the role of depreciation in the accounts

10.1 Financial Statements – Depreciation

Objective: Understand the role of depreciation in the accounts and how it affects financial statements. 🚀

What is Depreciation?

Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. Think of it like a bike 🚲 that slowly loses its shiny new look as you ride it more. The bike’s value drops each year, just as an asset’s value drops in the books.

Why Do We Need Depreciation?

• Shows the real cost of using an asset over time.
• Matches the expense with the revenue it helps generate (matching principle).
• Reduces taxable profit, giving tax relief.
• Helps investors see the true value of the company’s assets.

How to Calculate Depreciation

The most common method is straight‑line depreciation:

\$\text{Annual Depreciation} = \frac{\text{Cost of Asset} - \text{Residual Value}}{\text{Useful Life}}\$

1. Determine the cost of the asset (e.g., £10,000).
2. Estimate the residual (salvage) value at the end of its life (e.g., £1,000).
3. Decide the useful life in years (e.g., 5 years).
4. Apply the formula to get the yearly depreciation.

Example Calculation

Result: Each year the company records £1,800 as an expense, reducing profit and the book value of the asset.

Impact on Financial Statements

• Income Statement: Depreciation is an operating expense, lowering net profit.
• Balance Sheet: Asset’s carrying amount is reduced by accumulated depreciation.
• Cash Flow Statement: Depreciation is added back to net profit in the operating activities section (non‑cash expense).

Exam Tips

• Remember the formula: Cost – Residual Value ÷ Useful Life.
• Check that the depreciation method is stated in the question.
• Show the calculation step‑by‑step; examiners love clear work.
• Explain how depreciation affects profit, asset value, and cash flow.
• Use the bike analogy to remember that depreciation is about “wear and tear” over time.