5.2 Depreciation Accounting Policies & Journal Entries

Depreciation Accounting Policies & Journal Entries

Once an entity selects an appropriate depreciation method (Straight-Line or Reducing Balance) for each class of non-current asset under IAS 16 Property, Plant and Equipment, it must define its operational accounting policies for timing and execute the double-entry bookkeeping entries in the nominal ledger.

Accurate accounting for depreciation ensures that operating expenses on the Statement of Profit or Loss (SPL) reflect the true cost of asset usage and that the Statement of Financial Position (SFP) presents a true and fair view of non-current asset carrying amounts.

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Accounting Policies for Depreciation Timing

Non-current assets are rarely acquired or disposed of precisely on the first or last day of an accounting financial year. Consequently, a business must choose and consistently apply one of two standard accounting policies for mid-year additions and disposals:

┌──────────────────────────────────────────────────────────────────────────┐
│                     DEPRECIATION TIMING POLICIES                         │
├──────────────────────────┬───────────────────────────────────────────────┤
│ Policy A: Full-Year      │ • Charge a full 12 months of depreciation in  │
│ Policy                   │   the year of acquisition, regardless of date │
│ (Year of Purchase)       │ • Charge ZERO depreciation in year of disposal│
│                          │ • Administratively simple for high volumes    │
├──────────────────────────┼───────────────────────────────────────────────┤
│ Policy B: Proportionate  │ • Calculate depreciation on a monthly pro-rata│
│ (Pro-Rata / Monthly)     │   basis for the exact months owned in year    │
│ Policy                   │ • Charge depreciation in year of disposal up  │
│                          │   to the month of disposal                    │
│                          │ • Provides precise matching for high-value    │
│                          │   capital investments                         │
└──────────────────────────┴───────────────────────────────────────────────┘

1. The Full-Year Depreciation Policy

• Rules:
  • Year of Acquisition: A full 12-month depreciation charge is recognized in the financial year the asset is purchased, even if purchased on the final day of the financial year.
  • Year of Disposal: No depreciation is charged in the financial year in which the asset is sold or scrapped, even if disposed of near the end of the year.
• Advantages: Simplicity, reduced administrative bookkeeping burden, highly practical for large asset registers containing many low-to-medium value items.

2. The Proportionate (Monthly / Pro-Rata) Policy

• Rules:
  • Depreciation is computed based on the exact number of complete months the asset is owned and operational during the financial year.
  • Formula:
    • Depreciation Charge = Full Annual Depreciation × (Months Owned in Financial Year / 12)
• Counting Rule: An asset acquired on or before the 15th of a month is typically treated as owned for that full month; if acquired after the 15th, depreciation begins from the start of the following month (or calculated based on the specific convention stated in the assessment).

Comparative Worked Example: Mid-Year Acquisition

Merlin Industrial Ltd has an accounting year ending on 31 December 20X4. On 1 October 20X4, Merlin purchased a new delivery lorry for £36,000. The business depreciates motor vehicles at 20% per annum on cost (Straight-Line).

• Under Full-Year Policy:

  • Charge for Year Ended 31 Dec 20X4: £36,000 × 20% = £7,200
  • Carrying Amount at 31 Dec 20X4: £36,000 − £7,200 = £28,800

• Under Proportionate (Pro-Rata) Policy:

  • Asset owned from 1 October to 31 December = 3 months (October, November, December).
  • Charge for Year Ended 31 Dec 20X4: £36,000 × 20% × (3 / 12) = £1,800
  • Carrying Amount at 31 Dec 20X4: £36,000 − £1,800 = £34,200

Analysis: In the acquisition year, the full-year policy reports a higher expense (£7,200 vs £1,800), reducing Year 1 profit by an additional £5,400, but eliminates the need for monthly apportionment calculations.

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Double-Entry Bookkeeping Flow for Depreciation

The Contra-Asset Account Concept

In the general ledger, a separate Asset at Cost Account is maintained for each asset category. This account records the original capital expenditure and remains at historical cost until the asset is either enhanced or disposed of.

Depreciation is never credited directly to the Asset at Cost Account. Doing so would obscure the historical cost basis and destroy the clear audit trail of capital investment. Instead, depreciation is accumulated in a dedicated Accumulated Depreciation Account (also called Provision for Depreciation).

• The Accumulated Depreciation account is a Contra-Asset Account:
  • It carries a Credit balance.
  • On the Statement of Financial Position, it is presented as a deduction directly beneath the Asset Cost account to show the net Carrying Amount.

