explain the reasons for accounting for depreciation

Topic 4.2 – Accounting for Depreciation and Disposal of Non‑Current Assets

1. Why depreciation must be recorded

• Matching principle: the expense of using an asset is matched with the revenue it helps to generate in each period.
• True financial position: the balance sheet shows the asset’s reduced service potential, preventing an over‑statement of assets and equity.
• Accurate profit measurement: profit is not inflated by charging the whole purchase price to a single year.
• Tax compliance: most tax regimes allow a depreciation deduction, reducing taxable profit.
• Decision‑making: managers can plan replacements, evaluate capital‑budgeting projects and monitor asset utilisation.
• Legal / contractual requirements: accounting standards, company law and loan covenants often require depreciation.

2. Key concepts that underpin depreciation

1. Cost of the asset – purchase price + import duties + non‑recoverable taxes + directly attributable costs (delivery, installation, testing).
2. Residual (salvage) value – estimated amount to be recovered at the end of the asset’s useful life. It is deducted from the cost before depreciation is calculated and is **not** shown on the balance sheet.
3. Useful life – the period (in years, months or units of production) over which the asset is expected to be used.
4. Depreciable amount – Cost – Residual value.
5. Depreciation method – the systematic approach used to allocate the depreciable amount.

Worked illustration of the concepts

Machine purchased on 1 Jan 2023 for £15 000. Additional costs: delivery £500, installation £1 000. Estimated residual value £3 000 and useful life 5 years.

• Cost of the asset = £15 000 + £500 + £1 000 = £16 500
• Residual value = £3 000
• Depreciable amount = £16 500 − £3 000 = £13 500
• Useful life = 5 years

3. Depreciation methods required by the Cambridge IGCSE 0452 syllabus

Method	Formula (per period)	When it is appropriate
Straight‑line (SL)	\(\displaystyle \frac{\text{Cost} - \text{Residual}}{\text{Useful life}}\)	Asset provides roughly equal service each period (e.g. buildings, furniture).
Reducing‑balance (RB) – double‑declining (DDB) is the most common	\(\displaystyle \text{Depreciation expense}= \text{Opening book value} \times \text{Depreciation rate}\) Rate \(= \dfrac{2}{\text{Useful life}}\) (for DDB)	Asset loses value quickly in early years (e.g. computers, motor vehicles).
Units of Production (UoP) – also called revaluation method	\(\displaystyle \text{Depreciation expense}= \frac{\text{Depreciable amount}}{\text{Total estimated units}} \times \text{Units produced in the period}\)	Wear‑and‑tear is directly related to output (e.g. machinery measured in kilometres or units produced).

4. Calculating depreciation – numerical examples

4.1 Straight‑line

Using the machine from the illustration above (cost £16 500, residual £3 000, useful life 5 years):

\[ \text{Annual depreciation}= \frac{£16 500-£3 000}{5}=£2 700\text{ per year} \]

4.2 Reducing‑balance (double‑declining)

Vehicle purchased for £20 000, residual value £2 000, useful life 4 years.

• Depreciation rate = \(2/4 = 50\%\) per year.
• Year 1: \(50\% \times £20 000 = £10 000\)
• Year 2: \(50\% \times (£20 000-£10 000) = £5 000\)
• Year 3: \(50\% \times (£20 000-£15 000) = £2 500\)
• Year 4: Depreciate only to residual value → remaining book value £2 500, depreciation = £500.

4.3 Units of Production

Machine cost £12 000, residual £2 000, total estimated production 10 000 hours.

• Depreciable amount = £12 000 − £2 000 = £10 000
• Depreciation per hour = £10 000 ÷ 10 000 h = £1 per hour
• If 2 500 hours are worked in the year, depreciation = 2 500 × £1 = £2 500.

5. Partial‑year depreciation

5.1 Straight‑line (partial first year)

Asset bought on 1 Apr, useful life 3 years, cost £9 000, residual £0.

\[ \text{Annual SL charge}= \frac{£9 000}{3}=£3 000 \] \[ \text{Charge for 9 months}= £3 000 \times \frac{9}{12}=£2 250 \]

5.2 Reducing‑balance (partial first year)

Vehicle (cost £20 000, rate 50 %) bought on 1 Apr. Opening book value for the first 9 months = £20 000.

\[ \text{Depreciation for 9 months}= £20 000 \times 50\% \times \frac{9}{12}=£7 500 \]

6. Changes in estimate (useful life or residual value)

At the start of Year 3 the machine from the illustration (cost £16 500, residual £3 000, useful life 5 years) is re‑estimated to have only 2 years of useful life remaining and a new residual value of £1 500.

