What Is Depreciation? Methods, Examples and Why It Matters
Depreciation spreads the cost of a fixed asset over its useful life. This guide explains what depreciation is, the main calculation methods, and how it affects financial statements.
What Is Depreciation?
Depreciation is the systematic allocation of the cost of a tangible fixed asset over its useful economic life. When a business buys a piece of machinery for 50,000 that it expects to use for five years, it does not expense the full 50,000 in year one. Instead, it depreciates the asset — spreading the cost across the five years to match the expense to the periods in which the asset generates economic benefit.
Why Depreciation Exists
Depreciation reflects the matching principle: costs should be recognised in the same period as the revenues they help generate. It also reflects economic reality — most assets wear out, become obsolete, or lose value over time. Without depreciation, financial statements would overstate profits in years when assets are purchased and understate them in subsequent years.
The Straight-Line Method
The most commonly used method. Annual depreciation = (Cost - Residual Value) / Useful Life. A vehicle costing 30,000 with a 5,000 residual value and a five-year useful life depreciates at (30,000 - 5,000) / 5 = 5,000 per year. The net book value reduces by the same amount each year.
The Reducing Balance Method
Depreciation is charged as a fixed percentage of the net book value each year, so the charge reduces over time. A 20% reducing balance on an asset with a 10,000 cost gives: Year 1 depreciation 2,000 (10,000 x 20%), Year 2 depreciation 1,600 (8,000 x 20%), Year 3 depreciation 1,280, and so on. This method better reflects assets that lose more value early in their life, such as vehicles.
How Depreciation Appears in Financial Statements
Depreciation appears as an expense in the income statement, reducing profit. It also reduces the net book value of fixed assets on the balance sheet. In the cash flow statement, depreciation is added back to operating profit because it is a non-cash charge — it reduces profit but does not involve a cash outflow.
Depreciation in ACCA and CIMA
Depreciation and the treatment of tangible fixed assets under IAS 16 is examinable in ACCA FA and FR papers. IAS 16 requires the chosen depreciation method to reflect the pattern of consumption of the asset's economic benefits, and requires residual values and useful lives to be reviewed annually.
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