The Period-End Double-Entry Recording

At the end of each financial year, the depreciation adjustment is recorded via the General Journal:

┌──────────────────────────────────────────────────────────────────────────┐
│                     DOUBLE-ENTRY POSTING MECHANICS                       │
├──────────────────────────────────────────────────────────────────────────┤
│ 1. GENERAL JOURNAL ENTRY:                                                │
│    Debit:  Depreciation Expense (SPL Operating Expenses)         £X,XXX  │
│    Credit: Accumulated Depreciation (SFP Contra-Asset)          £X,XXX   │
│    [Narrative: Annual depreciation charge for the year]                  │
├──────────────────────────────────────────────────────────────────────────┤
│ 2. NOMINAL LEDGER POSTINGS:                                              │
│    • Post debit to Depreciation Expense T-Account                        │
│    • Post credit to Accumulated Depreciation T-Account                   │
├──────────────────────────────────────────────────────────────────────────┤
│ 3. PERIOD-END CLOSING & FINANCIAL STATEMENTS:                            │
│    • Depreciation Expense account balance is transferred (cleared) to   │
│      the Statement of Profit or Loss as an operating cost.               │
│    • Accumulated Depreciation balance carries forward (Balance c/d)     │
│      on the Statement of Financial Position as a cumulative deduction.   │
└──────────────────────────────────────────────────────────────────────────┘

Comprehensive T-Account Ledger Flow

Consider a business that purchased machinery for £50,000 on 1 January 20X1, depreciated at £10,000 per year straight-line over 5 years.

                             PLANT & MACHINERY AT COST
Dr                                                                            Cr
────────────────────────────────────────────────────────────────────────────────
Date        Details              £     Date        Details              £
20X1 Jan 1  Bank               50,000  20X1 Dec 31 Balance c/d          50,000
────────────────────────────────────────────────────────────────────────────────
                               50,000                                   50,000
────────────────────────────────────────────────────────────────────────────────
20X2 Jan 1  Balance b/d        50,000  20X2 Dec 31 Balance c/d          50,000


                      ACCUMULATED DEPRECIATION - MACHINERY
Dr                                                                            Cr
────────────────────────────────────────────────────────────────────────────────
Date        Details              £     Date        Details              £
20X1 Dec 31 Balance c/d        10,000  20X1 Dec 31 Depreciation (SPL)   10,000
────────────────────────────────────────────────────────────────────────────────
                               10,000                                   10,000
────────────────────────────────────────────────────────────────────────────────
                                       20X2 Jan 1  Balance b/d          10,000
20X2 Dec 31 Balance c/d        20,000  20X2 Dec 31 Depreciation (SPL)   10,000
────────────────────────────────────────────────────────────────────────────────
                               20,000                                   20,000
────────────────────────────────────────────────────────────────────────────────
                                       20X3 Jan 1  Balance b/d          20,000


                          DEPRECIATION EXPENSE (SPL)
Dr                                                                            Cr
────────────────────────────────────────────────────────────────────────────────
Date        Details              £     Date        Details              £
20X1 Dec 31 Accum Depn         10,000  20X1 Dec 31 Profit or Loss       10,000
────────────────────────────────────────────────────────────────────────────────
20X2 Dec 31 Accum Depn         10,000  20X2 Dec 31 Profit or Loss       10,000

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Changes in Accounting Estimates (IAS 8 & IAS 16)

Annual Review Requirement

Under IAS 16, the useful economic life, depreciation method, and residual value of every tangible non-current asset must be reviewed at least at the end of each financial year.

If expectations differ significantly from previous estimates—due to changes in operational intensity, technological breakthroughs, physical damage, or market shifts—the estimate must be revised.

Accounting Treatment: Prospective Application

Under IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors:

• A change in useful life, residual value, or depreciation method is classified as a Change in Accounting Estimate.
• It must be accounted for PROSPECTIVELY (looking forward only).
• Never make retrospective restatements or prior period adjustments for changes in estimates. The depreciation charged in prior years remains untouched and valid.

Prospective Recalculation Formula

When an estimate changes, recalculate annual straight-line depreciation from the date of the change using the Carrying Amount at the date of revision:

┌──────────────────────────────────────────────────────────────────────────┐
│               PROSPECTIVE REVISION FORMULA (IAS 8 / IAS 16)              │
├──────────────────────────────────────────────────────────────────────────┤
│ Revised Annual Depreciation =                                            │
│   (Carrying Amount at Date of Change − Revised Residual Value)           │
│   ────────────────────────────────────────────────────────────           │
│                  Remaining Useful Economic Life                          │
└──────────────────────────────────────────────────────────────────────────┘

Step-by-Step Worked Case: Revision of Useful Life & Residual Value

Titan Engineering Ltd acquired a specialised computerised milling machine on 1 January 20X1 for £100,000.

• Original Estimate: Useful economic life of 10 years, residual value of £0. Straight-line depreciation = £10,000 per year.
• On 31 December 20X3, after 3 full years of depreciation (accumulated depreciation = £30,000; carrying amount = £70,000), management conducts an annual review.
• Revised Estimate (Effective 1 January 20X4):
  • Due to heavy market demand and wear, the machine will only last for 2 more years (total life of 5 years instead of 10).
  • Estimated residual value at the end of Year 5 is revised to £6,000.

