Revise Depreciation for Cambridge 9609 (10.1.4)

Depreciation is an accounting concept that systematically allocates the cost of a tangible non-current asset over its useful economic life. It is not a measure of an asset's falling market value but rather an application of the matching (or accruals) principle. This principle dictates that the cost of an asset should be matched against the revenue it helps to generate over several accounting periods. Depreciation represents the consumption of an asset's economic benefits due to factors like wear and tear or technological obsolescence. Crucially, it is a non-cash expense; no money physically leaves the business when depreciation is recorded. It is an accounting entry designed to give a true and fair view of a business's profitability and asset values.

The straight-line method is the most common and straightforward approach to calculating depreciation. It allocates an equal amount of depreciation expense to each year of the asset's useful life. The formula is: (Historic Cost – Residual Value) / Useful Economic Life. 'Historic Cost' is the original purchase price of the asset, including any delivery and installation charges. 'Residual Value' (or scrap value) is the estimated amount the asset will be worth at the end of its use. 'Useful Economic Life' is the estimated time period the business expects to use the asset. For example, a machine costing £55,000 with a 5-year life and a £5,000 residual value would have an annual depreciation charge of £10,000.

The Net Book Value (NBV) represents the value of a non-current asset as recorded in the business's accounts at a specific point in time. It is calculated using the formula: NBV = Historic Cost – Accumulated Depreciation. 'Accumulated Depreciation' is the sum of all depreciation charged against that specific asset since it was acquired. For instance, using the previous example, after Year 1 the NBV is £55,000 - £10,000 = £45,000. After Year 2, the accumulated depreciation is £20,000, so the NBV becomes £55,000 - £20,000 = £35,000. The NBV decreases annually by the depreciation amount until it equals the asset's residual value at the end of its useful life.

Depreciation has a dual impact on a firm's financial statements. Firstly, on the Income Statement (Profit and Loss Account), the annual depreciation charge is recorded as an expense, usually classified under overheads. This reduces the gross profit to arrive at a lower net profit before tax. Secondly, on the Statement of Financial Position (Balance Sheet), it affects the non-current assets section. The asset is initially recorded at its historic cost, but each year the accumulated depreciation increases, which in turn reduces the asset's Net Book Value. This ensures the Statement of Financial Position presents a more accurate picture of the company's asset values by accounting for their usage over time.

Annual depreciation = $\frac{\text{Cost} - \text{Residual value}}{\text{Useful life (years)}}$

Net book value = Cost − Accumulated depreciation