Overview of Depreciation

What is Depreciation?

• Depreciation is the loss of value of a non-current asset over time due to wear and tear or
obsolescence.

• It is an expense recorded in the Income Statement.

• It reduces the value of non-current assets in the Balance Sheet.

Exam Tips for Depreciation

1. Methods of Depreciation (O-Level Exam Focus)

1. Straight-Line Method (Equal Depreciation Each Year)

• Formula: (Cost - Residual Value) ÷ Useful Life

• Key Features:

o Same amount charged every year.

o Best for assets like buildings and furniture.

• Double Entry:

Depreciation Expense Dr xxxx

Provision for depreciation Cr xxxx

2. Reducing Balance Method (Declining Amount Each Year)

• Formula: Net Book Value × Depreciation Rate

• Key Features:

o Higher depreciation in the early years, lower in later years.

o Best for assets like machinery and vehicles (higher initial wear and tear).

• Double Entry:

Depreciation Expense Dr xxxx (Income Statement)

Provision for depreciation Cr xxxx (Balance Sheet)

3. Revaluation Method (For Small, Indistinct Items)

• Used for loose tools or livestock.

• Formula: Opening Value + Purchases−Closing Value=Depreciation Expense

Exam Tip: If no method is mentioned in the question, assume Straight-Line Method.

 2. Key Adjustments in Depreciation Questions

Full-Year vs. Month-to-Month Depreciation

• If nothing is mentioned, assume full-year depreciation for the year of purchase.

• If month-to-month depreciation is required, calculate based on months used.

Treatment of Accumulated Depreciation

• Total depreciation over the years accumulates under Non-Current Assets in the Balance Sheet.

• To find Net Book Value:

Cost−Accumulated Depreciation=Net Book Value

3. Recording Depreciation in Financial Statements

Income Statement (Expense Section)

• Current year depreciation is recorded as an expense under operating expenses.

Balance Sheet (Statement of Financial Position)

• Non-current assets are shown after deducting accumulated depreciation ( Current year
depreciation + provision for depreciation mentioned in trial balance)

Exam Question Types & How to Answer

Basic Depreciation Calculation Questions

• Expect a question asking for depreciation for a specific year using either:

o Straight-line method

o Reducing balance method

• Key Exam Tip: Always check if there’s a residual value and deduct it from cost.

Ledger Accounts (Depreciation & Provision for Depreciation)

• You may be asked to prepare ledger accounts for:

o Depreciation Expense Account (shows yearly expense).

o Provision for Depreciation Account (accumulates total depreciation).

Disposal of Non-Current Assets

• If an asset is sold, you must:

1. Remove the asset’s cost and accumulated depreciation.

2. Calculate profit or loss on disposal.

3. Record in the Income Statement as either other income (profit) or expense (loss).
 Formula for Profit/Loss on Disposal

Selling Price−Net Book Value

• If selling price is greater than NBV → Profit on Disposal

• If selling price is less than NBV → Loss on Disposal

Double Entry for Asset Disposal

• Debit: Bank (If sold for cash)

• Debit: Accumulated Depreciation (Remove all past depreciation)

• Credit: Non-Current Asset (Remove cost from records)

• Debit/Credit: Disposal Account (To record profit/loss)

“Open disposal account for the removal of an asset”

1. Cost Removal Entry

Disposal Account Dr xxxx
Asset Cr xxxx
2. PFD Removal Entry
Provision for depreciation Dr xxxx
Disposal Account Cr xxxx
3. Sale Proceeds
Bank Dr xxxx
Disposal Account Cr xxxx
4. Recoding Entry for loss on disposal
Income Statement Dr xxxx
Disposal Account Cr xxxx
Recording Entry for profit on disposal
Disposal Account Dr xxxx
Income Statement Cr xxxx
 Key Exam Mistakes & How to Avoid Them

Forgetting to Deduct Residual Value in Straight-Line Method

Always subtract the residual/scrap value before dividing by useful life.

Not Calculating Depreciation for Partial Years

If an asset is bought/sold mid-year, calculate only for months owned.

Confusing Accumulated Depreciation with Depreciation Expense

Remember:

• Depreciation Expense = Charged yearly in Income Statement.

• Accumulated Depreciation = Total depreciation collected over years in Balance Sheet. (Total
Depreciation from start till date)

Misplacing Depreciation in Financial Statements

Correct placement:

• Income Statement: Depreciation as an expense.

• Balance Sheet: Deduct accumulated depreciation from asset cost.

Final Exam Tips for Full Marks

✔ Show clear workings for depreciation calculations.

✔ Use proper headings in ledger accounts (e.g., "Provision for Depreciation").
✔ Balance your accounts correctly, especially when dealing with disposal.
✔ Cross-check formulas and calculations to avoid simple math mistakes.
✔ Understand why depreciation is important (Prudence Concept – prevents overstating profits).
 Importance Of Depreciation
Businesses charge depreciation because:

1. Expense Matching (Matching Concept)

o Depreciation spreads the cost of a non-current asset over its useful life.

o This ensures that each year’s income statement includes only the expense related to
that year.

