Lesson 8 — Depreciation of Non-Current Assets | O Level Accounting

📘 Lesson 8 of 16

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1. What is Depreciation? 7707 / 3.5

Most non-current assets (machinery, vehicles, equipment) do not last forever. Over time they lose value. Depreciation is the process of spreading the cost of a non-current asset over its useful economic life.

Key Definition: Depreciation is the systematic allocation of the depreciable amount of a non-current asset over its estimated useful life. It is a non-cash expense that reduces the carrying value of the asset and is charged to the Income Statement each year.

Why is Depreciation Charged?

Matching principle — the cost of the asset is matched against the revenue it helps to earn over its life.
True and fair view — the asset is shown at a realistic value in the Statement of Financial Position.
Wear and tear — physical deterioration through use.
Obsolescence — the asset becomes out of date due to technology advances.
Passage of time — some assets (e.g. leases) lose value simply with time.
Depletion — natural resources diminish as they are used up.

Key Terms

Cost of Asset

The original purchase price plus any costs to bring the asset into use (delivery, installation, legal fees).

Residual Value (Scrap Value)

The estimated value of the asset at the end of its useful life — what it can be sold for when it is no longer needed.

Depreciable Amount

Cost minus residual value. This is the total amount to be depreciated over the asset's useful life.

Net Book Value (NBV) / Carrying Amount

Cost minus total accumulated depreciation to date. This is the value shown in the Statement of Financial Position.

Net Book Value = Cost − Accumulated Depreciation

2. Method 1 — Straight Line Method (SLM)

Under the Straight Line Method, the same fixed amount of depreciation is charged every year. The depreciation charge is equal in each period of the asset's life.

Straight Line Method — Formula

Annual Depreciation = (Cost − Residual Value) ÷ Useful Life (years) OR: Annual Depreciation = (Cost − Residual Value) × Rate %

Worked Example — Straight Line

📋 Example 1: SLM Depreciation Schedule

A machine is purchased on 1 January 2023 for $20,000. Estimated useful life: 4 years. Estimated residual value: $2,000.

Annual depreciation = (20,000 − 2,000) ÷ 4 = $4,500 per year

Year	Cost ($)	Depreciation ($)	Accumulated Dep. ($)	Net Book Value ($)
Start (Jan 2023)	20,000	—	—	20,000
Year 1 (2023)	20,000	4,500	4,500	15,500
Year 2 (2024)	20,000	4,500	9,000	11,000
Year 3 (2025)	20,000	4,500	13,500	6,500
Year 4 (2026)	20,000	4,500	18,000	2,000 ✓

At the end of Year 4, the NBV equals the residual value of $2,000 — exactly as planned. The depreciation charge is equal every year — a straight line on a graph.

Advantages and Disadvantages of SLM

Advantages	Disadvantages
Simple to calculate and understand	Does not reflect that assets often lose more value in early years
Equal charge each year — predictable impact on profit	Repair costs rise in later years, so total charge (depreciation + repairs) is uneven
Suitable for assets that are used evenly (e.g. buildings, furniture)	Less suitable for assets that lose value rapidly (e.g. vehicles, technology)

3. Method 2 — Reducing Balance Method (RBM)

Under the Reducing Balance Method, depreciation is calculated as a fixed percentage of the Net Book Value (the remaining book value) at the start of each year. Because the NBV falls each year, the depreciation charge also falls — larger in early years, smaller in later years.

Reducing Balance Method — Formula

Annual Depreciation = Net Book Value at start of year × Rate % NBV at end of year = NBV at start of year − Depreciation charge for year

Worked Example — Reducing Balance

📋 Example 2: RBM Depreciation Schedule

A vehicle is purchased on 1 January 2023 for $20,000. Depreciation rate: 25% per annum on reducing balance.

Year	NBV at Start ($)	Depreciation 25% ($)	NBV at End ($)
Year 1 (2023)	20,000	5,000	15,000
Year 2 (2024)	15,000	3,750	11,250
Year 3 (2025)	11,250	2,813	8,437
Year 4 (2026)	8,437	2,109	6,328

Notice: the depreciation charge decreases each year. The NBV never actually reaches zero under this method — it simply gets smaller and smaller. This more closely reflects how many assets (especially vehicles) lose value in the real world.

Advantages and Disadvantages of RBM

Advantages	Disadvantages
Reflects reality — assets lose more value in early years	More complex to calculate
Rising repair costs in later years offset falling depreciation — total charge more even	NBV never reaches zero — asset can appear on books indefinitely
Suitable for assets that depreciate quickly (vehicles, computers)	Harder to plan budgets as charge changes each year

4. SLM vs RBM — Direct Comparison

Feature	Straight Line Method	Reducing Balance Method
Basis of calculation	Fixed amount each year (based on cost)	Fixed % of NBV each year (based on remaining value)
Annual charge	Equal every year	Higher in early years, lower later
NBV at end of life	Equals residual value exactly	Never reaches zero
Suitable for	Buildings, furniture, fixtures (even use)	Vehicles, technology (rapid early loss)
Formula involves	Cost, residual value, useful life	NBV at start of year, rate %
Complexity	Simple	More complex

5. Ledger Entries for Depreciation

Two ledger accounts are used to record depreciation: the Asset Account (kept at cost) and the Provision for Depreciation Account (accumulates total depreciation). The asset is never reduced directly — instead, accumulated depreciation is recorded separately.

