Depreciation and Changes in Estimate

Learning objectives

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

• Calculate depreciation using the straight-line and reducing-balance methods, applying consistent assumptions and time apportionment where required.
• Record depreciation charges and accumulated depreciation using correct double-entry and ledger logic.
• Recalculate depreciation when useful life and/or residual value estimates change, applying prospective treatment from the date of change.
• Explain the effect of depreciation on profit, carrying amount (net book value), and equity through retained earnings.
• Identify common depreciation errors and explain how they affect reported results and asset carrying amounts.

Overview & key concepts

Depreciation is how we share out the cost of using a long-term tangible asset across the periods it helps to generate revenue. Each period includes a charge for the portion of the asset’s usefulness that has been consumed. Depreciation is not a cash fund and it is not an attempt to update the asset to its current selling price.

Depreciation has two headline reporting effects:

• Profit is lower because depreciation is an operating expense.
• The asset’s carrying amount (net book value) falls because accumulated depreciation builds up over time.

Depreciable amount

The depreciable amount is the part of an asset’s cost that will be allocated as depreciation over the time it is expected to be used.

Depreciable amount = Cost − Residual value

Example: cost £10,000, residual value £1,000.

Depreciable amount = 10,000 − 1,000 = 9,000

Useful life and residual value

• Useful life is how long (or how much output) the entity expects to obtain from using the asset.
• Residual value is the estimated net amount expected on disposal at the end of use (i.e., expected proceeds after any expected disposal costs, where relevant).

These are estimates. If expectations change, the depreciation charge is updated for future periods.

Carrying amount (net book value) and accumulated depreciation

Accumulated depreciation is the total depreciation recognised since the asset began being depreciated. Carrying amount (also called net book value) is what remains after deducting accumulated depreciation (and any impairment, if applicable).

Carrying amount (NBV) = Cost − Accumulated depreciation (− Impairment, if any)

Core principles

When depreciation starts and part-year charges

Start charging depreciation from the point the asset is ready to do the job you bought it for—meaning it has been set up so it can operate in the way management plans to use it. This date can differ from the invoice date or payment date (for example, delivered in June but installed and usable from August).

If the asset is only ready for use part-way through the reporting period, calculate the full-year depreciation under the chosen method and then time-apportion for the months (or days) it was ready during the period.

Depreciation usually continues while the asset remains available for use (even if temporarily idle), unless it is fully depreciated or classified as held for sale.

Recognition and double-entry

Depreciation is recognised as an operating expense in profit or loss. The common double-entry is:

• Debit depreciation expense (profit or loss)
• Credit accumulated depreciation (statement of financial position contra-asset)

This records the expense without altering the asset’s original cost.

Measurement: choosing a method

A depreciation method should reflect the pattern in which the asset’s benefits are expected to be consumed. Two common methods are:

Straight-line method

Equal charge each period across the useful life.

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

Reducing-balance method

A fixed percentage is applied to the opening carrying amount each period (so the charge is higher early and lower later).

Annual depreciation = Opening carrying amount × Depreciation rate

If parts of an asset are significant and wear out at different rates, depreciate those parts separately.

Reviews and changes in method or estimates

At least annually, entities reassess whether useful life, residual value and the depreciation method remain reasonable. If expectations change, depreciation is updated. If the pattern of consumption changes, the method should be updated to better reflect that pattern, with the effect applied to future periods.

Changes in estimate: useful life and residual value

If new information changes what you expect about an asset’s remaining life or disposal proceeds, you do not go back and rework earlier years. Instead, take the carrying amount at the revision date, update the estimates, and calculate a new depreciation charge that applies from that point onward.

Mechanics:

1. Calculate carrying amount at the date of change.
2. Update residual value and remaining useful life based on the new estimate.
3. Spread the remaining depreciable amount over the revised remaining life.

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

Presentation in the financial statements

• Profit or loss: depreciation is included within operating expenses. It may be included within cost of sales when the asset is used in production (because it forms part of the cost of manufacturing).
• Statement of financial position: the asset is presented at cost (or revalued amount, where relevant) less accumulated depreciation (and less any impairment).

Impact on the accounting equation

Depreciation is non-cash. It reduces assets and reduces equity through retained earnings.

• Assets decrease (via accumulated depreciation reducing carrying amount).
• Equity decreases (profit is lower, so retained earnings are lower).
• Liabilities are unchanged.

Exam technique: quick depreciation routine

Use this short routine to stay accurate under time pressure:

1. Identify the method and what the calculation is based on (straight-line: depreciable amount; reducing-balance: opening carrying amount).
2. For straight-line, compute depreciable amount (cost − residual value) and divide by useful life.
3. Time-apportion if the asset becomes ready for use part-way through a period.
4. If estimates change, compute carrying amount at the change date first.
5. Recalculate future depreciation using the revised residual value and remaining life (prospective).
6. Post the correct double entry (Dr depreciation expense, Cr accumulated depreciation).

Worked example

Narrative scenario

Tech Solutions Ltd purchased machinery on 1 January 2023 for £50,000. The machine was ready for use immediately. It was originally expected to have a useful life of 10 years and a residual value of £5,000. Depreciation is charged using the straight-line method.

On 1 January 2026, the company reviewed its expectations and revised them. The remaining useful life from that date is now 8 years, and the revised residual value is £4,000.

Depreciation has been recorded for the years ended 31 December 2023, 2024 and 2025 using the original estimates.

