Depreciation

Depreciation is one of the most tested ideas in FA, and one of the easiest places to lose marks through carelessness rather than misunderstanding. Questions ask you for a charge for the year, a carrying amount at a date, or the effect of a change in estimate, and the options are designed so that every common slip leads to a wrong answer that is sitting there waiting for you. Learn the method once, properly, and these become some of the quickest marks in the exam.

What depreciation is

When a business buys a machine, it expects to use it to earn revenue for several years. IAS 16 Property, Plant and Equipment requires the cost of the machine, less what the business expects to get back at the end, to be spread over the years that benefit from it. That spreading is depreciation.

Three ideas matter:

• Depreciable amount is cost less residual value. Residual value is what the business expects to receive for the asset at the end of its useful life, after disposal costs.
• Useful life is the period over which the business expects to use the asset. It is the business's own estimate, not the asset's physical life.
• Carrying amount is cost less accumulated depreciation (and any impairment). It is the figure shown in the statement of financial position.

Depreciation is not an attempt to show what the asset is worth today, and it does not set aside cash to replace the asset. It is an allocation of cost. Land normally has an unlimited useful life and is not depreciated; the building on it is.

Depreciation starts when the asset is available for use, and the method chosen should reflect the pattern in which the business uses up the asset's benefits.

The two methods you must know

Straight line charges the same amount every year:

Reducing balance charges a fixed percentage of the carrying amount at the start of each year, so the charge falls every year. It suits assets that give more benefit when new, such as vehicles.

Read every question for its policy on the year of purchase. Some say "a full year's charge in the year of acquisition and none in the year of disposal"; others say "charged pro rata on a monthly basis". If the question says nothing, the standard approach is to charge from the date the asset is available for use, month by month.

The double entry

Depreciation never touches the asset's cost account. It builds up in a separate accumulated depreciation account, which is netted against cost in the statement of financial position.

The expense account is closed to profit or loss each year. The accumulated depreciation account keeps growing until the asset is sold or scrapped.

Changes in estimates

Useful lives and residual values are estimates, and businesses revise them when circumstances change. A change in estimate is accounted for prospectively: you do not go back and correct earlier years. You take the carrying amount at the date of the change and spread what remains to be depreciated over the remaining useful life.

Worked example

Kaduna Mills buys a machine for $50,000 on 1 April 20X5. Its year end is 31 December. The machine has an expected useful life of five years and a residual value of $5,000. Depreciation is charged on the straight-line basis, pro rata by month.

Step 1: the annual charge. ($50,000 − $5,000) ÷ 5 = $9,000 a year.

Step 2: the first, part year. The machine is owned for nine months in 20X5 (April to December): $9,000 × 9/12 = $6,750.

The journal for 20X5 is: debit depreciation expense $6,750; credit accumulated depreciation $6,750.

Step 3: a change in estimate. On 1 January 20X7 the directors decide the machine will last four more years from that date, not the 39 months left on the original estimate. The residual value is still $5,000.

Revised charge = ($34,250 − $5,000) ÷ 4 = $7,312.50 a year, from 20X7. The figures for 20X5 and 20X6 are not changed.

A reducing balance comparison. The company also buys a delivery van for $20,000 on 1 January 20X5, depreciated at 30% a year on the reducing balance, with a full year's charge in the year of purchase.

Common mistakes

• Forgetting to deduct the residual value in a straight-line calculation.
• Deducting the residual value in a reducing balance calculation, or applying the rate to cost instead of the opening carrying amount.
• Charging a full year when the question says pro rata, or pro rata when it says a full year in the year of purchase.
• Going back and restating earlier years after a change in useful life. A change in estimate is always prospective.
• Debiting the asset's cost account with depreciation instead of using accumulated depreciation.
• Depreciating land.

Exam technique

Draw a quick timeline before you calculate anything: purchase date, year ends, and the date of any change. Then build the small table above, one column per year, until you reach the date the question asks about. It takes less than a minute, and it protects you from the part-year and change-of-estimate traps that most wrong options are built on. When the question asks for a carrying amount, check whether it wants it at the start or the end of a year.

Study with AI

I am studying ACCA Financial Accounting (FA), depreciation under IAS 16. Give me five
short questions, one at a time, mixing straight-line with part-year charges, reducing
balance, and a change in useful life. Wait for my answer to each before giving the
correct answer with a full working. Use $ and years like 20X5.

AI assistants can make arithmetic mistakes and can misstate the rules: check every answer against these notes before you rely on it.

Lecturer's note: Every depreciation question becomes simple when you remember one sentence: depreciation spreads cost, it does not value the asset. Students who think of depreciation as "how much the asset is worth now" are the ones who try to restate earlier years after a change in estimate, or who expect the carrying amount to match a market price. Spread what remains to be spread, over the time that remains, and the numbers follow.

Key points

• Depreciation allocates the depreciable amount (cost less residual value) over the useful life; it is not a valuation.
• Straight line gives the same charge each year; reducing balance applies a fixed rate to the opening carrying amount and ignores residual value in the calculation.
• The double entry is debit depreciation expense, credit accumulated depreciation; carrying amount is cost less accumulated depreciation.
• Read the question's policy for the year of purchase and apply it exactly.
• A change in useful life or residual value is prospective: spread the remaining carrying amount, less residual value, over the remaining life.

Quick check

1. A machine costs $36,000 on 1 October 20X4, has a residual value of $6,000 and a useful life of five years. Depreciation is straight line, pro rata by month, and the year end is 31 December. What is the carrying amount at 31 December 20X5?
2. A car costs $24,000 and is depreciated at 25% a year on the reducing balance, with a full year's charge in the year of purchase. What is the depreciation charge in its third year?
3. An asset has a carrying amount of $18,000 at the start of a year, with a residual value of $2,000. Its remaining useful life is revised to four years from that date. What is the annual straight-line charge from now on?

Answers

1. Annual charge ($36,000 − $6,000) ÷ 5 = $6,000. 20X4: 3 months = $1,500; 20X5: $6,000. Accumulated $7,500, so the carrying amount is $36,000 − $7,500 = $28,500.
2. Year 1: $6,000 (carrying amount $18,000). Year 2: $4,500 (carrying amount $13,500). Year 3: $13,500 × 25% = $3,375.
3. ($18,000 − $2,000) ÷ 4 = $4,000 a year.