1. Principle of Accounting
Chapter 12 &14
Depreciation of non-current assets
BA. in International Business
Foreign Trade University

2. Outline
 The meaning of depreciation
 The meaning of cost
 Methods of calculating depreciation
 Straight-line method
 Reducing balance method
 A comparison of the two methods
 Depreciation methods: Which one to use?
 The adjusting entry for depreciation

3. Outline (cont’d)
 Depreciation and the statement of financial
position and the statement of financial
performance
 Historical cost versus fair value
 Revenue recognition

4. The meaning of depreciation
 Depreciation is the allocation of the cost of a
non-current asset over its effective working life.
 An asset’s effectiveness gradually diminishes
because of physical deterioration such as wear
and tear and becomes obsolete. At the end of its
useful working life, it may be scrapped or sold.
 Depreciation complies with the matching
principle as non-current assets are used to
generate revenue, some amount of cost
(depreciation) should be matched with this
revenue.

5. The meaning of cost
 Two elements to be identified in measuring the
cost of a non-current asset:
1. The historical (original) cost of the asset
2. All other costs incurred to get the asset into a
revenue-earning capacity.
 Other costs relating to the purchase of an asset
are necessary to make the asset ready to earn
revenue. Those costs may include delivery,
installation, stamp duty, dealer charges, etc.
Consider the examples in the text book, pg. 215

6. Depreciation – Straight line method
 The straight line method of depreciation (fixed
instalment method) allocates the same amount of
cost each reporting period.
 The formula to calculate depreciation under the
straight line method:
Cost - Scrap
Depreciation expense = -------------------------
Useful life
 Depreciation can also be expressed as a
percentage rate per annum

7. Depreciation – Straight line method
 The following details relate to a vehicle bought on
1 Jan 05:
 Purchase price of van: $16,000
 Estimated useful life: 4 years
 Estimated residual (scrap) value $6,400
Depreciation expense = (16,000 – 6,400) / 4 = $2,400
per year
Depreciation rate per annum = $2,400 / $16,000 =
15%

8. Depreciation – Straight line method
Depreciation Accumulated Carrying
Year expense depreciation value
2005 2,400 2,400 13,600
2006 2,400 4,800 11,200
2007 2,400 7,200 8,800
2008 2,400 9,600 6,400

9. Depreciation – Reducing balance method
 Some assets tend to be much more efficient in their early
years. Therefore, they are likely to generate more revenue
in early years of their life and less in later years.
 The matching principle requires revenue earned to match
with expense incurred. The reducing balance method
follows the principle that If an asset earns more revenue in
a particular year, greater amount of depreciation is
allocated in that year.

10. Depreciation – Reducing balance method
 The following details relate to a vehicle bought on 1
Jan 05:
 Purchase price of van: $16,000
 Estimated useful life: 4 years
 Estimated residual (scrap) value $6,400
Assume the depreciation rate under reducing
balance method is 1.5 times the straight line
method.
Depreciation rate = 1.5 * 15% = 22.5%

11. Depreciation – Reducing balance
method
Depreciation Accumulated
Year expense depreciation Carrying value
(1)=(3)*22.5 (2) (3)=16,000-(2)
2005 3,600 3,600 12,400
2006 2,790 6,390 9,610
2007 2,162 8,552 7,448
2008 1,048 9,600 6,400

12. Depreciation methods:
a comparison
 As the years pass, the amount of depreciation
allocated under the reducing balance method
decreases.
 Depreciation under straight line method will be
constant throughout the asset’s life.
 The difference between depreciation methods is
the amount of cost to be allocated in a particular
reporting period.
 Over the life of the asset, both methods allocate
the same amount of cost and end up with the
estimated scrap value.

13. Depreciation methods:
which one to use?
 The method to be selected should be chosen on
the basis of best satisfying the matching principle.
 The choice of depreciation method should be
linked to the nature of asset being considered.
 A business may use both methods for different
assets that have different revenue-earning
patterns.
Shop fittings Straight line
Office furniture Straight line
Machinery Reducing balance
Vehicles Reducing balance

14. The adjusting entry for depreciation
 Depreciation is usually allocated on the last day of
each reporting period and is therefore known as a
balance-day adjustment.
 The debit entry to “depreciation expense” is an
increase in expense to match with the revenue for
the period.
 The credit entry to “Accumulated depreciation” is
an increase in a negative asset account.
 The accumulated depreciation account is used to
add up the total depreciation. The account is a
negative asset account because it is shown as a
deduction to the asset account on the statement of
financial position.

