Welcome to the World of Depreciation!

Hi everyone! This chapter, Depreciation, is a super important part of our section on "Accounting for end of period adjustments." Don't worry if the term sounds complicated; it’s actually based on a simple, everyday reality: things wear out!

Every business owns expensive, long-lasting items, like machinery, vehicles, and buildings. These are called Non-Current Assets (NCAs). Unlike inventory (which is sold quickly), NCAs are used over many years to help the business generate revenue.

What we will learn:

  • Why assets lose value over time.
  • How to calculate this loss of value accurately using two key methods.
  • How to record this adjustment in the accounts at the end of the financial period.
Mastering depreciation is essential for ensuring your financial statements show a true and fair view of the business. Let’s get started!

1. Understanding Depreciation: Why Assets Lose Value

1.1. Defining Depreciation

In simple terms, Depreciation is the systematic allocation of the cost of a non-current asset over its useful life.

Wait, what does that mean?

It means we are spreading the total cost of the asset (e.g., a delivery van costing $20,000) across all the years the business uses it (e.g., 5 years). We do this because the van helps generate revenue for 5 years, so the cost must be matched to those 5 years' revenues (The Matching Concept!).


Key Term: Depreciation is the part of the original cost of the non-current asset that has been consumed or used up during the current accounting period.

Did you know? (The Expense Connection)

Depreciation is an expense for the business, even though no actual cash is paid out when recording it. It reflects the cost of using the asset during the year.

1.2. Causes of Depreciation

Why does an asset lose value? There are several reasons we need to account for:

  1. Wear and Tear (Physical Deterioration): This is the most obvious cause. When a machine is used regularly, its parts wear out. Example: Running a taxi service wears out the engine and tyres.
  2. Obsolescence: This happens when an asset becomes outdated or inefficient compared to newer technology, even if it still works perfectly. Example: An old computer system becoming obsolete because new software requires faster processing power.
  3. Effluxion of Time: Simply put, time passes. Certain assets (like a patent or a lease) lose value just because their legal time limit is expiring.
  4. Depletion: This applies mainly to natural resources (like mines or quarries). The asset value decreases as the resource is extracted or used up.

Quick Review – Key Takeaway: Depreciation is not about the asset's market value; it's about matching the cost of the asset with the revenue it helps earn throughout its useful life.


2. Calculating Depreciation: The Two Main Methods

The Edexcel syllabus requires you to master two standard methods of calculating depreciation.

2.1. Method 1: The Straight Line Method (SLM)

This is the simplest method. It assumes that the asset loses the same amount of value every single year.

Analogy: Imagine buying a subscription for 5 years. You pay the exact same amount for that subscription every year.

How to calculate Straight Line Depreciation:

The calculation requires three key figures:

  1. Cost: The original purchase price of the asset.
  2. Residual Value (or Scrap Value): The estimated value you think you can sell the asset for at the end of its useful life.
  3. Useful Life: The estimated number of years the business plans to use the asset.

Formula 1 (Using Cost and Residual Value):
\[\text{Annual Depreciation} = \frac{(\text{Cost} - \text{Residual Value})}{\text{Estimated Useful Life (in years)}}\]

Formula 2 (Using a Fixed Percentage Rate):
Sometimes, the business just applies a fixed percentage to the original cost.
\[\text{Annual Depreciation} = \text{Cost} \times \text{Depreciation Rate (\%)}\]

Example Walkthrough (SLM)

A piece of machinery costs \$50,000. It has an estimated useful life of 5 years and an estimated residual value of \$5,000.


\[\text{Annual Depreciation} = \frac{(\$50,000 - \$5,000)}{5 \text{ years}} = \frac{\$45,000}{5} = \$9,000\]

The depreciation expense will be \$9,000 every year for 5 years.

2.2. Method 2: The Reducing Balance Method (RBM)

This method assumes that the asset loses more value in its early years and less value as it gets older. This is generally more realistic for items like vehicles or computers.

Analogy: Think about your first car. It loses a huge chunk of value the moment you drive it off the lot (Year 1), and then the annual decrease slows down.

How to calculate Reducing Balance Depreciation:

Under RBM, the depreciation percentage is applied not to the original cost, but to the Net Book Value (NBV) at the start of the year.


Key Term Reminder:
Net Book Value (NBV) is the cost of the asset minus its total accumulated depreciation up to that point.
\[\text{NBV} = \text{Cost} - \text{Accumulated Depreciation}\]

Formula (RBM):
\[\text{Annual Depreciation} = \text{Net Book Value (NBV)} \times \text{Depreciation Rate (\%)}\]

Example Walkthrough (RBM)

A machine costs \$50,000. The company uses the Reducing Balance Method at a rate of 20% per annum.

