreciation?

Typically, no.

Instead, use pro-rated depreciation based on the number of months you owned the asset that year.

Example: Buy office equipment for S$12,000 in July (mid-year), with a useful life of 4 years.

• Annual depreciation: S$3,000
• Pro-rated for 6 months: S$1,500

Make sure your accounting software can handle partial-year depreciation correctly—or your financials may show inconsistencies.

Disposal of Depreciated Assets

What happens when you sell, scrap, or donate an asset? You’ll need to:

1. Remove the asset's cost from your books
2. Reverse the accumulated depreciation
3. Record any gain or loss on disposal

Example:

• You bought a delivery van for S$50,000.
• After 4 years, you’ve depreciated S$40,000.
• You sell the van for S$15,000.

Book value = 50,000 – 40,000 = S$10,000
Sale price = S$15,000

You record a gain of S$5,000 on disposal.

Role of Depreciation in Cash Flow Planning

Although depreciation doesn’t affect your cash position directly, it’s critical in cash flow forecasting.

Here’s why:

• It reduces taxable income → you pay less tax → more real cash retained.
• It helps you plan asset replacement costs.
• It informs budgeting for CAPEX (Capital Expenditure).

Use your depreciation schedules to forecast non-cash adjustments and align them with future purchases or financing needs.

Conclusion

Understanding depreciation is crucial for accurate financial reporting, tax planning, and asset management. By choosing the appropriate depreciation method and maintaining detailed records, Singapore SMEs can ensure compliance and make informed financial decisions.

How Aspire Supports Your Business

If you're looking to simplify your financial processes andgain better control over your business finances, consider partnering with Aspire. We can help with depreciation and asset management by making the tracking and accounting process easier and more efficient for your business.

Our comprehensive solutions are designed to meet the unique needs of Singapore's dynamic business landscape.

• Automated Accounting: Streamline your bookkeeping with integrated solutions.
• Expense Tracking: Monitor and categorise expenses effortlessly.
• Financial Reporting: Generate accurate reports for better insights.

With Aspire, you can focus on growing your business while we handle the financial intricacies.