Depreciation

A non-current asset typically benefits the business over many years. Charging its FULL cost in the year of purchase would:

• Distort that year's profit downwards (overstate the expense).
• Distort future years' profit upwards (no charge for using the asset).
• Misrepresent the asset's value on the SOFP at any point in time.

Depreciation solves this by spreading the cost over the asset's useful life. The reasons assets need depreciating:

1. Physical wear and tear (vehicles, machinery).
2. Obsolescence (computers, technology).
3. Economic / market factors — the asset is no longer competitive.
4. Depletion — natural resources, mineral rights.
5. Passage of time — leasehold property.

The driving concept: the matching (accruals) concept — recognise the expense in the same period as the income it helps generate.

Important: depreciation is a NON-CASH expense. No money leaves the business when depreciation is charged. It simply reallocates the original cash outflow (which happened at purchase) over the asset's life.

Formula:

$\text{Annual Depreciation} = \dfrac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}}$

Or expressed as a percentage:

$\text{Annual Depreciation} = \text{Cost} \times \text{Depreciation Rate \%}$

Worked example: Machinery cost £40,000, residual £4,000, useful life 8 years. Annual depreciation = (£40,000 − £4,000) ÷ 8 = £4,500 per year.

Each year the SAME £4,500 is charged. After 8 years the accumulated depreciation is £36,000 and the carrying amount equals the residual £4,000.

Suitable for: assets whose benefit is consumed evenly over time — premises, fixtures and fittings, leasehold improvements, office equipment.

Why some questions describe this as 'on cost': because the divisor (useful life) means the SAME amount is taken off each year, the depreciation is effectively a fixed percentage of the original cost.

Formula:

$\text{Annual Depreciation} = \text{Carrying Amount at Start of Year} \times \text{Rate \%}$

Worked example: Vehicle cost £20,000, 25% reducing balance.

Year	Start CA £	Depreciation £	End CA £
1	20,000	5,000	15,000
2	15,000	3,750	11,250
3	11,250	2,812.50	8,437.50
4	8,437.50	2,109.38	6,328.13

The charge declines each year. The asset never quite reaches zero — there's always a residual carrying amount (which approximates the eventual scrap value).

Suitable for: assets that lose value rapidly in early years OR that are more productive when new — motor vehicles, computers, plant and machinery subject to obsolescence.

Why higher charges in early years matches reality:

• The asset's earning power is greatest when new.
• Its market value drops fastest in the first year (think of a new car).
• The matching concept is therefore better served by recognising more depreciation early.

Formula:

$\text{Annual Depreciation} = (\text{Cost} - \text{Residual Value}) \times \dfrac{\text{Units used in year}}{\text{Total estimated lifetime units}}$

Worked example: Van cost £20,000, residual £2,000, estimated total mileage 100,000 miles. In year 1 the van travels 25,000 miles.

Depreciation Y1 = (£20,000 − £2,000) × 25,000/100,000 = £4,500.

If in year 2 the van travels 10,000 miles, Y2 depreciation = (£20,000 − £2,000) × 10,000/100,000 = £1,800.

Suitable for: assets whose useful life is best measured in usage rather than time — delivery vehicles (miles), machinery (hours), natural resources (units extracted), aircraft (flight hours).

The two accounts:

1. Asset Account (e.g., Motor Vehicles) — Dr balance at COST. Stays at cost throughout the asset's life until disposal.

2. Provision for Depreciation Account (e.g., Provision for Depreciation — Motor Vehicles) — Cr balance, increases each year by the annual charge.

Year-end journal entry:

Dr	Cr	Amount
Depreciation Expense (Income statement)		£X
	Provision for Depreciation (SOFP — contra-asset)	£X

The Depreciation Expense is closed off to the income statement each year. The Provision for Depreciation accumulates.

SOFP presentation (3-column format):

Non-current Assets	Cost £	Acc. Dep. £	Carrying Amount £
Premises	200,000	(24,000)	176,000
Motor Vehicles	30,000	(12,500)	17,500
Fixtures & Fittings	8,000	(3,200)	4,800
Total	238,000	(39,700)	198,300

This format preserves the original cost information AND shows the cumulative wear-and-tear.

When an asset is sold or scrapped, three accounts come together:

1. The Asset Account — remove the COST (Cr).
2. The Provision for Depreciation Account — remove the accumulated depreciation on this asset (Dr).
3. The Bank/Cash — record any proceeds (Dr).
4. A Disposal Account — captures all three transfers; the balancing figure is the gain or loss.

Formula:

$\text{Gain (Loss) on Disposal} = \text{Disposal Proceeds} - \text{Carrying Amount at Disposal}$

Where Carrying Amount = Cost − Accumulated Depreciation to disposal date.

Worked example: Van cost £20,000; accumulated depreciation £12,000; sold for £6,000.

• Carrying amount = £20,000 − £12,000 = £8,000.
• Gain (Loss) = £6,000 − £8,000 = (£2,000) Loss on disposal.

The £2,000 loss is recognised as an expense in the income statement of the year of disposal.

Why losses are common: the depreciation estimate (useful life, residual) may be over-optimistic, leaving a carrying amount above the actual market value at disposal.

Asset type	Recommended method	Why
Premises, buildings	Straight-line	Even consumption over long life
Fixtures and fittings	Straight-line	Even use over life
Office equipment	Straight-line	Generally even
Motor vehicles	Reducing balance	Lose value fast in early years
Computers / IT	Reducing balance	Obsolescence; high value loss year 1
Machinery (general)	Either — case-by-case	Depends on usage pattern
Delivery vehicles	Units of production	Mileage drives wear
Mining equipment	Units of production	Tons extracted drives wear

A good exam answer always links the choice of method to the asset's actual usage pattern, not just to convention.