Double Entry for Annual Depreciation

DR Depreciation Expense Account (Income Statement — expense) CR Provision for Depreciation Account (Statement of Financial Position)

📌 Important: The Asset Account always stays at its original cost. Only the Provision for Depreciation Account accumulates the depreciation. The NBV is calculated by subtracting the provision from cost — it is never a separate ledger account.

Worked Example — Ledger Entries

📋 Example 3: Ledger Accounts for Depreciation (SLM, 3 years)

Equipment purchased 1 Jan 2024 for $15,000. SLM, 3 years, residual value $3,000. Annual depreciation = (15,000 − 3,000) ÷ 3 = $4,000.

Equipment Account (at cost)

Equipment Account

Details	$
1 Jan 2024 — Bank/Cash	15,000
Balance b/d (2025)	15,000
Balance b/d (2026)	15,000

Details	$
Balance c/d (2024)	15,000
Balance c/d (2025)	15,000
Balance c/d (2026)	15,000

Provision for Depreciation — Equipment Account

Provision for Depreciation — Equipment Account

Details	$
Balance c/d (2024)	4,000
Balance c/d (2025)	8,000
Balance c/d (2026)	12,000

Details	$
2024 — Dep. Expense	4,000
Balance b/d	4,000
2025 — Dep. Expense	4,000
Balance b/d	8,000
2026 — Dep. Expense	4,000

NBV at end of Year 3 (2026): Cost $15,000 − Accumulated Depreciation $12,000 = $3,000 ✓ (equals residual value)

How NBV Appears in the Statement of Financial Position

Non-Current Assets	$	$
Equipment — at cost	15,000
Less: Accumulated depreciation	(12,000)
Net Book Value (Carrying Amount)		3,000

6. Disposal of Non-Current Assets Exam Focus

When a non-current asset is sold, scrapped, or traded in, the business must remove it from the books and calculate whether a profit or loss on disposal was made.

Profit on disposal = Sale proceeds > Net Book Value at date of disposal
Loss on disposal = Sale proceeds < Net Book Value at date of disposal

Three Ledger Accounts Used in Disposal

1. Asset Account

Transfer cost of asset to Disposal Account (CR the Asset Account, DR Disposal Account).

2. Provision for Depreciation Account

Transfer accumulated depreciation to Disposal Account (DR the Provision Account, CR Disposal Account).

3. Disposal Account

Records cost, accumulated depreciation, and sale proceeds. The balancing figure is profit or loss on disposal.

Double Entry Summary for Disposal

DR Disposal Account CR Asset Account (cost) DR Provision for Depreciation CR Disposal Account (accum. dep.) DR Bank / Cash CR Disposal Account (sale proceeds) If profit: DR Disposal Account CR Income Statement If loss: DR Income Statement CR Disposal Account

Worked Example — Asset Disposal

📋 Example 4: Disposal with Profit

A machine was purchased on 1 Jan 2022 for $12,000. Depreciation: SLM, 25% per annum, no residual value. On 31 Dec 2024, the machine is sold for $4,500. Prepare the Disposal Account.

Step 1 — Calculate accumulated depreciation:
Annual depreciation = 12,000 × 25% = $3,000. Years held: 3 (2022, 2023, 2024).
Accumulated depreciation = 3 × $3,000 = $9,000

Step 2 — Calculate NBV at date of disposal:
NBV = 12,000 − 9,000 = $3,000

Step 3 — Compare sale proceeds with NBV:
Sale proceeds $4,500 > NBV $3,000 → Profit on disposal = $1,500

Step 4 — Prepare the Disposal Account:

Disposal Account — Machine

Details	$
Machine Account (cost)	12,000
Total	12,000

Details	$
Provision for Depreciation	9,000
Bank (sale proceeds)	4,500
Profit on disposal → Income Statement	(1,500)
Total	12,000

The Disposal Account balances at $12,000 on both sides. The profit of $1,500 is transferred to the Income Statement as other income.

📋 Example 5: Disposal with Loss

Using the same machine as above, but assume it was sold for $2,000 instead.

NBV = $3,000. Sale proceeds = $2,000 → Loss on disposal = $1,000

Disposal Account — Machine (Loss Scenario)

Details	$
Machine Account (cost)	12,000
Total	12,000

Details	$
Provision for Depreciation	9,000
Bank (sale proceeds)	2,000
Loss on disposal → Income Statement	1,000
Total	12,000

⚠️ Profit vs Loss: When the Disposal Account has a debit balance (DR side exceeds CR side), it is a loss — transferred to the Income Statement as an expense. When the CR side exceeds the DR side, it is a profit — income.