Rounding convention: amounts are shown to 2 decimal places where needed.

Required

1. Calculate the original annual depreciation charge.
2. Determine the accumulated depreciation as at 31 December 2025.
3. Calculate the revised annual depreciation charge from 2026 onward.
4. Record the journal entry for depreciation for the year ended 31 December 2026.
5. Explain the impact on the financial statements and the accounting equation.

Solution

1) Original annual depreciation charge

Depreciable amount = Cost − Residual value
Depreciable amount = 50,000 − 5,000 = 45,000

Annual depreciation = Depreciable amount / Useful life
Annual depreciation = 45,000 / 10 = 4,500

Original annual depreciation charge: £4,500 per year.

2) Accumulated depreciation as at 31 December 2025

Depreciation charged for 2023, 2024 and 2025: 3 full years.

Accumulated depreciation = Annual depreciation × Number of years
Accumulated depreciation = 4,500 × 3 = 13,500

Accumulated depreciation at 31 December 2025: £13,500.

3) Revised annual depreciation charge from 2026 onward

Carrying amount at the date of change (1 January 2026):

Carrying amount = Cost − Accumulated depreciation
Carrying amount = 50,000 − 13,500 = 36,500

Apply revised estimates from 1 January 2026:

Revised residual value: £4,000
Revised remaining useful life: 8 years

Revised depreciable amount = Carrying amount − Revised residual value
Revised depreciable amount = 36,500 − 4,000 = 32,500

Revised annual depreciation = Revised depreciable amount / Revised remaining useful life
Revised annual depreciation = 32,500 / 8 = 4,062.50

Revised annual depreciation from 2026: £4,062.50 per year.

4) Journal entry for depreciation in 2026

(Year ended 31 December 2026)

Dr Depreciation expense (profit or loss) .......................... £4,062.50
Cr Accumulated depreciation (statement of financial position) .... £4,062.50

5) Impact on financial statements and the accounting equation

Profit or loss (2026):
Depreciation expense of £4,062.50 reduces operating profit for 2026.

Statement of financial position (at 31 December 2026):
Accumulated depreciation increases by £4,062.50. The machinery’s carrying amount falls by the same amount.

Carrying amount at 31 December 2026:

Carrying amount at 31 Dec 2026 = Carrying amount at 1 Jan 2026 − Depreciation (2026)
Carrying amount at 31 Dec 2026 = 36,500 − 4,062.50 = 32,437.50

Accounting equation effect (2026):

• Assets decrease by £4,062.50 (lower carrying amount).
• Equity decreases by £4,062.50 (lower profit reduces retained earnings).
• Liabilities are unchanged.

The revision is applied from 1 January 2026 onward, using updated expectations at that date.

Common pitfalls and misunderstandings

• Starting depreciation from the purchase or payment date rather than the ready-for-use date.
• Stopping depreciation when the asset is temporarily idle but still available for use.
• Forgetting residual value under straight-line depreciation.
• Applying estimate changes to prior years instead of updating depreciation from the change date onward.
• Applying reducing-balance percentages to cost instead of the opening carrying amount.
• Omitting time apportionment when an asset becomes ready for use mid-year.
• Posting the credit entry to the asset cost account rather than to accumulated depreciation (unless explicitly instructed).
• Missing the equity link: depreciation reduces profit and therefore reduces retained earnings.

Summary

Depreciation allocates the depreciable amount of a tangible non-current asset over the periods that benefit from using it. Straight-line produces an even charge, while reducing-balance applies a fixed rate to the opening carrying amount, producing higher early charges.

Depreciation begins when the asset is set up so it can operate in the way management plans to use it. It usually continues while the asset remains available for use, even if temporarily idle, unless it is fully depreciated or classified as held for sale. Useful life, residual value and the depreciation method are reviewed at least annually. If estimates change, future depreciation is recalculated using the carrying amount at the change date and applied from that point onward. The double-entry is Dr depreciation expense and Cr accumulated depreciation, reducing profit and reducing the asset carrying amount.

FAQ

When exactly does depreciation start?

Depreciation starts when the asset is ready for its intended use—meaning it has been set up so it can operate in the way management plans to use it. This may be later than the invoice, payment, or delivery date.

Does depreciation stop if the asset is not being used?

Not usually. Depreciation normally continues while the asset remains available for use, even if it is temporarily idle, unless it is fully depreciated or classified as held for sale.

How do I deal with a change in useful life or residual value?

Work out the carrying amount at the change date, update the residual value and remaining useful life, then calculate a new depreciation charge to apply from that date onward.

Glossary

Depreciation
A way of spreading the depreciable cost of a tangible non-current asset over the periods that benefit from its use.

Depreciable amount
Cost minus residual value.

Residual value
The estimated net amount expected from disposal at the end of the asset’s use.

Useful life
The time period (or output) over which the entity expects to use the asset.

Carrying amount (Net book value)
Cost (or revalued amount) less accumulated depreciation (and any impairment, if applicable).

Accumulated depreciation
Total depreciation recognised to date, recorded as a contra-asset.

Straight-line method
A method that produces an equal depreciation charge each period over the useful life.

Reducing-balance method
A method that applies a fixed percentage to the opening carrying amount each period.

Change in estimate
An update to earlier expectations (for example, remaining life or disposal proceeds) based on new information, affecting depreciation from the change date onward.

Component depreciation
Where significant parts of an asset are depreciated separately because they are used up at different rates.