Step-by-Step Computation:

1. Determine Carrying Amount at Date of Revision (1 Jan 20X4):

   • Historical Cost = £100,000
   • Accumulated Depreciation (3 years) = 3 × £10,000 = £30,000
   • Carrying Amount at 1 Jan 20X4 = £100,000 − £30,000 = £70,000

2. Identify Revised Parameters:

   • Revised Residual Value = £6,000
   • Remaining Useful Economic Life = 2 years (Years 20X4 and 20X5)

3. Calculate Revised Annual Depreciation Charge:

   • New Annual Charge = (£70,000 − £6,000) / 2 years = £64,000 / 2 = £32,000 per year

Adjusted Depreciation Schedule Over Total Life

Observation: No prior period adjustments were made to Years 20X1–20X3. The unamortized carrying amount of £70,000 was systematically allocated across the remaining 2 years to leave the revised scrap value of £6,000.

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Statement of Financial Position Presentation: 3-Column Disclosure Format

Under international and UK GAAP standards, non-current assets must be disclosed on the face of the Statement of Financial Position (or in the supporting notes) using the standard 3-column format:

1. Cost: Gross historical capital expenditure.
2. Accumulated Depreciation: Cumulative depreciation written off from acquisition to the balance sheet date.
3. Carrying Amount (Net Book Value): Cost minus Accumulated Depreciation.

Comprehensive Financial Statement Extracts

Statement of Profit or Loss (Extract) for Year Ended 31 December 20X5

Statement of Financial Position (Extract) as at 31 December 20X5

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Master Case Study: End-to-End Period-End Depreciation Workflow

Scenario Background

At 1 January 20X5, Highland Distribution Ltd had the following non-current asset balances:

• Motor Vehicles at Cost: £80,000; Accumulated Depreciation (1 Jan 20X5): £32,000 (Depreciated at 25% Straight-Line on Cost).
• Plant & Machinery at Cost: £120,000; Accumulated Depreciation (1 Jan 20X5): £45,000 (Depreciated at 20% Reducing Balance).

Transactions During the Year Ended 31 December 20X5:

1. On 1 April 20X5, Highland acquired a new forklift truck (Plant & Machinery) for £18,000 paid by bank transfer.
2. On 1 July 20X5, Highland purchased a new delivery van for £24,000 paid by bank transfer.
3. Accounting Policy on Timing: Highland Distribution Ltd enforces a proportionate (monthly pro-rata) depreciation policy for all non-current assets.

Calculation of Depreciation Charges for Year Ended 31 December 20X5:

1. Motor Vehicles (25% Straight-Line on Cost, Proportionate):

• Existing Fleet: Held for the full 12 months.
  • Depreciation = £80,000 × 25% = £20,000
• New Delivery Van: Acquired 1 July 20X5 (owned for 6 months: July to December).
  • Depreciation = £24,000 × 25% × (6 / 12) = £3,000
• Total Motor Vehicles Depreciation Expense (SPL): £20,000 + £3,000 = £23,000

2. Plant & Machinery (20% Reducing Balance, Proportionate):

• Existing Plant:
  • Opening Carrying Amount (1 Jan 20X5) = Cost (£120,000) − Accum Depn (£45,000) = £75,000
  • Full Year Depreciation = £75,000 × 20% = £15,000
• New Forklift Truck: Acquired 1 April 20X5 (owned for 9 months: April to December).
  • Opening Carrying Amount = £18,000 (Cost in year of purchase)
  • Proportionate Depreciation = £18,000 × 20% × (9 / 12) = £2,700
• Total Plant & Machinery Depreciation Expense (SPL): £15,000 + £2,700 = £17,700

General Journal Entries at 31 December 20X5:

Closing Ledger Balances as at 31 December 20X5:

• Motor Vehicles:

  • Total Cost = £80,000 + £24,000 = £104,000
  • Closing Accumulated Depreciation = £32,000 + £23,000 = £55,000
  • Closing Carrying Amount = £104,000 − £55,000 = £49,000

• Plant & Machinery:

  • Total Cost = £120,000 + £18,000 = £138,000
  • Closing Accumulated Depreciation = £45,000 + £17,700 = £62,700
  • Closing Carrying Amount = £138,000 − £62,700 = £75,300

Statement of Financial Position Presentation at 31 December 20X5:

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Critical Exam Checkpoints & Best Practice Checklist

1. Always Check the Timing Policy: Before starting calculations, verify whether the question specifies a full-year policy or a monthly proportionate (pro-rata) policy.
2. Asset Additions Date Counting: When proportionate policy applies, count the exact number of months from the acquisition date to the end of the financial year.
3. Never Touch Historical Cost for Depreciation: Post all depreciation adjustments to the Accumulated Depreciation account, leaving the asset cost account intact.
4. Changes in Estimates Are Prospective: When useful life or residual value changes, take the carrying amount at the date of change, subtract the revised residual value, and divide by the remaining useful life. Never adjust prior years' accounts.