Depreciation
This chapter introduces depreciation and explains why it matters in financial reporting. You’ll see how depreciation is recorded in the general ledger, how it affects both the statement of profit or loss and the statement of financial position, and how accumulated depreciation builds up over time.
Learning objectives
By the end of this chapter, you should be able to:
- Explain the purpose of depreciation.
- Calculate the charge for depreciation using straight-line and diminishing balance (reducing-balance) methods.
- Identify the circumstances where different methods of depreciation would be appropriate.
- Illustrate how the depreciation charge and accumulated depreciation are recorded in the general ledger accounts.
- Calculate the adjustments to depreciation necessary if changes are made in the estimated useful life and/or residual value of a tangible non-current asset.
- Record depreciation in the statement of profit or loss and statement of financial position.
Definition of key terms
As stated earlier in the previous chapter, the full cost of a non-current asset is not expensed in the year of acquisition. Instead, the portion of the asset’s economic benefits that is consumed each period is charged to profit or loss as depreciation.
Illustration: Depreciation
Continuing the earlier illustration, Gyabaku Ltd must estimate the machine’s useful life (the period over which it will be used in operations). Organizations typically specify useful lives for each asset class in their accounting policies.
With an estimated useful life of 10 years, the machine is expected to have a residual value (also called salvage value) at the end of this period - the estimated amount recoverable from disposal. For this machine, the residual value is estimated at $10,000.
The depreciable amount equals the asset’s cost minus its residual value:
This depreciable amount is then allocated over the asset’s useful life through depreciation. The pattern of allocation depends on the depreciation method selected.
The journal entry for the depreciation charge is:
Debit: Depreciation expense
Credit: Accumulated Depreciation
Methods of depreciation
There are several methods of depreciation. However, for the purposes of the syllabus, we will focus on:
- Straight line method
- Reducing balance method
Straight line method
This is the simplest and most commonly used method. Under the straight-line method, the asset’s depreciable amount is spread evenly over its useful life, so the annual depreciation expense is constant.
The formula is:
Under this method, except where the asset is being revalued (to be treated later), the annual depreciation charge will be the same each year.
Illustration: Straight line method
Assume Gyabaku Ltd acquired the machine for $543,000 on 1 January 20X0. Its estimated useful life is 10 years with a residual value of $10,000. The annual depreciation at the end of each year will be:
| Year-end | Computations | Depreciation charge |
|---|---|---|
| 31 December 20X0 | $53,300 | |
| 31 December 20X1 | $53,300 | |
| 31 December 20X2 | $53,300 |
The following table shows the effect of depreciation on the asset’s value over time (this will be explained later using a ledger account).
| Year-end | Value at year beginning ($) | Depreciation ($) | Value at year end ($) |
|---|---|---|---|
| 31/12/20X0 | 543,000 | 53,300 | 489,700 |
| 31/12/20X1 | 489,700 | 53,300 | 436,400 |
| 31/12/20X2 | 436,400 | 53,300 | 383,100 |
The table illustrates how depreciation reduces the asset’s carrying amount over time. When acquired on 1 January 20X0, the machine’s cost was $543,000. At year-end, a depreciation charge of $53,300 (the portion of economic benefits consumed) reduces the carrying amount to $489,700. This continues each period until the asset’s useful life is fully used.
Note: The carrying amount (or net book value) of an asset is its opening balance for the year minus the depreciation charge for that year.
Straight line method: depreciation in percentage
Because the annual depreciation charge under the straight-line method is constant, it is sometimes expressed as a percentage of cost.
Using the example above, the annual depreciation charge is $53,300. As a percentage of cost, this is 9.82% (i.e., $53,300/$543,000).
Thus, when depreciation is given as a percentage under the straight-line method, it is applied to the cost of the asset, not the depreciable amount.
Straight-line method: mid-year acquisitions
Sometimes, non-current assets are acquired partway through the year. In that case, the depreciation treatment depends on the firm’s accounting policy - for example:
- Prorating depreciation based on the period of use, or
- Charging a full year’s depreciation regardless of the acquisition date.
Illustration: Mid-year acquisitions
Assume Gyabaku Ltd acquired the machine at a cost of $543,000 on 1 July 20X0. Its estimated useful life is 10 years with a residual value of $10,000. It is the firm’s policy to depreciate assets from the date of purchase.
The depreciation at the end of the first and second years will respectively be:
| Year-end | Computations | Depreciation charge |
|---|---|---|
| 31 December 20X0 | $26,650 | |
| 31 December 20X1 | $53,300 | |
| 31 December 20X2 | $53,300 |
Since the asset was acquired partway through the year, the first year’s depreciation is prorated based on the number of months the asset was in use.
Reducing balance method
The reducing balance method calculates depreciation as a fixed percentage of the asset’s carrying amount (CA) at the beginning of each year. The carrying amount, also called the net book value (NBV), declines each year as depreciation is charged.
This method often better reflects the pattern of economic benefits for many assets, because it charges higher depreciation in the earlier years and lower depreciation in the later years.
The formula is:
In most cases, the depreciation rate under the reducing balance method will be provided. If it is not given, it can be calculated using:
where = useful life
Like the straight-line method, the reducing balance method also applies the mid-year acquisition rule, meaning depreciation may need to be prorated based on when the asset was purchased.