2. Prudence Concept (Avoid Overstating Profits)

o If depreciation is not recorded, profits will be overstated because no cost is deducted

for the asset’s use.

o This could mislead business owners and investors about real financial performance.

3. Accurate Asset Valuation

o Over time, assets lose value due to wear and tear.

o Without depreciation, the balance sheet would show non-current assets at an

unrealistic value.

4. Tax Benefits

o Businesses can deduct depreciation as an expense, reducing taxable income.

5. Prepares for Asset Replacement

o Depreciation helps businesses save money for future replacements of non-current

assets.

Comparing Methods

Straight-Line vs. Reducing Balance Method

Method Advantage Disadvantage

Straight- Does not consider higher wear
Easy to calculate and apply.
Line and tear in early years.
Reducing Charges higher depreciation in early years, Harder to calculate, and
Balance which matches higher maintenance costs. depreciation never reaches zero.
Best Method for a Motor Vehicle

• Reducing Balance Method is better because:

A van loses value faster in the early years due to heavy usage.
Maintenance costs increase as the motor vehicle ages, so higher depreciation earlier
balances total expenses.
The method matches real-life usage of the asset.

• Straight-Line would not be suitable because it charges the same amount every year, which
does not reflect the actual wear and tear of a motor vehicle.
 Theoretical depreciation questions
1. What is depreciation, and why is it necessary in accounting?

Depreciation is the process of allocating the cost of a non-current asset over its useful life. It is
necessary because:

• It matches the expense to the period in which the asset is used (Matching Concept).

• It reflects the asset's loss of value over time due to wear and tear, obsolescence, or usage.

• It helps businesses prepare accurate financial statements by not overstating the value of assets
and profits.

2. How does depreciation affect the Income Statement and Balance Sheet?

• In the Income Statement, depreciation is recorded as an expense, reducing the business's net
profit.

• In the Balance Sheet, the accumulated depreciation is deducted from the asset's cost, giving
the net book value of the asset.

3. Why is depreciation considered a non-cash expense?

Depreciation is a non-cash expense because it represents the allocation of an asset's cost over time, not
a cash outflow. The actual cash outflow happens when the asset is purchased, not when depreciation is
charged.

4. What are the causes of depreciation?

• Wear and tear due to regular usage.

• Obsolescence due to technological advancements or changes in market demand.

• Physical damage (e.g., machinery breakdown).

• Passage of time, especially for assets like buildings and vehicles.

5. Describe the straight-line method of depreciation.

• In the straight-line method, depreciation is calculated by subtracting the residual value from the
cost and dividing it by the useful life of the asset.

• Depreciation is constant each year.

Formula:

Depreciation= (Cost−Residual Value)/Useful Life

6. Describe the reducing balance method of depreciation.

• In the reducing balance method, a fixed percentage of depreciation is applied to the remaining
book value of the asset each year.

• Depreciation decreases over time, as the value of the asset reduces each year.

• It is useful for assets that lose value more quickly in their early years, such as vehicles and
machinery.

Formula:

Depreciation=Net Book Value × Depreciation Rate

7. Compare the advantages and disadvantages of the straight-line and reducing balance methods.

Method Advantage Disadvantage

Does not reflect actual wear and tear

Straight-Line Simple to calculate and apply.
over time.

Reducing Reflects higher depreciation in early years, More complex to calculate; depreciation
Balance matching actual asset use. decreases over time.

8. In what situations would a business use the reducing balance method instead of the straight-line
method?

A business would use the reducing balance method for assets that experience higher wear and tear in
the early years (e.g., vehicles, machinery). This method allows for higher depreciation in the early years
when maintenance costs are higher.

9. What is the revaluation method of depreciation, and when is it used?

The revaluation method is used when an asset’s value changes significantly due to market conditions or
improvements. Instead of applying a fixed rate, the asset is revalued periodically, and depreciation is
calculated based on the revalued amount. This method is commonly used for property or assets that
appreciate in value.

10. What is accumulated depreciation, and where is it recorded?

Accumulated depreciation is the total depreciation charged against an asset over its life. It is recorded in
the Balance Sheet under the Non-Current Assets section, deducted from the asset’s cost to show its net
book value.
11. Explain the purpose of a provision for depreciation account.

The Provision for Depreciation Account is a contra-asset account used to accumulate depreciation over
time. This account does not affect the actual cost of the asset but reduces the carrying amount of assets
in the Balance Sheet.

