Depreciation: Methods, Estimates, and Revaluations

Learning objectives

By the end of this chapter, you should be able to:

• Calculate depreciation using straight-line and reducing-balance methods, including part-year adjustments for acquisition or disposal.
• Record depreciation in journals and explain its effect on profit and the asset’s carrying amount in the financial statements.
• Recalculate depreciation when estimates change (useful life and/or residual value), applying changes to future periods only.
• Explain and record the basics of revaluing property, plant and equipment, and compute depreciation after revaluation.
• Identify common errors in depreciation, estimate changes and revaluation scenarios.

Overview & key concepts

Depreciation spreads the cost of a non-current asset over the periods that benefit from its use. Instead of expensing the full purchase price immediately, the asset is recognised on the statement of financial position and then an expense is recognised over time as the asset’s service potential is consumed.

Throughout this chapter, amounts are shown in $ (any currency).

Two ideas drive most exam questions:

1. Depreciable amount: the portion of the asset’s value expected to be used up. This is usuallycost (or revalued amount) minus residual value.
2. Pattern of consumption: depreciation should follow how the asset’s benefits are expected to be used (evenly over time, faster in earlier years, etc.).

Depreciation affects the financial statements as follows:

• Profit or loss: depreciation is an operating expense, reducing profit for the period.
• Statement of financial position: the asset is shown atcarrying amount, which is the amount recognised after deducting accumulated depreciation (and any impairment losses, where relevant).

Depreciation and why it matters

Depreciation is an allocation process, not a market valuation. It ensures the asset’s cost is recognised as an expense over the periods that use the asset, rather than being concentrated in the year of purchase.

Illustration (straight-line):
A machine costs $100,000, has residual value $10,000 and useful life 10 years.

• Depreciable amount = $100,000 − $10,000 = $90,000
• Annual depreciation = $90,000 / 10 =$9,000

Core theory and frameworks

Straight-line method

Straight-line charges the same depreciation each year and is appropriate when benefits are expected to arise evenly over time.

Formula
Annual depreciation = (Cost − Residual value) / Useful life

Journal entry

• Dr Depreciation expense
• Cr Accumulated depreciation

Accumulated depreciation is a contra-asset that reduces the asset’s carrying amount.

Reducing-balance method

Reducing-balance applies a constant percentage to the asset’s carrying amount at the start of the period, so depreciation is higher early on and falls over time.

Formula
Depreciation for the period = Opening carrying amount × Depreciation rate

Illustration:
Asset cost $20,000, reducing-balance rate 20%, no residual value.

• Year 1 depreciation = $20,000 × 20% = $4,000
• Carrying amount end of Year 1 = $16,000
• Year 2 depreciation = $16,000 × 20% = $3,200
• Carrying amount end of Year 2 = $12,800

Journal entry

• Dr Depreciation expense
• Cr Accumulated depreciation

Time apportionment

If an asset is acquired or disposed of partway through the reporting period, depreciation is charged only for the time it is held for use.

Formula (months basis)
Depreciation for the period = Annual depreciation × (Months used / 12)

Illustration:
Annual depreciation is $12,000. Purchased 1 April, year-end 31 December (9 months).

• Depreciation = $12,000 × 9/12 =$9,000

Depreciation base and components

Depreciation is calculated by reference to the depreciable amount of the asset. Where a non-current asset has significant parts with different useful lives or patterns of use, those parts should be depreciated separately.

In many exam questions, the asset is treated as a single component unless the requirement clearly splits it into parts.

Changes in estimates

Useful life and residual value are estimates and may change as new information becomes available. A change in estimate affects future depreciation only: you do not go back and rework prior years’ depreciation simply because estimates have changed.

Revised depreciation calculation
New annual depreciation = (Carrying amount at change date − Revised residual value) / Revised remaining useful life

Change in estimate vs error

• Change in estimate:updating useful life/residual value because expectations have changed. This is reflectedprospectively(future periods only).
• Error:a mistake such as using the wrong method, wrong fraction of a year, incorrect arithmetic, or posting to the wrong account. Some questions may explicitly ask for correction/restatement; others expect you to identify that the prior treatment was wrong and correct it.

Revaluation of assets

Revaluation updates an asset’s carrying amount to a current value. After revaluation, depreciation is calculated from the revalued carrying amount (less any updated residual value) over the remaining useful life.

