Depreciation: Methods, Journals, and Asset Balances

Learning objectives

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

• Explain why depreciation is recorded and what it represents in the statement of profit or loss and the statement of financial position.
• Calculate depreciation using straight-line and reducing balance methods, incorporating residual value and useful life.
• Record depreciation using journals and track accumulated depreciation to determine carrying amount.
• Update asset balances at period end and interpret how depreciation affects profit and net assets.
• Calculate part-year depreciation using a consistent “available for use” time-apportionment policy and avoid common exam errors.

Overview & key concepts

When a business buys a tangible non-current asset (such as machinery, vehicles, or equipment), the cost is not treated as an immediate operating expense if the asset will be used over more than one accounting period. Instead, the asset is recognised in the statement of financial position and its cost is allocated across the periods that benefit from its use.

Depreciation is the periodic charge that reflects the consumption of an asset’s service potential over time. It supports consistent profit measurement by recognising a portion of an asset’s recorded cost as an expense in each period of use.

A practical way to link the topic is:

• Cost(including expenditure directly tied to getting the asset ready to operate as intended)
• Less residual value→depreciable amount
• Choose method+time-apportionment policy
• Journal entry
• Accumulated depreciation
• Carrying amount

Depreciation affects the financial statements in two linked ways:

• Statement of profit or loss:a depreciation charge reduces profit for the period.
• Statement of financial position:accumulated depreciation increases (or the asset cost account is reduced), lowering the asset’scarrying amount.

Depreciation is an accounting allocation, not a payment. Cash is paid (or a liability arises) when the asset is purchased; depreciation is recorded as the asset is used.

Depreciation and its purpose

Depreciation is recorded so that the cost of using an asset is reflected in the periods that benefit from that use. Without depreciation, later periods could report revenue generated by an asset with no related charge for the service potential consumed.

Depreciation does not attempt to update an asset to market value each year. It is a systematic allocation based on estimates of use and recovery.

Depreciable amount and residual value

The depreciable amount is the portion of the asset’s recorded cost that the business expects to “use up” over time.

• Start with the asset’s purchase price and add expenditure directly tied to getting the asset ready to operate as intended (for example, delivery and installation).
• Deduct theresidual value, which is the estimated amount expected to be recovered at the end of use (after considering disposal costs if those are significant).

Example:

• Cost: £20,000
• Residual value: £2,000
• Depreciable amount: £18,000

Only the depreciable amount is allocated through depreciation.

When depreciation starts and stops

Depreciation starts when the asset is available for use (not necessarily the invoice date or payment date). Depreciation stops at the earlier of:

• the date the asset is derecognised (for example, on disposal), or
• the date it isclassified as held for sale (i.e., meets the held-for-sale criteria).

Time-apportionment in the year of acquisition (or disposal) should therefore be based on the period the asset is available for use, applying the entity’s chosen convention (for example, by months).

Straight-line method

The straight-line method spreads the depreciable amount evenly across the asset’s useful life. It is often appropriate when the asset is expected to provide broadly consistent service each period.

Annual depreciation (straight-line)
Annual depreciation = (Cost − Residual value) ÷ Useful life (years)

Example:

• Cost: £5,000
• Residual value: £500
• Useful life: 3 years
• Annual depreciation: (5,000 − 500) ÷ 3 = £1,500

Reducing balance method

The reducing balance method applies a constant percentage to the asset’s carrying amount at the start of the period. Depreciation is higher in earlier years and decreases over time.

Annual depreciation (reducing balance)
Annual depreciation = Carrying amount at start of period × Depreciation rate

Example:

• Opening carrying amount: £10,000
• Rate: 20%
• Depreciation: £2,000

If residual value is material and still expected, ensure depreciation does not reduce the carrying amount below that residual value.

Accumulated depreciation and carrying amount

Depreciation is commonly recorded in a separate contra-asset account called accumulated depreciation. This keeps the original cost visible while showing how much depreciation has been charged to date.

Some entities record depreciation by reducing the asset cost account directly. However, a separate accumulated depreciation account is typical and usually clearer for control accounts, disclosures, and disposals.

Carrying amount (net book value)
Carrying amount = Cost − Accumulated depreciation

Example:

• Cost: £15,000
• Accumulated depreciation: £4,000
• Carrying amount: £11,000

Part-year depreciation

When an asset is brought into service part-way through the year (or taken out of service part-way through the year), depreciation is normally time-apportioned so that the charge reflects only the period the asset is available for use, applying the entity’s convention (for example, by months).

