3.2 Depreciation Methods, Accounting & Changes in Estimate

The Purpose of Depreciation

Non-current assets, such as machinery, vehicles, and buildings, gradually wear out or become obsolete over time. Depreciation is the systematic allocation of the depreciable amount of an asset over its expected useful life.

It is vital to understand that depreciation is not a process of valuing the asset at its current market price, nor is it a way of setting aside cash for replacement. Instead, depreciation applies the matching principle: it ensures that a portion of the asset's cost is recognized as an expense in the Statement of Profit or Loss in the same periods that the asset is used to generate revenue.

Key terms:

• Cost: The initial capitalized amount of the asset.
• Useful Life: The estimated period over which the business expects to use the asset.
• Residual Value: The estimated amount the business expects to receive from disposing of the asset at the end of its useful life.
• Depreciable Amount: Cost minus Residual Value.
• Carrying Amount (Net Book Value): Cost minus Accumulated Depreciation.

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Depreciation Methods

There are two primary methods of depreciation tested in the ACCA FA syllabus: the Straight-Line method and the Reducing Balance method.

1. Straight-Line Method

The straight-line method results in a constant depreciation charge over the useful life of the asset, assuming the asset's residual value does not change. It is appropriate when the asset's economic benefits are expected to be consumed evenly over time (e.g., a building).

Formula: Depreciation Expense = (Cost - Residual Value) / Estimated Useful Life Alternatively, it can be expressed as a percentage of cost: Cost x Straight-Line % (Note: sometimes the percentage is applied to cost ignoring residual value, depending on how the policy is stated in the exam question, but the standard formula uses the depreciable amount).

Worked Example: Delta Co buys a machine for $50,000. It has an estimated useful life of 5 years and an estimated residual value of $5,000.

• Depreciable Amount = $50,000 - $5,000 = $45,000.
• Annual Depreciation = $45,000 / 5 years = $9,000 per year.

2. Reducing Balance Method

The reducing balance (or diminishing balance) method results in a decreasing depreciation charge over the asset's useful life. A fixed percentage is applied to the asset's Carrying Amount at the start of the year. This method is appropriate for assets that rapidly lose value or require more maintenance in later years, such as motor vehicles or IT equipment.

Formula: Depreciation Expense = Carrying Amount x Reducing Balance % (Remember: Carrying Amount = Cost - Accumulated Depreciation. Residual value is generally ignored in the calculation until the final year, ensuring the asset is not depreciated below its residual value).

Worked Example: Echo Co buys a delivery van for $20,000. The depreciation policy is 20% reducing balance.

• Year 1: $20,000 x 20% = $4,000 depreciation. Carrying amount at end of Year 1 = $20,000 - $4,000 = $16,000.
• Year 2: $16,000 x 20% = $3,200 depreciation. Carrying amount at end of Year 2 = $16,000 - $3,200 = $12,800.
• Year 3: $12,800 x 20% = $2,560 depreciation.

Pro-Rata Depreciation vs. Full Year Depreciation

Exam questions will specify the company's accounting policy for the year of acquisition and disposal:

• Pro-rata (time apportioned): Depreciation is calculated based on the exact number of months the asset was owned in the year. For example, if bought on 1 October and the year-end is 31 December, only 3/12 of the annual depreciation is charged.
• Full year in year of acquisition, none in year of disposal: A full year's depreciation is charged regardless of the purchase month, and absolutely no depreciation is charged in the year the asset is sold.

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Accounting Entries for Depreciation

Depreciation is recorded periodically (usually at year-end) using a standard double-entry journal:

Debit: Depreciation Expense (Statement of Profit or Loss) Credit: Accumulated Depreciation (Statement of Financial Position)

The Accumulated Depreciation account is a negative asset (contra-asset) account. It accumulates all the depreciation charged against the asset over its life, reducing the gross cost down to the carrying amount on the Statement of Financial Position.

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Changes in Accounting Estimates (IAS 8)

Estimates regarding an asset's useful life, residual value, or the expected pattern of consumption (depreciation method) must be reviewed at least annually. If expectations differ from previous estimates, the change must be accounted for as a change in accounting estimate in accordance with IAS 8.

Crucially, a change in accounting estimate is applied prospectively. This means you do not go back and correct past years' financial statements. Instead, you calculate the new carrying amount at the date of the change and depreciate that carrying amount over the remaining revised useful life.

Worked Example: Change in Useful Life Gamma Co bought a machine for $100,000 with a 10-year useful life and zero residual value (Straight-line depreciation = $10,000/year). After 4 years, Accumulated Depreciation is $40,000. The Carrying Amount is $60,000. At the start of Year 5, management reviews the machine and decides it will only last for a total of 7 years instead of 10.

• Original useful life = 10 years.
• Years elapsed = 4 years.
• Revised total life = 7 years. Therefore, remaining revised life = 7 - 4 = 3 years.

The new annual depreciation from Year 5 onwards will be: Carrying Amount / Remaining Life = $60,000 / 3 years = $20,000 per year. Past years' depreciation of $10,000 remains unchanged.