Illustration: Reducing balance method
Assume an entity acquires a factory plant at a cost of $100,000 on 1 January 20X0. The annual depreciation rate is 10%. The annual depreciation at the end of each year will be:
| Year-end | NBV at year beginning (A) | Depreciation charge (10% of NBV) (B = 10% x A) | NBV at year end (C = A - B) |
|---|---|---|---|
| 31 Dec. 20X0 | $100,000 | $10,000 | $90,000 |
| 31 Dec. 20X1 | $90,000 | $9,000 | $81,000 |
| 31 Dec. 20X2 | $81,000 | $8,100 | $72,900 |
Changes in estimated useful life and residual value
Depreciation under both methods depends on an asset’s useful life and residual value. Since these are management estimates, they can change over time as circumstances change or new information becomes available.
When the useful life or residual value changes, the depreciation charge will also change. The revised charge is based on the carrying amount of the asset at the date of the change, spread over the remaining useful life.
So, where the straight line method is being used, the formula becomes:
Illustration: Changes in useful life
D&D Ltd acquired a factory plant for $100,000 on 1 January 20X0 with an estimated residual value of zero and depreciated it over its useful life of 10 years. On 31 December 20X4, the asset’s useful life was revised to 13 years (i.e., remaining useful life 8 years). Analysis of the question:
What is the annual depreciation charge?
The annual depreciation charge will be $10,000 (i.e., $100,000 - $0 / 10 years)
What would be the remaining useful life?
By 31 December 20X4, the asset had been in use for 5 years (20X0-20X4). Based on the original estimate of a 10-year useful life, the remaining useful life on that date would be 5 years (10 - 5).
What would be the accumulated depreciation on the date of the change?
As at 31 December 20X4, the asset has been depreciated for 5 years under the straight-line method. With an annual charge of $10,000, the accumulated depreciation amounts to $50,000 ($10,000 × 5 years).
What is the carrying amount as at this date?
The carrying value of the asset as at 31 December 20X4 would be $50,000 (i.e., $100,000 - $50,000), being the difference between the cost and the accumulated depreciation.
What is the remaining useful life after the change in the useful life?
If the useful life is revised to 13 years, then after 5 years of use, the remaining useful life is 8 years.
What is the effect of the changes in the estimated useful life on the depreciation charged:
Depreciation already charged up to 31 December 20X4 remains unaffected by any changes in the estimated useful life. Such changes are applied prospectively, meaning they take effect only from the date of the revision onward.
What will be the new annual depreciation charge from the date of the change in the useful life?
On this basis, depreciation from 1 January 20X5 is calculated using the carrying amount at the date of change (i.e., $50,000) and the remaining useful life of 8 years:
Follow these steps when there are changes in estimated useful life:
- Calculate the annual depreciation.
- Determine the number of useful life utilised as at the date of change.
- Compute the accumulated depreciation and use it to determine the carrying amount as at the date of the change
- Determine the remaining useful life of the asset from the date of change
- Compute the annual depreciation using the carrying amount and the remaining useful life of the asset.
The depreciation expense reduces profit, while accumulated depreciation offsets the asset’s cost in the statement of financial position.
Illustration: Journal entries for tangible non-current assets
D&D Ltd acquired a factory plant for$100,000 on 1 January 20X0 with an estimated residual value of zero and depreciated it over its useful life of 5 years. Required: Present the accounting entries of how the transaction will be accounted for, as well as extracts in the statement of profit or loss and statement of financial position. Suggested solution:
The solutions are presented in T-account form instead of the general journal entries only. Upon purchase of the factory plant on 1 January 20X0:
At the end of year 1 (i.e. 31 December 20X0) depreciation charge ($100,000 - 0 / 5 years = $20,000) is posted as:
At year-end, the depreciation expense is closed to the profit and loss account, transferring the charge to the income statement. Meanwhile, accumulated depreciation is deducted from the asset’s cost to show its net book value.
At year-end, non-current assets are presented in the statement of financial position at cost less accumulated depreciation (net book value).
Statement of Financial Position as at year end (Extract)
Factory Plant ($100,000 - $20,000) $80,000
Statement of Profit or Loss for the year end (Extract)
Depreciation Charge$20,000
Depreciation is recorded annually through the depreciation expense and accumulated depreciation accounts. The yearly charge is transferred to the profit or loss statement, while the accumulated depreciation balance is carried forward and increased by each new year’s charge. See below.
As shown in the accumulated depreciation account, at any point in time, the carrying amount of the non-current asset is the original cost minus accumulated depreciation. Statement of Profit or Loss Statement (Extract)
| $ | ||
|---|---|---|
| Year 1: 31/12/20X0 | Depreciation | 10,000 |
| Year 2: 31/12/20X1 | Depreciation | 10,000 |
| Year 3: 31/12/20X2 | Depreciation | 10,000 |
| Year 4: 31/12/20X3 | Depreciation | 10,000 |
| Year 5: 31/12/20X4 | Depreciation | 10,000 |
Statement of Financial Position (Extract)
| $ | ||
|---|---|---|
| Year 1: 31/12/20X0 | Factory Plant ($100,000 - $20,000) | 80,000 |
| Year 2: 31/12/20X1 | Factory Plant ($100,000 - $40,000) | 60,000 |
| Year 3: 31/12/20X2 | Factory Plant ($100,000 - $60,000) | 40,000 |
| Year 4: 31/12/20X3 | Factory Plant ($100,000 - $80,000) | 20,000 |
| Year 5: 31/12/20X4 | Factory Plant ($100,000 - $100,000) | 0 |
The statement of financial position extract shows how depreciation reduces the carrying amount over the years. With no residual value, the asset’s carrying amount is zero at the end of year 5.