  • Year 1: NBV is \$50,000 (Cost). Depreciation = \$50,000 \times 20\% = \$10,000 NBV at end of Year 1 = \$50,000 - \$10,000 = \$40,000
  • Year 2: NBV is \$40,000. Depreciation = \$40,000 \times 20\% = \$8,000 NBV at end of Year 2 = \$40,000 - \$8,000 = \$32,000
  • Year 3: NBV is \$32,000. Depreciation = \$32,000 \times 20\% = \$6,400

Notice the difference: The depreciation amount gets smaller each year!

2.3. Common Mistakes to Avoid

  • RBM Mistake: For the Reducing Balance Method, never apply the percentage to the original cost in Year 2 and beyond! Always use the NBV.
  • SLM Mistake: If there is a Residual Value, you must subtract it from the cost before dividing by the useful life.

Quick Review – Key Takeaway: Straight Line is simple (same amount every year). Reducing Balance is more complex (depreciation amount decreases every year because the percentage is applied to the NBV).


3. Accounting Treatment: The Ledger Accounts

We use two main accounts to record depreciation. This separation is vital for both the Income Statement (P&L) and the Statement of Financial Position (SFP).

3.1. The Depreciation Expense Account (P&L)

This account records the depreciation charge for the current year.

  • It is an expense, so it has a Debit (Dr) balance.
  • At the end of the year, this balance is transferred to the Income Statement (P&L) to calculate the profit or loss.

Journal Entry (To record the annual charge):
Dr. Depreciation Expense Account
Cr. Accumulated Depreciation (or Provision for Depreciation) Account

3.2. Accumulated Depreciation Account (SFP)

This account is where we collect the depreciation from all the years the asset has been in use. It is also often called the Provision for Depreciation.

  • This is a Contra-Asset Account, meaning it reduces the value of the asset on the SFP. It has a Credit (Cr) balance.
  • It appears on the SFP deducted from the original cost of the asset.
How it Looks on the Statement of Financial Position (SFP)

The SFP always shows the asset at its original cost, and then the accumulated depreciation is subtracted to show the Net Book Value. 

    
Non-Current Assets

    
Machinery (at Cost) .................... $50,000
     
Less: Accumulated Depreciation ....... ($18,000) (This is the total from all years)

    
Net Book Value (NBV) .................... $32,000
Memory Trick: Where the Money Goes

Depreciation Expense (Dr) -> Goes to the Expense section (P&L)
Accumulated Depreciation (Cr) -> Reduces the Asset (SFP)

Quick Review – Key Takeaway: The annual depreciation charge hits the P&L (Dr. Expense). The running total of depreciation is collected in the Accumulated Depreciation account (Cr. SFP).


4. Disposal of Non-Current Assets

Eventually, an asset stops being useful and is sold, scrapped, or disposed of. When this happens, we must remove all related balances from the books. We use a temporary account called the Disposal Account (or Asset Disposal Account) to calculate any profit or loss on the sale.

4.1. The Three Essential Steps for Disposal

We need to zero out the asset's original cost and its accumulated depreciation before we can calculate the profit or loss.

Step 1: Transfer the Original Cost to the Disposal Account

We must remove the asset from the main Asset account (e.g., Machinery Account). Since assets have a Dr balance, we Credit the Asset account to remove it.

Journal Entry:
Dr. Disposal Account (The cost moves here)
Cr. Asset Account (The asset is removed from the SFP)

Step 2: Transfer the Accumulated Depreciation to the Disposal Account

We must remove the total accumulated depreciation relating to the disposed asset. Since accumulated depreciation has a Cr balance, we Debit it to clear it.

Journal Entry:
Dr. Accumulated Depreciation Account (The provision is cleared)
Cr. Disposal Account (The total usage cost moves here)

Step 3: Record the Proceeds from Sale (If Sold for Cash)

Record the cash received from selling the asset.

Journal Entry:
Dr. Bank/Cash Account (Cash increases)
Cr. Disposal Account

4.2. Calculating Profit or Loss on Disposal

Once all the transfers are made, the Disposal Account is balanced. The balance of this account represents the profit or loss on disposal.

  • Profit on Disposal: If the Credit side of the Disposal Account is larger than the Debit side, there is a Profit. This profit is transferred to the Income Statement (Cr. P&L).
  • Loss on Disposal: If the Debit side of the Disposal Account is larger than the Credit side, there is a Loss. This loss is transferred to the Income Statement (Dr. P&L).

The Final Journal Entry:
If Profit: Dr. Disposal Account / Cr. Income Statement
If Loss: Dr. Income Statement / Cr. Disposal Account

Don't worry if this seems tricky at first! The key is to remember the objective: clear out the cost and clear out the accumulation, and then compare the NBV to the cash received.

Quick Review: Disposal Steps
  1. Dr Disposal (Cost), Cr Asset (Clears Asset)
  2. Dr Accum Dep, Cr Disposal (Clears Accumulation)
  3. Dr Cash/Bank, Cr Disposal (Records Money Received)
  4. Balance the Disposal Account – the balancing figure is Profit (Cr P&L) or Loss (Dr P&L).

Congratulations, you have covered the essential concepts of depreciation! Keep practicing those calculations and ledger entries, and you'll master this topic easily.