Introduction to Depreciation

Depreciation is the systematic allocation of the depreciable amount (cost less residual value) of a non-current asset over its useful life, charging part of the cost as an expense in each period that benefits from the asset.

1. Wear and tear — physical deterioration through use.
2. Obsolescence — becoming out of date due to new technology.
3. Passage of time — e.g. a lease running down.
4. Depletion — natural resources being used up.

Cost (including delivery) = $62,000. Depreciable amount = cost − residual value = 62,000 − 8,000 = $54,000.

(a) Carrying value = cost − accumulated depreciation = 40,000 − 22,500 = $17,500.

(b) It represents the unexpired cost of the machine (the part not yet charged as depreciation). It is not the market value or the amount the machine could be sold for.

Matching (accruals). A non-current asset helps to earn revenue over several years, so the matching concept requires its cost to be spread (as depreciation) over those years, rather than charged all at once — giving a fair profit each period.

Prudence. Charging depreciation ensures the asset is not overstated in the statement of financial position and profit is not overstated, consistent with caution.

Depreciation is a non-cash expense. When it is charged, no money leaves or is set aside — it simply allocates the original cost of the asset (already paid) across the periods that benefit.

Because no cash is moved, no fund is built up to replace the asset. The carrying value falls and profit is reduced, but the bank balance is unaffected by the depreciation charge.

To replace the asset, the business must plan separately for the cash — for example by retaining profits or arranging finance. Depreciation only affects the profit and the carrying value, not the availability of cash.

Land normally has an indefinite useful life — it does not wear out, become obsolete or get used up — so there is no finite period over which to allocate a cost, and it is not depreciated.

Buildings, by contrast, have a finite useful life: they deteriorate and eventually need replacing. The matching concept therefore requires their cost (less residual value) to be spread over that useful life as depreciation.

The depreciation charge depends on the useful life and residual value, both of which are estimates of the future that cannot be known with certainty at the time the asset is bought. Different reasonable estimates would give different charges, so depreciation is an approximation, not an exact figure.

If the business later finds the estimate was wrong (e.g. the asset will last longer or shorter than expected), it should revise the depreciation charge for the remaining useful life — applying the change going forward (it does not normally restate past years). This keeps the carrying value and future charges realistic.

Why the owner thinks it is fine. The machines still work, so it may seem they have not 'lost value', and not charging depreciation raises profit and keeps the asset value higher.

Why it is not acceptable.

• Depreciation is not about whether the asset still works — it spreads the cost of using the asset over its useful life (the matching concept). The machines are being used up and will eventually need replacing.
• Omitting depreciation overstates profit (no expense charged) and overstates the asset in the statement of financial position, breaching prudence.
• The statements would not give a true and fair view, misleading users.

Conclusion. It is not acceptable. Depreciation must be charged each year the asset is used, regardless of whether it still functions, so that profit and net assets are not overstated. Stopping it would distort both statements.

The method should reflect the pattern in which the asset's economic benefits are consumed (so that depreciation matches the benefit each year).

Vehicles. They tend to lose more value in the early years and incur rising repair costs as they age. The reducing balance method charges more depreciation early and less later, which matches this pattern; combined with rising repairs, the total annual cost (depreciation + repairs) is more even over the life.

Office fixtures. They are typically used evenly across their life with little change in benefit year to year. The straight-line method charges an equal amount each year, which best matches this even usage.

Conclusion. There is no single 'correct' method — the business should choose the one whose depreciation pattern best matches how each asset is used, applying it consistently thereafter.