Part-year depreciation (time-apportionment)
Part-year depreciation = Annual depreciation × (Time available for use ÷ Time period)

Where a months convention is used:

Part-year depreciation = Annual depreciation × (Months available for use ÷ 12)

Consistency is essential: apply the same convention to similar assets and from one period to the next.

Core theory and frameworks

Recognition of depreciation

Depreciation is recognised as an expense in the statement of profit or loss. The credit entry increases accumulated depreciation (or reduces the asset cost account), lowering the asset’s carrying amount in the statement of financial position.

In published statements, the depreciation charge may be included within cost of sales, distribution costs, or administrative expenses, depending on the function of the asset.

Measurement choices

Depreciation requires estimates and choices, including:

• useful life
• residual value
• depreciation method
• timing convention for part-year charges

These estimates should be reviewed at least annually and revised if expectations change. Any revision is treated as a change in estimate and affects depreciation prospectively (current and future periods only).

Presentation in financial statements

• Depreciation expense appears within the statement of profit or loss (often analysed by function).
• The statement of financial position shows assets at carrying amount, often presented as cost less accumulated depreciation (either on the face of the statement or in a note).

Journal entries for depreciation

The typical depreciation journal at period end is:

Dr Depreciation expense
Cr Accumulated depreciation (relevant asset category)

This records the period’s allocation and updates the carrying amount.

Impairment and write-downs

Depreciation is planned and systematic. Impairment is different: it reflects an unexpected reduction in recoverable amount and is recorded separately. Both reduce carrying amount, but they arise for different reasons and are not interchangeable.

Worked example

Narrative scenario

A manufacturing company purchased:

Machinery on 1 April for £50,000.

• Residual value:£5,000
• Useful life:10 years
• Depreciation method:straight-line

Office equipment on 1 July for £10,000.

• Residual value:£1,000
• Useful life:5 years
• Depreciation method:straight-line

The financial year end is 31 December. Under the company’s policy, depreciation is time-apportioned based on months the asset is available for use in the year of acquisition.

Required

• Calculate the annual depreciation for the machinery and office equipment.
• Determine the part-year depreciation for each asset to 31 December, using the company’s “months available for use” convention.
• Prepare the journal entries for the depreciation charges at year end.
• Update the carrying amounts for both assets at 31 December.
• Explain the impact of these transactions on the financial statements.

Solution

Summary table

1) Machinery

Annual depreciation

• Depreciable amount = £50,000 − £5,000 = £45,000
• Annual depreciation = £45,000 ÷ 10 =£4,500

Part-year depreciation (available for use from 1 April to 31 December = 9 months)

• Depreciation for the year = £4,500 × (9 ÷ 12) =£3,375

Carrying amount at 31 December

• Cost: £50,000
• Accumulated depreciation: £3,375
• Carrying amount = £50,000 − £3,375 =£46,625

2) Office equipment

Annual depreciation

• Depreciable amount = £10,000 − £1,000 = £9,000
• Annual depreciation = £9,000 ÷ 5 =£1,800

Part-year depreciation (available for use from 1 July to 31 December = 6 months)

• Depreciation for the year = £1,800 × (6 ÷ 12) =£900

Carrying amount at 31 December

• Cost: £10,000
• Accumulated depreciation: £900
• Carrying amount = £10,000 − £900 =£9,100

3) Year-end journal entries

A combined entry is acceptable provided accumulated depreciation is analysed by asset category:

Dr Depreciation expense ........................................ £4,275
Cr Accumulated depreciation — machinery .......................... £3,375
Cr Accumulated depreciation — office equipment ................... £900

4) Impact on the financial statements

Statement of profit or loss

• Depreciation expense increases by£4,275, reducing profit for the year by£4,275.
• In published statements, this charge may be included within cost of sales, distribution costs, or administrative expenses depending on how the assets are used.

Statement of financial position

• Machinery carrying amount:£46,625
• Office equipment carrying amount:£9,100
• Total non-current assets are lower by£4,275compared with showing the assets at cost.

Equity (via retained earnings)

• Profit is lower, so retained earnings are lower by£4,275(ignoring tax and other movements).

Cash flow

• No cash movement arises from the depreciation entry itself.