1. Book value at the start of Year 3 = Cost − Accumulated depreciation (2 years × £2 700) = £16 500 − £5 400 = £11 100.
2. New depreciable amount = £11 100 − £1 500 = £9 600.
3. New annual depreciation (straight‑line) = £9 600 ÷ 2 = £4 800 per year.

Journal entry for Year 3 (no retroactive adjustment required):

Debit   Depreciation Expense      4 800
Credit  Accumulated Depreciation  4 800

7. Recording depreciation – journal entry

Debit   Depreciation Expense      XXX
Credit  Accumulated Depreciation  XXX

Accumulated Depreciation is a contra‑asset account that reduces the gross cost of the asset on the balance sheet.

8. Disposal of non‑current assets

Disposal may be by sale, scrapping, or trade‑in. The required steps are:

1. Remove the asset’s cost and its accumulated depreciation from the books.
2. Record any cash or trade‑in allowance received.
3. Calculate gain or loss:
   \(\displaystyle \text{Gain/Loss}= \text{Proceeds} - (\text{Cost} - \text{Accumulated Depreciation})\)
4. Recognise the gain (credit) or loss (debit) in the profit and loss account.

Journal entries

• Sale for cash

  Debit   Cash (or Bank)                     XXX
  Debit   Accumulated Depreciation – Asset   YYY
  Credit  Asset (Cost)                       ZZZ
  [If loss] Debit   Loss on Disposal           LLL
  [If gain] Credit  Gain on Disposal           GGG
          

• Scrapped (no proceeds)

  Debit   Accumulated Depreciation – Asset   YYY
  Debit   Loss on Disposal                  (ZZZ‑YYY)
  Credit  Asset (Cost)                      ZZZ
          

• Trade‑in – treat the allowance received as cash, use the “sale” entry above, then record the acquisition of the new asset separately.

Worked disposal example (sale)

The machine from Section 2 is sold on 30 June 2025 for £3 500.

1. Depreciation recorded for 2½ years (SL): £2 700 × 2.5 = £6 750.
2. Book value at disposal = Cost − Accumulated depreciation = £16 500 − £6 750 = £9 750.
3. Gain/Loss = £3 500 − £9 750 = **Loss of £6 250**.

Journal entry on 30 June 2025:

Debit   Cash                              3 500
Debit   Accumulated Depreciation – Machine 6 750
Debit   Loss on Disposal                  6 250
Credit  Machine (Cost)                  16 500

9. Effect of depreciation on the financial statements

Statement	Effect of recording depreciation
Statement of Financial Position (Balance Sheet)	Asset shown at cost – accumulated depreciation (net book value). Equity is reduced by the expense recognised.
Statement of Profit or Loss (Income Statement)	Depreciation expense appears as an operating expense, lowering profit before tax.
Cash Flow Statement	Depreciation is added back to profit in the operating activities section because it is a non‑cash expense.

10. Consequences of not recording depreciation (expanded)

Consequence	Impact on financial statements & decision‑making
Over‑stated asset values	Balance sheet inflates total assets and equity; ratios such as ROA become misleading.
Under‑stated expenses	Profit appears higher; tax liability may be overstated; performance ratios (gross profit margin, net profit margin) are distorted.
Mis‑allocation of capital	Management may delay replacement of ageing assets, leading to inefficiency and higher future repair costs.
Non‑compliance with standards / tax law	Financial statements may be rejected by auditors; tax authorities could disallow deductions, resulting in penalties.

11. Summary – why depreciation is recorded

• Applies the matching principle – expense matched with related revenue.
• Shows a realistic net book value of assets on the balance sheet.
• Provides an accurate measure of profit for the period.
• Ensures compliance with tax regulations and accounting standards.
• Supports sound managerial decisions on asset replacement and capital budgeting.

12. Suggested classroom flowchart (text description)

Acquisition → Determine cost, residual value & useful life → Choose depreciation method (SL, RB, UoP) → Record periodic depreciation entry → Adjust for partial‑year or change in estimate → Dispose (sale, scrap, trade‑in) → Record disposal entry → Recognise gain/loss → Update financial statements.