Contents: 9 sections
Syllabus points
- Explain the causes of depreciation and why it is charged.
- Calculate depreciation using the straight-line, reducing-balance and revaluation methods.
- Record depreciation in the ledger and present it in the financial statements.
- Compare the methods and justify a choice for a given asset.
What depreciation is
Depreciation is the allocation of the cost of a non-current asset over its useful life. It is not a valuation, and it is not a fund of cash set aside for a replacement.
Two consequences follow from that definition, and both are examined:
- Depreciation is charged because of the accruals concept. The asset earns revenue over several years, so its cost must be spread over those years to match.
- Depreciation does not involve any movement of cash. The cash left when the asset was bought. This is why depreciation is added back in a cash flow statement.
The causes are wear and tear, obsolescence (a newer model makes this one uneconomic), the passage of time (a lease of a fixed number of years), and depletion (a quarry runs out).
Straight line
An equal charge every year.
annual depreciation = (cost − residual value) / useful life
Alternatively a fixed percentage of cost is given, in which case residual value is usually zero.
A machine costs $50 000, has a residual value of $5 000 and a useful life of 5 years. The annual charge is 45 000 divided by 5, which is $9 000 every year. After 3 years the accumulated depreciation is $27 000 and the carrying amount is $23 000.
Straight line suits assets that give an even benefit over their life, and assets whose life is defined by time: fixtures, buildings, a lease.
Reducing balance
A fixed percentage of the carrying amount, so the charge falls each year.
annual depreciation = carrying amount at the start of the year x rate
The same $50 000 machine at 20% reducing balance:
| Year | Opening carrying amount | Charge at 20% | Closing carrying amount |
|---|---|---|---|
| 1 | 50 000 | 10 000 | 40 000 |
| 2 | 40 000 | 8 000 | 32 000 |
| 3 | 32 000 | 6 400 | 25 600 |
Note that the charge is calculated on the carrying amount, not the cost, from year 2 onward. Applying 20% to $50 000 every year is the single most common error in this topic.
Reducing balance suits assets that give more benefit early, and assets with rising repair costs: vehicles and machinery. Charging more depreciation in the early years, when repairs are low, gives a more even total cost across the life.
Revaluation
Used for many small items that are hard to track individually, such as loose tools, small equipment or crockery.
depreciation = opening valuation + purchases during the year − closing valuation
Loose tools valued at $4 200 at the start of the year, with $900 bought during the year and a closing valuation of $3 600, give a charge of 4 200 plus 900 minus 3 600, which is $1 500.
The ledger entries
Depreciation is recorded so that the asset account keeps showing cost, and the accumulated depreciation is held separately.
- Debit depreciation expense, credit provision for depreciation.
- The depreciation expense goes to the income statement.
- The provision for depreciation is a credit balance, deducted from cost in the statement of financial position to give the carrying amount.
So a machine at cost $50 000 with a provision of $27 000 is shown at a carrying amount of $23 000. The cost figure never changes because of depreciation.
Choosing a method, and the policies around it
Consistency requires the same method year after year. A change is allowed if it gives a fairer presentation, but it must be justified and disclosed.
Businesses also adopt a policy for the year of purchase. The two common ones are a full year's charge in the year of purchase and none in the year of sale, or a proportionate charge for the months owned. The question will tell you which applies. Read that sentence before calculating anything.
Effect if depreciation is wrong
| Error | Profit | Carrying amount |
|---|---|---|
| Depreciation overcharged | Understated | Understated |
| Depreciation undercharged | Overstated | Overstated |
| No depreciation charged at all | Overstated | Overstated |
Failing to depreciate breaks the accruals concept, because the cost is not matched to the periods that benefit, and prudence, because both profit and assets end up overstated.
Common mistakes
- Applying the reducing-balance rate to cost instead of to carrying amount.
- Deducting residual value when calculating reducing-balance depreciation. Residual value is used in the straight-line formula only.
- Saying depreciation sets money aside to replace the asset.
- Crediting the asset account instead of the provision account.
- Ignoring the stated policy on part years.
- Saying depreciation is a valuation of the asset. Carrying amount is very rarely market value.
- Treating the provision for depreciation as a debit balance in the trial balance.