Common pitfalls and misunderstandings

• Starting depreciation from thepurchase dateinstead of the date the asset isavailable for use(where these differ).
• Confusing “intended for sale” withclassified as held for sale (meets the held-for-sale criteria).
• Charging a full year’s depreciation in the year of acquisition when time-apportionment is required by policy.
• Ignoring residual value when it is given and material.
• Applying reducing balance tocostinstead of to openingcarrying amount.
• If residual value is material and still expected,depreciating below residual value.
• Crediting the asset cost account when the question expects accumulated depreciation (or vice versa).
• Treating depreciation as a cash expense and incorrectly adjusting bank/cash.
• Failing to keep accumulated depreciation analysed by asset category for later disposal calculations.
• Charging depreciation onland(land is not depreciated unless it has a finite useful life).
• Not reviewing estimates at least annually, or applying revisions retrospectively instead of prospectively.

Summary and further reading

Depreciation allocates the depreciable amount of a tangible non-current asset over the periods it is used. It reduces profit through an expense and reduces the asset’s carrying amount through accumulated depreciation (or a reduction of the asset cost account). Straight-line produces an even annual charge; reducing balance applies a percentage to the opening carrying amount and results in higher charges earlier. Depreciation begins when an asset is available for use and stops at derecognition or when it is classified as held for sale (meets the held-for-sale criteria). Where an asset is brought into service part-way through a period, depreciation is time-apportioned based on the period it is available for use, using the entity’s stated convention.

For wider context, review guidance on accounting for property, plant and equipment, including changes in useful life, residual value, and depreciation method, and the relationship between depreciation and impairment.

FAQ

Why is depreciation described as a non-cash expense?

Because the depreciation entry does not involve a payment. Cash is paid (or a liability is recognised) when the asset is purchased. Depreciation is recorded later to reflect consumption of service potential during the period, reducing profit without changing the cash balance.

How does the depreciation method affect the financial statements?

Different methods change the timing of expense recognition. Straight-line gives a steady charge; reducing balance gives higher charges earlier and lower charges later. This affects period-by-period profit and carrying amounts, even though the total depreciation over the asset’s life is driven by the depreciable amount.

Why does residual value matter?

Residual value represents what is expected to be recovered at the end of use. Depreciation is charged only on the part of cost expected to be consumed. If residual value is ignored, depreciation is usually overstated and carrying amounts understated.

How should part-year depreciation be handled?

Time-apportion depreciation so that you charge only for the period the asset is available for use, applying the entity’s convention (for example, months available for use ÷ 12). Apply the convention consistently to similar assets and across periods.

What are common errors with the reducing balance method?

Using original cost instead of opening carrying amount, forgetting time-apportionment where policy requires it, and (where residual value is material and still expected) depreciating below residual value.

Why keep accumulated depreciation separate from cost?

It preserves the original cost record and shows the total depreciation charged to date, which supports clearer disclosures, reconciliations, and later disposal calculations. Some entities reduce the asset cost account directly, but a separate accumulated depreciation account is more common and usually clearer.

Summary (Recap)

Depreciation is the systematic charge that allocates an asset’s depreciable amount over the periods it is used, reflecting consumption of service potential. The depreciable amount is cost less residual value. Straight-line spreads the charge evenly; reducing balance applies a percentage to opening carrying amount, producing higher charges earlier. Depreciation begins when an asset is available for use and stops at derecognition or classification as held for sale (meets the held-for-sale criteria). The accounting entry records an expense and increases accumulated depreciation, reducing carrying amount. Part-year depreciation is time-apportioned based on the period the asset is available for use, using a consistent policy.

Glossary

Depreciation
A periodic expense that allocates the depreciable amount of a tangible non-current asset across the periods it is used.

Depreciable amount
The portion of the asset’s recorded cost expected to be consumed through use: cost less estimated residual value.

Residual value
The estimated amount expected to be recovered at the end of use, after considering disposal costs where significant.

Useful life
The expected period (or output capacity) over which the asset will be used by the business.

Straight-line method
A method that allocates the depreciable amount evenly over useful life.

Reducing balance method
A method that applies a fixed percentage to the opening carrying amount each period, giving higher charges earlier and lower charges later.

Depreciation expense
The depreciation charge for the period, presented within the statement of profit or loss.

Accumulated depreciation
The total depreciation charged to date, maintained separately from cost to determine carrying amount.

Carrying amount
The amount shown for an asset in the statement of financial position: cost less accumulated depreciation (and less any impairment losses, if applicable).

Part-year depreciation
A time-apportioned depreciation charge when an asset is available for use for only part of the year.

Depreciation policy
An entity’s consistent approach to methods, estimates, and time-apportionment conventions used to calculate depreciation.

Impairment
A separate reduction in carrying amount recorded when recoverable amount falls below carrying amount.