the role of depreciation in the accounts

10.1 Financial Statements – Depreciation

Objective

To understand the role of depreciation in the accounts, how it is calculated using the straight‑line method (the only method required for the Cambridge IGCSE/A‑Level Business syllabus), and how it amends the income statement and the statement of financial position.

1. Meaning & Purpose of Depreciation

• Depreciation – the systematic allocation of the cost of a tangible fixed asset over its estimated useful life.
• It reflects wear‑and‑tear, obsolescence, or any reduction in the asset’s value as it is used in the business.
• Purpose (matching principle): matches the cost of the asset with the revenue it helps generate, giving a realistic picture of profit.
• Depreciation is a non‑cash expense; no cash leaves the business when it is recorded.

2. Straight‑Line Depreciation (required method)

2.1 Formula

\[ \text{Annual Depreciation} = \frac{\text{Cost of the asset} - \text{Residual (salvage) value}}{\text{Estimated useful life (years)}} \]

• Residual value = estimated amount the asset could be sold for at the end of its useful life (may be £0).
• Useful life = period over which the asset is expected to contribute to the business.

2.2 Journal entry for each year

Date          Account                         Debit (£)   Credit (£)
-----------------------------------------------------------------------
31/12/20XX    Depreciation Expense              XXX
              Accumulated Depreciation – Asset                XXX
(To record annual depreciation)

2.3 Numerical example (straight‑line)

1. Cost of machine: £50,000
2. Residual value: £5,000
3. Estimated useful life: 5 years
4. Annual depreciation: \[ \frac{£50,000 - £5,000}{5} = £9,000 \text{ per year} \]

2.3.1 Effect on the profit‑and‑loss account (after Year 1)

Revenue                £120,000
Cost of sales           £70,000
Gross profit            £50,000
Administrative expenses £10,000
Operating profit        £40,000

Revenue                £120,000
Cost of sales           £70,000
Gross profit            £50,000
Administrative expenses £10,000
Depreciation expense      £9,000
Operating profit        £31,000

2.3.2 Effect on the statement of financial position (after Year 1)

Non‑current assets
   Machinery (cost)        £50,000
Current assets
   Cash                    £20,000
Total assets                £70,000

Non‑current assets
   Machinery (cost)        £50,000
   Accumulated depreciation (£9,000)
   Net book value          £41,000
Current assets
   Cash                    £20,000
Total assets                £61,000

2.4 What‑If: Changing the Useful Life

Suppose the estimated useful life is revised from 5 years to 4 years at the start of Year 2.

1. New annual depreciation: \[ \frac{£50,000 - £5,000}{4} = £11,250 \text{ per year} \]
2. Amended profit‑and‑loss for Year 2:

   Revenue                £120,000
   Cost of sales           £70,000
   Gross profit            £50,000
   Administrative expenses £10,000
   Depreciation expense    £11,250
   Operating profit        £28,750
   

3. Amended balance sheet at 31 Dec Year 2:

   Non‑current assets
      Machinery (cost)        £50,000
      Accumulated depreciation (£22,500)   ← £11,250 × 2 years
      Net book value          £27,500
   Current assets
      Cash                    £20,000
   Total assets                £47,500
   

This demonstrates how a change in the estimate of useful life amends both the income statement (higher expense) and the balance sheet (lower net book value).

3. Disposal of a Depreciated Asset

When an asset is sold or scrapped, the following steps are required:

1. Remove the asset’s original cost and its accumulated depreciation from the books.
2. Record any cash received.
3. Recognise a gain or loss:
   Gain/Loss = Proceeds – Net Book Value

3.1 Worked example (continuing the machine above)

• After 3 years, accumulated depreciation = £9,000 × 3 = £27,000.
• Net book value = £50,000 – £27,000 = £23,000.
• Machine sold for £20,000.
• Loss on disposal = £20,000 – £23,000 = ‑£3,000.

3.2 Journal entries for the disposal

Date          Account                              Debit (£)   Credit (£)
---------------------------------------------------------------------------
xx/xx/20XX    Cash                                   20,000
              Accumulated Depreciation – Machinery    27,000
              Loss on Disposal of Machinery            3,000
                 Machinery (cost)                                 50,000
(To record sale of a fully depreciated portion of the machine)

3.3 Before/after balance sheet (after disposal)

Non‑current assets
   Machinery (cost)        £50,000
   Accumulated depreciation (£27,000)
   Net book value          £23,000
Current assets
   Cash                    £20,000
Total assets                £43,000

Non‑current assets
   (Machinery removed)
Current assets
   Cash                    £40,000   ← £20,000 cash received + £20,000 existing
   Loss on disposal         £3,000   (shown in P&L)
Total assets                £43,000   (unchanged – only composition differs)

4. Optional Enrichment – Other Depreciation Methods

These methods are not required for the Cambridge IGCSE/A‑Level Business (9609) syllabus but are useful for further study.

5. Accounting Depreciation vs. Tax Depreciation

6. Key Points to Remember

• Depreciation is a non‑cash expense; it does not affect cash flow directly.
• Only the straight‑line method is required for the Cambridge Business (9609) syllabus; other methods are enrichment only.
• Consistent application of the chosen method is essential for comparability between periods.
• Residual (salvage) value is an estimate and may be zero; it is deducted before spreading the cost over the useful life.
• When an asset is disposed of, record the removal of cost and accumulated depreciation, the cash received, and any gain or loss.
• Tax depreciation schedules can differ from accounting depreciation; the two figures are treated separately for financial reporting and tax calculation.