Accounting 2.3

Depreciation

Useful Life (Life)

The number of years a non-current asset will be used to earn revenue.

Depreciation

The allocation of the cost of a non-current asset over its useful life.

Straight-line Depreciation

Assumes that a non-current asset will be consumed evenly over its useful life.

Depreciation expense (per year) = (HC - RV) / Life

Historical Cost (HC)

The original purchase price of the non-current asset.

Reported in the Balance Sheet

Residual Value (RV)

The estimated value of the asset at the end of its useful life.

Depreciation Expense

The part of a non-current asset that has been consumed/used up in each reporting period.

Expense per year stays the same (using straight-line method)

Accumulated Depreciation

The total value of the non-current asset consumed so far.

Negative asset, reported in the Balance Sheet, increases every period

Balance Day Adjustment Double-entry

Dr	Depreciation
Cr	Accumulated Depreciation

Effect on Accounting Equation - Depreciation

Assets	Decrease
Liabilities	No Effect
Owner’s Equity	Decrease

Carrying Value

The value of the non-current asset that is yet to be consumed plus any residual value.

HC - Accumulated Depreciation

Depreciation Expense (less than one year)

yearly depreciation / 12 x # months depreciated

The Going Concern Assumption

The business will continue to operate in the future, and its records are kept on that basis.

• Reporting the carrying amount of the non-current asset in the Balance Sheet at the end of the period reflects future benefits expected from the non-current asset.

The Period Assumption

Reports are prepared for a specified period of time (reporting period), such as a month or a year, in order to obtain comparability of results.

• Depreciation of non-current assets recognizes that part of the cost of an asset has been incurred/consumed in each period the asset assists the business to earn revenue.

• By reporting the Depreciation Expense for the period (e.g. month or year), all expenses incurred within the period will be used in the calculation of profit, and can then be compared to revenues earned in the same period.

The Accrual Basis Assumption

Revenue is recognized in the period in which it is earned and expenses are recognized in the period in which they are incurred.

• Depreciation of non-current assets recognizes that part of the cost of the asset has been incurred/consumed in each period the asset earns revenue.

• Even though no cash has been paid, the depreciation expense has been incurred and should be recognized to enable an accurate calculation of profit by comparing all expenses incurred with all revenues earned for the period.

Relevance

Financial information must be capable of influencing decisions made by users to help them make predictions and/or confirm or change their previous evaluations.

• Information that is capable of making a difference to decision-making about profit should be included.

• Depreciation Expense represents that part of the cost of the asset has been incurred in the current period, so it must be included to compare all revenues with all expenses incurred.

• The Carrying Value must be shown as it reflects the unallocated cost of the asset (plus residual value) at a point in time and will influence decision making about replacement of the asset.

Comparability

Financial information should be able to be compared over time and compared with similar information about other businesses.

• Using a consistent method of depreciation (Straight-line Method) helps to ensure the comparability of financial information from one period to the next; changes in performance can be easily identified.

Faithful Representation

Financial information must be a truthful representation of the real-world economic event and must be complete, free from material errors, and without bias.

• Depreciation is NOT entirely free from bias as it is based on estimates such as Useful Life and Residual value.

• Financial reports will be more complete if depreciation is reported, as the non-current asset has been consumed to earn revenue.

Verifiability

Financial information should allow different knowledgeable and independent observers to agree that the event is faithfully represented.

• Verifiability is maintained by retaining source documents and checking through auditing.

• The Historical Cost (original purchase price) reported in the Balance Sheet can be verified by referring to the source document.