Welcome to the World of Depreciation!
Ever bought a brand-new smartphone and noticed that a year later, it’s not worth nearly as much as what you paid for it? That "loss in value" is exactly what we are looking at today, but from a business perspective. In Financial Accounting, we call this Depreciation.
By the end of these notes, you will understand how businesses account for the "wear and tear" of their big purchases (like machinery and delivery vans) so that their financial statements show a fair and honest picture. Don't worry if it seems a bit technical at first—we'll break it down step-by-step!
1. What is Depreciation?
Businesses buy Non-Current Assets (NCAs) like cars, computers, and machinery to help them generate revenue over several years. Because these assets wear out or become outdated over time, we shouldn't record the entire purchase cost as an expense in the first year. That would distort profitability across the asset's life.
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. It spreads the cost of the asset to match the revenue it helps generate, following the accrual accounting concept.
Example: If a bakery buys a delivery van for \$10,000 and expects it to last for 5 years, depreciation records a portion of that \$10,000 as an expense in each of those 5 years.
Key Terms to Remember:
• Cost: The purchase price plus all directly attributable costs of bringing the asset to its working location and condition.
• Useful Life: The period over which the business expects to use the asset (or the number of production units expected from it).
• Residual Value (or Scrap Value): The estimated net amount the business would obtain from disposing of the asset at the end of its useful life.
• Depreciable Amount: The total cost to allocate over time: \( \text{Cost} - \text{Residual Value} \).
• Carrying Amount: The net amount at which an asset is recognised in the statement of financial position: \( \text{Cost} - \text{Accumulated Depreciation} \).
2. The Two Main Methods of Calculation
The ACCA FA syllabus focuses on two methods of depreciation. The method chosen should reflect the pattern in which the asset's future economic benefits are expected to be consumed.
Method A: The Straight-Line Method
This method charges an equal amount of depreciation each year throughout the asset's useful life. It is appropriate when an asset delivers steady benefits over time (such as buildings or fixtures).
The Formula:
\( \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life in Years}} \)
When given a percentage on cost:
\( \text{Annual Depreciation} = (\text{Cost} - \text{Residual Value}) \times \% \)
Quick Tip: If an exam question specifies "20% straight line" without stating a residual value, simply multiply the Cost by 20%.
Method B: The Diminishing-Balance (Reducing-Balance) Method
This method applies a constant percentage rate to the asset's carrying amount at the start of each accounting period. As carrying amount falls each year, the depreciation charge also decreases. It is appropriate for assets that provide higher benefits or lose value fastest in their early years (such as motor vehicles or computer equipment).
The Formula:
\( \text{Annual Depreciation} = \text{Carrying Amount} \times \% \)
where \( \text{Carrying Amount} = \text{Cost} - \text{Accumulated Depreciation to date} \).
Common Mistake to Avoid: Do not deduct the residual value before calculating diminishing-balance depreciation. The reducing carrying amount naturally converges towards the residual value over time.
Key Takeaway:
Straight Line: Constant expense each year.
Diminishing Balance: High expense in Year 1, decreasing each subsequent year.
3. Recording Depreciation (The Double Entry)
Depreciation involves two accounts: an expense account and a contra-asset account.
The Journal Entry:
Debit (Dr): Depreciation expense (reported in the statement of profit or loss)
Credit (Cr): Accumulated depreciation (contra-asset deducted from NCA in the statement of financial position)
Step-by-Step Process:
1. Calculate the depreciation charge for the current period.
2. Debit Depreciation expense with this year's charge.
3. Credit Accumulated depreciation with this year's charge.
4. In the statement of financial position, present the asset at carrying amount (Cost less Accumulated depreciation).
4. Important Rules to Watch Out For
Pro-rata Depreciation:
When an asset is acquired or disposed of during the accounting period, depreciation may be calculated on a monthly pro-rata basis for the exact months owned (e.g. \( 6/12 \) of the annual charge for an asset held 6 months).
Full-Year Convention:
Some entities apply a policy of charging a full year's depreciation in the year of acquisition and none in the year of disposal. Always check the question narrative for the specific policy required.
Note on Land: Land normally has an unlimited useful life and is not depreciated, whereas buildings have a limited life and are depreciated separately.
5. Adjustments for Changes in Useful Life or Residual Value
Estimates of useful life and residual value must be reviewed periodically. A change in either is a change in accounting estimate under IFRS Accounting Standards and is accounted for prospectively (from the date of change onwards, without adjusting past years).
How to calculate revised depreciation:
1. Determine the asset's carrying amount on the date the estimate changes.
2. Deduct any revised residual value.
3. Divide the remaining depreciable amount by the revised remaining useful life:
\( \text{Revised Annual Depreciation} = \frac{\text{Carrying Amount at Date of Change} - \text{Revised Residual Value}}{\text{Remaining Useful Life}} \)
6. Depreciation on Revalued Assets and Excess Depreciation
When a tangible non-current asset is revalued upwards to fair value, its future depreciation must be based on the new revalued carrying amount over its remaining useful life.
Because the revalued amount is higher than original cost, the new depreciation charge in profit or loss is greater than the historical cost depreciation would have been. The difference between the two is known as excess depreciation.
An entity is permitted to make an annual reserves transfer of this excess depreciation directly between reserves within equity, presenting it in the statement of changes in equity:
Debit (Dr): Revaluation surplus
Credit (Cr): Retained earnings
Key Rule: This transfer moves accumulated surplus to realised profits (retained earnings). It does not pass through the statement of profit or loss!
7. Summary and Quick Review
Quick Review Box:
• Depreciation: Systematic allocation of the depreciable amount over useful life.
• Straight Line: \( (\text{Cost} - \text{Residual}) / \text{Useful Life} \).
• Diminishing Balance: \( \text{Carrying Amount} \times \% \).
• Double Entry: Dr Depreciation expense (P&L), Cr Accumulated depreciation (SFP).
• Change in Estimates: Spread remaining carrying amount (less revised residual value) over remaining useful life prospectively.
• Revalued Assets: Depreciate the revalued amount over remaining life; optionally transfer excess depreciation annually (Dr Revaluation surplus, Cr Retained earnings).