Class of assets requirement

If an entity adopts a revaluation approach for property, plant and equipment, it applies it to an entire class of assets, and revaluations are kept sufficiently up to date so that carrying amounts are not materially different from current values.

This means you cannot revalue one asset within a class simply to improve ratios while leaving similar assets at cost.

Where revaluation gains and losses go

Revaluation movements may increase or decrease the carrying amount. The destination of the movement depends on direction and what happened on earlier revaluations of the same asset:

• Revaluation increase:
• Creditprofit or lossto the extent the increase reverses an earlier revaluation decrease that was charged to profit or loss. Any remaining increase is credited torevaluation surplus within equity(presented through other comprehensive income in a full set of statements).
• Revaluation decrease:
• Debitany existing revaluation surplus for that asset first; any excess is charged toprofit or loss.

Exam tip: transfer of “excess depreciation”

After an upward revaluation, depreciation will often be higher than it would have been under historical cost. An entity may transfer the “extra” amount (depreciation on revalued amount less depreciation on historical cost) from revaluation surplus to retained earnings. This is a movement within equity and does not go through profit or loss.

Journal entries for revaluation (high-level)

The exact journals depend on the way the question presents the ledger (whether cost and accumulated depreciation are shown separately). The key is that, after your entries, the asset’s carrying amount equals the revalued amount and the movement is posted to the correct place (profit or loss and/or revaluation surplus).

Upward movement (conceptual)

• Dr Asset (to increase to revalued amount)
• Cr Profit or loss to the extent of any reversal of a prior decrease recognised in profit or loss
• Cr Revaluation surplus (equity) for any remaining increase

Downward movement (conceptual)

• Dr Revaluation surplus (equity) to the extent available for that asset
• Dr Profit or loss for any excess
• Cr Asset

Updating cost and accumulated depreciation after revaluation (how to think about it)

Exam questions sometimes show an asset with two balances (cost and accumulated depreciation), but the valuation is always about the net carrying amount. Your postings must end with that net amount equal to the revalued figure.

One tidy way is to remove the accumulated depreciation balance so the ledger shows a single net figure, and then post the uplift/downlift to reach the valuation. Another way is to rebalance the gross cost and accumulated depreciation together so that their net difference equals the revalued carrying amount.

Pick an approach that matches the way the question lays out the balances, and use a final check:
Net carrying amount after entries = valuation.

Worked example

Narrative scenario

XYZ Manufacturing Ltd purchased a piece of machinery on 1 January 2025 for $125,000. The machinery has an expected residual value of $5,000 and a useful life of 10 years. The company uses the straight-line method of depreciation. On 1 January 2027, the machinery is revalued to $140,000 and the remaining useful life is revised to 8 years. The year-end is 31 December.

Required

1. Calculate the annual depreciation for 2025 and 2026.
2. Record the journal entries for depreciation for 2025 and 2026.
3. Calculate the revaluation increase on 1 January 2027.
4. Record the journal entry for the revaluation.
5. Calculate the revised annual depreciation from 2027.

Solution

1) Depreciation for 2025 and 2026 (straight-line)

Depreciable amount = $125,000 − $5,000 = $120,000
Annual depreciation = $120,000 / 10 = $12,000 per year

So depreciation is $12,000 in each of 2025 and 2026.

2) Journal entries for depreciation

31 December 2025

• Dr Depreciation expense $12,000
• Cr Accumulated depreciation $12,000

31 December 2026

• Dr Depreciation expense $12,000
• Cr Accumulated depreciation $12,000

Accumulated depreciation at 31 December 2026 = $24,000

3) Revaluation increase on 1 January 2027

Check: Carrying amount at 31 December 2026 = $125,000 − $24,000 = $101,000

Revalued amount = $140,000
Increase = $140,000 − $101,000 = $39,000

4) Journal entry for the revaluation (illustrated using the “clear accumulated depreciation” approach)

Step A: clear accumulated depreciation against the asset’s cost

• Dr Accumulated depreciation $24,000
• Cr Machinery $24,000

This removes the accumulated depreciation balance and leaves the machinery shown at a single net amount of $101,000.

Step B: record the uplift to the revalued amount

• Dr Machinery $39,000
• Cr Revaluation surplus (equity) $39,000

After Step B, the machinery’s carrying amount is $140,000.

5) Revised annual depreciation from 2027

Depreciation from 2027 is based on the revalued amount and revised remaining life.

