Depreciation

Objective A: Purpose of Depreciation

Depreciation is the systematic allocation of the depreciable amount of a tangible non-current asset over its useful life. It is NOT a measure of the decline in market value — it is a cost allocation mechanism.

The depreciable amount = Cost (or revalued amount) − Residual value

Depreciation serves two purposes:

1. Matching: It matches the cost of the asset with the revenue it helps generate over its useful life (accrual accounting)
2. Carrying amount: It reduces the carrying amount of the asset in the SFP to reflect the consumption of its economic benefits

Land is generally NOT depreciated because it has an unlimited useful life. Buildings, however, ARE depreciated because they have a finite useful life.

Objective B: Straight-Line and Reducing-Balance Methods

Straight-Line Method

The straight-line method allocates an equal amount of depreciation to each year of the asset's useful life.

Annual depreciation = (Cost − Residual value) ÷ Useful life

Example: Asset costs £100,000, residual value £10,000, useful life 5 years.
Annual depreciation = (£100,000 − £10,000) ÷ 5 = £18,000 per year

Reducing-Balance (Diminishing-Balance) Method

The reducing-balance method applies a fixed percentage to the carrying amount (not the original cost) each year. This produces a higher charge in the early years and a lower charge in later years.

Annual depreciation = Carrying amount at start of year × Depreciation rate

Example: Asset costs £100,000, depreciation rate 30%.
Year 1: £100,000 × 30% = £30,000 (carrying amount = £70,000)
Year 2: £70,000 × 30% = £21,000 (carrying amount = £49,000)
Year 3: £49,000 × 30% = £14,700 (carrying amount = £34,300)

Objective D & G: Recording Depreciation

The journal entry to record depreciation is:

Dr Depreciation Expense (SPL) | Cr Accumulated Depreciation (SFP)

Note that the credit goes to accumulated depreciation (a contra-asset account), NOT to the asset cost account. The asset remains at its original cost in the ledger, and accumulated depreciation builds up over time. The carrying amount shown in the SFP is:

Carrying amount = Cost − Accumulated depreciation

In the statement of profit or loss, depreciation expense is typically included in operating expenses (or cost of sales for production assets).

In the statement of financial position, non-current assets are shown at their carrying amount. A note to the financial statements provides a reconciliation showing cost, accumulated depreciation, and carrying amount.