12. What is the double-entry for recording depreciation?

Depreciation expense Dr xxxx

Accumulated Depreciation/ Provision for Depreciation Cr xxxx

13. How is disposal of a non-current asset recorded in ledger accounts?

When an asset is disposed of:

1. Debit the bank account if cash is received.

2. Debit the accumulated depreciation account to remove accumulated depreciation.

3. Credit the non-current asset account to remove the asset’s cost.

4. Any difference between the selling price and the net book value is recorded as profit or loss on
disposal.

14. What is the difference between Depreciation Expense Account and Provision for Depreciation
Account?

• The Depreciation Expense Account records the annual charge for depreciation. It is an expense
account in the Income Statement.

• The Provision for Depreciation Account accumulates the total depreciation charged over the
life of an asset. It is a contra-asset account in the Balance Sheet.

15. How does depreciation follow the Prudence Concept?

The Prudence Concept requires that losses are recognized as soon as they are probable. Depreciation
ensures that the value of assets is not overstated, preventing the overstatement of profits and providing
a more realistic view of the financial position.

16. How does depreciation follow the Matching Concept?

The Matching Concept requires that expenses are recorded in the period in which they relate to the
revenues they help generate. Depreciation matches the cost of the asset to the periods during which the
asset contributes to revenue generation.

17. Why is the historical cost principle important in depreciation?

The Historical Cost Principle ensures that assets are recorded at their original cost and depreciation is
charged based on this amount, regardless of changes in market value. This provides consistency and
reliability in financial reporting.

18. How does depreciation help in the preparation of accurate financial statements?

Depreciation ensures that the value of assets is not overstated and that the correct expense is matched
to the correct period, thus providing a true and fair view of the business's financial performance and
position.

19. What happens if a business does not charge depreciation on its non-current assets?

If depreciation is not charged:

• Profit will be overstated, as the expense related to the asset’s use is not recorded.

• Non-current assets will be overstated, giving a false representation of the company’s financial
position.

20. Explain how depreciation is calculated when an asset is sold during the year.

If an asset is sold during the year, depreciation is calculated based on the number of months the asset
was owned. For example, if an asset was bought in March and sold in October, depreciation will be
calculated for 8 months instead of a full year.

21. How is profit or loss on disposal of an asset calculated?

Profit/Loss on Disposal is calculated as:

Selling Price−Net Book Value

Where Net Book Value = Cost - Accumulated Depreciation.

22. What happens to accumulated depreciation when an asset is sold?

When an asset is sold, its accumulated depreciation is removed from the books (debited from the
Provision for Depreciation account).

23. If an asset is sold for more than its Net Book Value, how is the profit recorded in the accounts?

The profit on disposal is recorded as Other Income in the Income Statement and is also shown in the
Disposal Account.

24. If an asset is sold for less than its Net Book Value, how is the loss recorded in the accounts?

The loss on disposal is recorded as an expense in the Income Statement and is also shown in the
Disposal Account.

25. What should be done if no depreciation policy (full-year/month-to-month) is mentioned in an

exam question?
 • If no specific depreciation policy is mentioned in the exam, you should assume the full-year
depreciation policy unless instructed otherwise.

• This means full-year depreciation is charged in the year of purchase, and no depreciation is
charged in the year of disposal.

• If the question doesn't specify, it's important to clearly state your assumption (i.e., "I am
assuming that full-year depreciation applies").

26. Why do some businesses charge full-year depreciation in the year of purchase but none in the year
of disposal?

• Full-year depreciation in the year of purchase is charged because the business expects to use
the asset for the entire year or the major part of the year, even if it is purchased mid-year.

• No depreciation in the year of disposal occurs because the asset is no longer in use after the
disposal date. Charging depreciation for a partial year would inaccurately represent the asset's
use in that year.

27. Why might a business use different depreciation rates for different assets?

A business may use different depreciation rates for different assets based on:

• Asset's useful life: Different assets have varying useful lives (e.g., machinery vs. vehicles).

• Usage and wear and tear: Some assets like machinery may wear out faster than others,
requiring higher depreciation rates.

• Market or technological obsolescence: Assets like computers or phones become outdated

faster, so they may be depreciated at a higher rate.

• Depreciation method: Some assets might use reducing balance (faster depreciation in early
years), while others use straight-line (equal depreciation each year).

28. How does inflation affect depreciation calculations?

• Inflation increases the replacement cost of assets over time. While depreciation is based on the
historical cost of an asset, inflation means that the real value of the asset might decrease faster
than anticipated.

• Some businesses may choose to adjust the depreciation rate or revalue their assets periodically
to account for inflation, but generally, depreciation is calculated using the original cost (under
historical cost principle).

• Note: Depreciation does not directly account for inflation unless assets are revalued.

29. Should land be depreciated? Why or why not?

• No, land should not be depreciated because it does not wear out or become obsolete over
time.
• Land is considered to have an indefinite useful life, and its value typically appreciates or remains
stable rather than decreasing.

• Depreciation is meant to allocate the cost of assets that lose value over time, and land does not
meet this criterion.