What depreciation is
An asset bought to use for more than one year is a non-current asset. Its cost is not all an expense of the year it was bought. The cost is shared over the years the asset helps to earn income, and each year's share is called depreciation.
- Cost
- What the business paid for the asset.
- Useful life
- How long the business expects to use the asset.
- Residual value
- What the business expects to sell the asset for at the end of its useful life.
- Accumulated depreciation
- All the depreciation charged on an asset so far.
- Carrying amount
- Cost less accumulated depreciation. It is also called net book value.
Depreciation is a share of a cost that has already been paid. No money leaves the bank when it is charged, and no cash is set aside.
The carrying amount is the part of the cost not yet charged as an expense. It is not an estimate of what the asset would sell for.
Inventory and money are not depreciated. Nor is land, because it does not wear out.
The two methods
The straight line method charges the same amount in every year of the useful life. The yearly charge is cost less residual value, divided by the useful life in years.
Straight line is also given as a percentage of cost. With no residual value, the percentage is 100 divided by the useful life in years.
The reducing balance method charges a fixed percentage of the carrying amount at the start of each year. As the carrying amount falls, so does the charge. Residual value is not taken off first: the percentage is chosen so that the asset is written down to about its residual value by the end of its life.
| Straight line | Reducing balance | |
|---|---|---|
| The percentage is applied to | Cost | The carrying amount at the start of the year |
| The charge each year | Stays the same | Falls |
| Residual value | Taken off before the sum | Not taken off |
| Suits | Assets that give the same use every year, such as shop fittings | Assets that lose most of their value when they are new, such as vehicles |
Once a method is chosen for a kind of asset, the business keeps to it from year to year, so that one year can be compared with the next.
The steps in order
Do this for each asset at the year end.
- Find the cost of the asset, and the method and the percentage or useful life the business uses for that kind of asset.
- For straight line, take the residual value from the cost and divide by the useful life in years. That is the charge for every year.
- For reducing balance, find the carrying amount at the start of the year: cost less all the depreciation charged so far. Multiply it by the percentage. That is the charge for this year.
- If the asset was bought part way through the year, follow the policy of the business: a full year's charge, or a charge only for the months it was owned.
- Write the journal: debit Depreciation charge, credit Accumulated depreciation.
- Add the charge to the accumulated depreciation brought forward. Take the new total from cost to find the carrying amount.
When the useful life is over, the whole of cost less residual value has been charged. Depreciation then stops, even if the asset is still in use.
A worked example of each method
Stonebridge Landscapes looks after gardens. It buys a ride-on mower for £7,400.00. It expects to use the mower for 5 years and then sell it for £1,400.00. The mower is depreciated straight line.
Cost less residual value is £6,000.00. Divided by 5 years, the charge is £1,200.00 a year. After 3 years the accumulated depreciation is £3,600.00 and the carrying amount is £3,800.00.
After all 5 years the carrying amount is £1,400.00, which is the residual value.
On the same day it buys a pickup truck for £20,000.00. The truck is depreciated at 30 per cent a year, reducing balance.
| Year | Carrying amount at start £ | Charge for the year £ | Carrying amount at end £ |
|---|---|---|---|
| 1 | 20,000.00 | 6,000.00 | 14,000.00 |
| 2 | 14,000.00 | 4,200.00 | 9,800.00 |
| 3 | 9,800.00 | 2,940.00 | 6,860.00 |
The first charge is 30 per cent of the cost, £6,000.00. The second is 30 per cent of £14,000.00, which is £4,200.00. Each charge is smaller than the one before, and the accumulated depreciation after three years is £13,140.00.
The year-end journal and the carrying amount
Depreciation is recorded with a journal at the year end. It uses two accounts.
- Depreciation charge
- An expense. It holds this year's depreciation and goes to the statement of profit or loss. It starts again from nil each year.
- Accumulated depreciation
- It holds all the depreciation so far, and is set against the asset's cost in the statement of financial position. It is not cleared at the year end, so it grows.
The asset's own account stays at cost until the asset is sold. Each class of asset has its own accumulated depreciation account.
| Account | Debit £ | Credit £ |
|---|---|---|
| Depreciation charge | 5,400.00 | |
| Accumulated depreciation, equipment | 1,200.00 | |
| Accumulated depreciation, vehicles | 4,200.00 |
The expense for year 2 is £1,200.00 on the mower plus £4,200.00 on the truck: £5,400.00.
| Detail | £ |
|---|---|
| Cost | 20,000.00 |
| Accumulated depreciation | 10,200.00 |
| Carrying amount | 9,800.00 |
Common mistakes
- Dividing the whole cost by the useful life in straight line. The residual value comes off first.
- Taking the residual value off in reducing balance. The percentage is applied to the carrying amount as it stands.
- Applying the reducing balance percentage to cost every year. That is straight line, and the charge would never fall.
- Crediting the asset's cost account. The cost account is not touched. The credit goes to Accumulated depreciation.
- Crediting Bank. No money moves when depreciation is charged.
- Showing only this year's charge as accumulated depreciation. It is every year's charge added together.
- Reading the carrying amount as a selling price. It is not changed to match what a dealer would pay.
How to check your work
- Straight line: the yearly charge times the useful life equals cost less residual value.
- Reducing balance: each year's charge is smaller than the last, and each is the percentage of the carrying amount at the start of that year.
- Accumulated depreciation at the year end is the figure brought forward plus this year's charge.
- Carrying amount is cost less accumulated depreciation.
- The journal has equal debits and credits. The charge is an expense, so profit falls by the same amount.
Practise it
Words used here
- Depreciation
- Depreciation shares the cost of a non-current asset over the years it is used. Each year's share is an expense.
- Straight line depreciation
- Straight line depreciation charges the same amount in every year of an asset's useful life.
- Reducing balance depreciation
- Reducing balance depreciation charges a fixed percentage of an asset's carrying amount each year, so the charge falls.
- Non-current asset
- A non-current asset is an asset a business keeps and uses for more than a year, such as a van, an oven or shop fittings.
- Journal
- The journal is the book of prime entry for anything that fits in neither a day book nor the cash book.
Questions
What is the difference between straight line and reducing balance depreciation?
Straight line charges the same amount every year: cost less residual value, divided by the useful life. Reducing balance charges a fixed percentage of the carrying amount at the start of each year, so the charge falls.
Does depreciation take money out of the bank?
No. Depreciation shares out a cost that was paid when the asset was bought. No money moves when it is charged, and no cash is set aside.
What is the journal for depreciation?
Debit Depreciation charge and credit Accumulated depreciation. The asset's cost account is not touched.
What is the carrying amount of an asset?
Cost less accumulated depreciation, which is all the depreciation charged so far. It is also called net book value, and it is not an estimate of a selling price.
When is each depreciation method used?
Straight line suits assets that give the same use every year, such as shop fittings. Reducing balance suits assets that lose most of their value when they are new, such as vehicles.