New depreciable amount = $140,000 − $5,000 = $135,000
Remaining useful life = 8 years
Revised annual depreciation = $135,000 / 8 = $16,875 per year

Common pitfalls and misunderstandings

• Revaluation decrease posted to the wrong place:
• A revaluation decrease is debited to any existing revaluation surplus for that asset first; any excess goes to profit or loss.
• Revaluation increase posted entirely to equity:
• If the increase reverses a prior revaluation decrease that was charged to profit or loss, that portion is credited to profit or loss first; only the remainder goes to revaluation surplus within equity.
• Ignoring the “class of assets” rule:
• Revaluation is applied to a class, not selectively to individual assets within that class.
• Using historical cost after revaluation:
• Once revalued, depreciation is based on the revalued carrying amount (less residual value) over remaining useful life.
• Treating transfers within equity as profit adjustments:
• Any transfer of excess depreciation is within equity only and does not affect profit.
• Weak handling of time apportionment:
• Depreciate only for the period held for use, based on the dates given.
• Confusing estimate changes with errors:
• Estimate changes affect future depreciation; errors are corrected as mistakes, not treated as estimate updates.
• Forgetting residual value:
• Depreciation is based on cost (or revalued amount) less residual value unless the question states residual value is nil.

Summary

Depreciation allocates the depreciable amount of an asset across the periods of use. Straight-line spreads the charge evenly, while reducing-balance applies a fixed percentage to the opening carrying amount, producing a declining expense profile. Part-year ownership requires time apportionment.

If useful life or residual value changes, depreciation is recalculated prospectively using the carrying amount at the date of change and the revised estimates. Revaluation updates the carrying amount to a current value, applies to an entire class of assets, and requires values to be kept up to date. Revaluation increases are credited to profit or loss to the extent they reverse prior decreases charged to profit or loss, with any remaining increase credited to revaluation surplus within equity. Revaluation decreases are debited to any existing surplus for that asset first, with any excess charged to profit or loss. After revaluation, depreciation is calculated on the revalued amount, and any optional transfer of “excess depreciation” is a movement within equity, not through profit.

FAQ

What is the impact of depreciation on the financial statements?

Depreciation is an operating expense that reduces profit. It also reduces the asset’s carrying amount through accumulated depreciation (or by directly reducing the asset balance, depending on how records are presented).

How does revaluation affect future depreciation?

After revaluation, the new carrying amount becomes the starting point for depreciation (less any residual value) over the remaining useful life. If the value is revalued upwards, future depreciation usually increases.

Why is time apportionment important?

It ensures depreciation is charged only for the period the asset is held for use in the reporting period, preventing overstatement or understatement of expenses and carrying amounts.

What are common errors in depreciation and revaluation questions?

Common errors include using historical cost after revaluation, failing to use residual value, missing time apportionment, mixing up estimate changes with errors, and posting revaluation movements to the wrong place (profit or equity).

How should changes in useful life or residual value be handled?

Recalculate depreciation from the date of change using the asset’s carrying amount and the revised estimates. Apply the revised charge to future periods only.

Glossary

Depreciation
An expense recognised over time to reflect the portion of an asset’s cost (or revalued amount) that is consumed through use.

Depreciable amount
The amount expected to be used up: typically the asset’s cost (or revalued amount) less its expected residual value.

Useful life
The period the asset is expected to be available for use, or the expected output/usage from the asset.

Residual value
The expected proceeds from disposal at the end of use, net of expected disposal costs (if material).

Carrying amount
The amount at which an asset is recognised after accumulated depreciation (and impairment losses, where relevant).

Accumulated depreciation
The total depreciation charged to date, presented as a contra-asset balance that reduces the asset’s carrying amount.

Straight-line method
A method that recognises an equal depreciation charge each year across the asset’s useful life.

Reducing-balance method
A method that applies a fixed percentage to the opening carrying amount each period, producing higher charges in early years.

Time apportionment
Adjusting depreciation for part-year ownership or use so the charge reflects the period held.

Change in estimate
An update to assumptions such as useful life or residual value, affecting depreciation in future periods.

Error
A mistake in method, arithmetic, or posting that requires correction as an error rather than being treated as an estimate update.

Revaluation
Updating an asset’s carrying amount to a current value and using that amount as the new basis for depreciation.

Revaluation surplus
An equity reserve that accumulates upward revaluation gains (with the rule that reversals of prior decreases charged to profit are credited to profit to that extent).