Key Concepts
Depreciation is the allocation of the cost of the non-current asset over its estimated useful life. As the business uses the asset to earn income, part of its cost is recorded as an expense each year.
Why charge depreciation?The asset helps the business earn income over several years, so part of its cost should be matched as an expense against the income of each of those years — not all in the year it was bought.
This follows the matching theory: expenses incurred must be matched against the income earned in the same period to determine the profit for the period. As the non-current asset is being used to generate income, a portion of the cost of using the non-current asset (the depreciation expense) should be matched against the income earned in the same financial period to determine the profit for the period.
Causes of depreciation:
| Cause | What it means |
|---|---|
| Usage | The asset's benefits are used up as the business uses it |
| Wear and tear | Physical parts wear out with use and exposure (e.g. a van's engine) |
| Obsolescence | Newer technology makes the asset out of date |
| Legal limits | The asset can only be used legally for a set period |
Two methods of depreciation
The method chosen should reflect the pattern of usage of the asset — how its benefit is spread over its useful life (the two cases are shown below). Once a method is chosen, the consistency theory says the business should keep using the same method each year, so the net book value of its non-current assets can be compared meaningfully over time.
| Straight-line method | Reducing-balance method |
|---|---|
| The asset gives roughly the same benefit each year | The asset gives more benefit in early years and less as it ages |
| Equal depreciation every year | Higher depreciation in early years, lower later |
| Suitable for e.g. fixtures and fittings | Suitable for e.g. motor vehicles, machinery, office equipment |
Two figures are needed to work out depreciation:
- Useful life — the number of years the business expects to use the asset before it is worn out or replaced.
- Scrap value — the estimated amount the business expects to receive for the asset at the end of its useful life.
Why straight-line subtracts scrap value.The scrap value is the amount the business expects to recover at the end of the asset's life — it is never "used up," so it should not be charged as an expense. Depreciation only spreads the portion of cost the business actually loses (Cost − Scrap value) evenly over the useful life.
Why reducing balance does not subtract scrap value.In the reducing-balance method, the rate is applied to a net book value that gets smaller every year, so the depreciation naturally tapers off toward the scrap value on its own. You do not subtract scrap value first (that step belongs to the straight-line method).
Accumulated depreciation and net book value
Accumulated depreciation is the total depreciation charged on an asset to date. It is a contra-asset — an account with a credit balance that exists only to reduce the value of a related asset — and is kept in its own account, separate from the asset.
Net book value is the asset's estimated remaining value to the business — it is not the price the asset could be sold for. Accumulated depreciation is only an estimate of how much of the asset has been used up so far.
Why a separate account?Keeping accumulated depreciation separate means the asset account still shows the original cost, while the accumulated depreciation account shows how much has been written off. The Statement of Financial Position can then show all three figures — cost, accumulated depreciation, and net book value.
The non-current asset section now has three columns.When you first learned the Statement of Financial Position, each non-current asset was shown at a single value. Now that depreciation applies, a non-current asset is shown across three columns —
Cost ($),Accumulated depreciation ($), andNet book value ($)— and it is the net book value that adds into Total assets. See the worked example below for what this looks like in full.
Why show net book value, not cost?The prudence theory says a business should not overstate the value of its assets or its profit. Charging depreciation each year and showing the asset at net book value (cost − accumulated depreciation), rather than at its original cost, keeps both the non-current asset and profit for the year from being overstated.
Recording depreciation
Journal entry for depreciation (recorded at the end of each financial year):
| Transaction | Debit | Credit |
|---|---|---|
| Charging the year's depreciation | Depreciation of [asset] (+expense) | Accumulated depreciation of [asset] (−asset) |
Depreciation is a non-cash expense — no money leaves the business when it is recorded. The cash was already paid when the asset was bought; depreciation just spreads that cost across the years it is used.
Depreciation spreads the cost; cash does not move. Dr Depreciation (expense), Cr Accumulated depreciation (contra-asset). Straight-Line = Same amount each year. Reducing Balance = Bigger amount early, smaller later. Net book value = Cost − Accumulated depreciation (not resale price).
Depreciation per year = ($100,000 − $10,000) ÷ 5 = $18,000
Rate = [$18,000 ÷ ($100,000 − $10,000)] × 100 = 20% per year
| Date | Particulars | Dr ($) | Cr ($) |
|---|---|---|---|
| 20X5 | |||
| 31 Dec | Depreciation of motor vehicles | 18,000 | |
| Accumulated depreciation of motor vehicles | 18,000 |
The same entry is made on 31 December 20X6 and 31 December 20X7.
Glow Up Beauty Studio buys beauty equipment for $24,000 on 1 April 20X5. It is depreciated by the straight-line method over 5 years with no scrap value. The financial year ends 31 December.
- Full annual depreciation = $24,000 ÷ 5 = $4,800
- The studio owned the equipment for 9 months in 20X5 (April–December):
Depreciation for 20X5 = $4,800 × 9/12 = $3,600
- In 20X6 (a full year), depreciation = $4,800.
Default to partial year unless told otherwise.Charge depreciation by whole months in the year of purchase, unless the question states the business's policy is to charge a full year's depreciation in the year of purchase (e.g. "it is the business's policy to charge a full year's depreciation in the year of purchase, and none in the year of sale") — only then use a full year.
Each year, depreciation = rate × net book value at the start of that year (cost − accumulated depreciation to date) — not the original cost, and not the scrap value. This is why the depreciation gets smaller each year.
| Year ended | Working | Depreciation |
|---|---|---|
| 31 Dec 20X5 | 40% × $100,000 | $40,000 |
| 31 Dec 20X6 | 40% × ($100,000 − $40,000) | $24,000 |
| 31 Dec 20X7 | 40% × ($100,000 − $40,000 − $24,000) | $14,400 |
Extract of the Statement of Financial Performance (showing the 20X7 depreciation):
Statement of Financial Performance for the year ended 31 December 20X7 (extract)
| $ | |
|---|---|
| Less: Other expenses | |
| Depreciation of motor vehicles | 14,400 |
Extract of the Statement of Financial Position (after three years):
Accumulated depreciation = $40,000 + $24,000 + $14,400 = $78,400
Net book value = $100,000 − $78,400 = $21,600
Statement of Financial Position as at 31 December 20X7 (extract)
| Cost ($) | Accumulated depreciation ($) | Net book value ($) | |
|---|---|---|---|
| Non-current assets | |||
| Motor vehicles | 100,000 | 78,400 | 21,600 |
Effects of using different depreciation methods
The same asset gives different yearly figures under each method:
| Method | Effect on depreciation (an expense) | Effect on profit | Effect on net book value |
|---|---|---|---|
| Straight-line | Equal each year | Falls by an equal amount each year | Falls by an equal amount each year |
| Reducing-balance | Higher in early years, lower later | Falls more in early years | Falls more in early years |
Subtracting scrap value in the reducing-balance method. Reducing-balance applies the rate to the net book value, with no scrap-value deduction. Only the straight-line method uses (Cost − Scrap value).
Treating depreciation as cash paid. Depreciation is a non-cash expense — no money leaves the business when it is recorded.
Deducting accumulated depreciation from the asset account itself. Keep it in its own account so the original cost stays visible; deduct it from cost only on the Statement of Financial Position.
Charging a full year when only part of the year is owned. For a mid-year purchase, charge depreciation only for the whole months owned by default — only charge a full year if the question states the business's policy is to do so.