How to determine the annual depreciation cost of an asset

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

05 January 2020

Is depreciation an actual cost or is just a trick that accountants use to inflate costs and thus avoid paying tax? How is its value calculated?

To answer these questions, let us consider a common asset that is purchased by many people. If you buy a brand-new car today, do you think you would be able to sell it at the same price that you bought it after using it for one year? Of course not!

If you spent, say, Sh2 million on the car, there is a good chance that, after one year of usage, it’s market price will have dropped to about Sh1.5 million. This is a loss of Sh500,000 in value. It is the depreciation after one year.

But, since life rarely moves in a straight line, chances are that, after two years, the market value of the car might be Sh1.3 million – a Sh200,000 loss – and then, perhaps, Sh1.2M after three years and so on.  The question then is, what is the correct loss of value to use?

To answer that question, you must decide how long you wish to keep the car for. It would be grossly unreasonable to assume that you will keep it for ever! Unless you are a collector of cars.

Most people keep a car for between 5 and 10 years; whether the car is brand new or a second-hand one. Thus, the median period is 7 years. So, what would be the market value of a car after seven years?

A quick and fair way to get the answer is to survey the market and see the typical price of a seven-year-old vehicle. If you are buying a brand-new car today (January 2020), then look around for prices of similar cars built in 2013.

If you are buying a seven-year old import, then check the prices of 14-year models (that is, those built in 2006). But knowing the current prices of the older cars is not enough. You should also factor in the effect of inflation.

Let me illustrate with an example. A 2013 Toyota Corolla is selling for an average of Sh1.2 million on a popular car sales website. On the same site, a 2006 vehicle of same make and model is Sh600,000.

So, if there was no inflation, we expect that seven years from now, the 2013 car will cost about Sh600,000. Now, data from the Kenya National Bureau of Statistics shows that over the last seven years, the annual inflation was 5.5 per cent, on average.

We can extrapolate to the next seven years using the same average inflation rate. Thus, by 2028, the 2013 Toyota Corolla will fetch about Sh850,000.

So, you buy a car today at Sh1.2M and expect to sell at Sh850,000 after seven years. In other words, you expect to incur a depreciation loss of Sh350,000 in that period.

This loss is then spread evenly over the seven-year period, hence, Sh50,000 is deducted annually from the value of the car. This Sh50,000 depreciation is a legitimate cost of owning the car.