15. Journal entries for depreciation
Date Accounts Debit Credit
Dec 31 Depreciation of vehicle 2,400
Accumulated depreciation of 2,400
vehicle
Adjusting entry for depreciation:
Straight line method at 15% pa
Dec 31 Profit and loss summary 2,400
Depreciation of vehicle 2,400
Closing entry for depreciation
expense

16. Depreciation and the statement of
financial position
 Statement of financial position (extract) as at 31.12.05
Non-current assets
Vehicle 16,000
less Accumulated depreciation 2,400 $13,600
$16,000: historical cost of the asset and other
incidental cost incurred in getting the asset in a
revenue-earning capacity.
$2,400: accumulated depreciation (expired cost)
$13,600: book value (carrying value) includes the value
of the asset yet to be depreciated and the estimated
scrap value.

17. Depreciation and the statement of financial
performance
 Depreciation is an expense item, it is reported in
the statement of financial performance.
 Depreciation is based on two estimates (residual
value and useful life), the amount depreciated can
not be reliably measured.
 However, depreciation is a relevant expense,
therefore it should be included in the statement of
financial performance.
 Therefore, the relevance outweighs the concern of
not being able to verify depreciation.

18. Historical cost versus fair value
 Traditionally, non-current assets have been
reported at historical cost.
 Historical cost may become irrelevant in the time of
inflation.
 In recent times, the accounting standards allow
business to value non-current assets at fair value.
 The adjustment made to reflect non-current assets
at fair value is known as revaluation.
 If an asset increases in value, an upward adjustment
may be made to the asset account. It is a revaluation
increment.
 If an asset decreases in value, a downward
adjustment may be recorded (a revaluation
decrement).

19. Historical cost versus fair value
 General journal entry for revaluation increment:
Dr Non-current Asset
Cr Asset revaluation reserve
 General journal entry for revaluation decrement:
Dr Asset revaluation reserve
Cr Non-current asset
 The “Asset revaluation reserve” account is a part of
owner’s equity and should be reported as a separate
item under owner’s equity section in the statement
of financial position.
 If an asset revaluation reserve is not yet created,
downward adjustment is written off as a reduction
in equity at that time.

20. Depreciation and fair value
 If an asset is shown at fair value, depreciation must
also be based on its fair value.
 Depreciation will change if there is any change in
the asset value or estimated residual value or
estimated useful life of the asset.
 Adjustments may be made to the fair value of the
asset to satisfy the relevance. However, it is
difficult to ensure the reliability of the fair value of
the asset.
 The value of relevant information can outweigh
the doubt about its reliability. Businesses can seek
for professional valuers to determine the fair value
of the asset.

21. Revenue recognition
 At what point should a business recognise
revenue?
 Point of sale: this method recognises revenue as
being earned as soon as it is possible to
determine that a sale has occurred.
 Two requirements that need to be satisfied for
revenue to be recognised at point of sale
1. The business must have fulfilled its obligations to the
customer. In most cases this means that the goods
required have been supplied.
2. Objective, verifiable evidence must be available to
confirm the amount of revenue earned (invoice, receipt
or contract).

22. Revenue recognition (cont’d)
 Point of cash transfer: this method recognises
revenue only when cash is received from
customers.
 It relies on verifiable evidence as receipts can be
issued to customers by the business when cash is
received.
 The inherent weakness is that it ignores revenue
unless cash changes hands.
 It includes cash receipts that belong to
transactions in a next period or cash receipts that
relate to sales from previous periods as revenue.
 Once a method of revenue recognition is chosen,
it should be applied consistently to each reporting
period.

23. Practice questions
Exercise 12.1
Exercise 12.2
Exercise 14.1
Exercise 14.2

24. Homework
Exercise 12.3
Exercise 12.4