7. Memory Aids & Common Mistakes

🧠 Memory Aid — SLM Formula

"Cost minus Scrap divided by Life"
C − S ÷ N (Cost minus Scrap value, divided by Number of years)

🧠 Memory Aid — Disposal Account Direction

Think of the Disposal Account as a clearing account:
DR side: what the asset cost us (cost)
CR side: what we got back (accum. dep. + proceeds)
The difference = profit (cr side bigger) or loss (dr side bigger)

⚠️ Common Mistake 1 — Reducing the Asset Account directly: Never credit the Asset Account with annual depreciation. The Asset Account always stays at cost. Only the Provision for Depreciation Account accumulates the charges.

⚠️ Common Mistake 2 — Using NBV in the RBM formula: Under RBM, always apply the rate to the NBV at the start of the year, not the original cost. Using cost gives the wrong answer from Year 2 onwards.

⚠️ Common Mistake 3 — Forgetting accumulated depreciation in disposal: When disposing of an asset, students often forget to transfer the full accumulated depreciation (not just one year) to the Disposal Account. Always calculate total depreciation from purchase date to disposal date.

⚠️ Common Mistake 4 — Part-year depreciation: Cambridge 7707 sometimes specifies that depreciation is charged for a full year in the year of purchase and no depreciation in the year of sale (or vice versa). Always read the question carefully — the policy will be stated.

📝 Exam Practice Questions

Question 1 Knowledge — 2 marks

State two causes of depreciation of non-current assets.

Any two of the following (1 mark each):

Physical wear and tear through use.
Obsolescence — the asset becomes out of date due to new technology.
Passage of time — some assets (e.g. leases) lose value simply with time.
Depletion — natural resources are used up (e.g. quarries, mines).
Economic factors — changes in market or demand reduce the value.

📌 Do not write "the asset gets older" — that is too vague. Name a specific cause.

Question 2 Application — 4 marks

A business buys a vehicle on 1 January 2024 for $18,000. Residual value $3,000. Useful life: 5 years. Using the straight line method, calculate:

The annual depreciation charge.
The net book value at 31 December 2025.

(i) Annual depreciation = (18,000 − 3,000) ÷ 5 = 15,000 ÷ 5 = $3,000 per year (2 marks)

(ii) NBV at 31 December 2025 (after 2 full years):
Accumulated depreciation = 2 × 3,000 = $6,000
NBV = 18,000 − 6,000 = $12,000 (2 marks)

📌 Always show working — even if your final answer is wrong, method marks are awarded for correct steps.

Question 3 Application — 4 marks

A machine costs $24,000 on 1 January 2023. Depreciation rate: 20% per annum reducing balance. Calculate the depreciation charge and net book value for each of the first three years.

Year	NBV at Start ($)	Depreciation 20% ($)	NBV at End ($)
2023	24,000	4,800	19,200
2024	19,200	3,840	15,360
2025	15,360	3,072	12,288

📌 Always apply the rate to the NBV at the start of the year — not to the original cost.

Question 4 Application — 6 marks

A business purchased equipment on 1 January 2022 for $30,000. It depreciates equipment at 10% per annum straight line, with no residual value. On 31 December 2024, the equipment is sold for $18,000.

Prepare the Disposal Account and state whether a profit or loss arises.

Step 1: Annual depreciation = 30,000 × 10% = $3,000
Years: 2022, 2023, 2024 = 3 years
Accumulated depreciation = 3 × 3,000 = $9,000

Step 2: NBV at disposal = 30,000 − 9,000 = $21,000

Step 3: Sale proceeds $18,000 < NBV $21,000 → Loss = $3,000

Disposal Account — Equipment

Details	$
Equipment Account (cost)	30,000
Loss on disposal → I/S	3,000
Total	33,000

Details	$
Provision for Depreciation	9,000
Bank (sale proceeds)	18,000

Total	27,000

Loss on disposal = $3,000 — transferred to the Income Statement as an expense. The loss arises because the sale proceeds ($18,000) are less than the net book value ($21,000) at the date of disposal.

Question 5 Analysis — 4 marks

A business is choosing between the straight line method and the reducing balance method to depreciate a new delivery van.
Recommend which method is more suitable and give two reasons to support your answer.

Recommended method: Reducing Balance Method (1 mark)

Reason 1: A delivery van loses a large proportion of its value in the first few years of ownership — the reducing balance method reflects this by charging a higher depreciation expense in early years. (1 mark)

Reason 2: In later years, the van will require more maintenance and repairs. As depreciation falls under RBM in later years, the combined charge (depreciation + repairs) remains more evenly spread — giving a fairer charge to the Income Statement each period. (1 mark)

Reason 3 (additional): The NBV under RBM more closely reflects the market (resale) value of the van — giving a more accurate picture of the asset in the Statement of Financial Position. (1 mark)

📌 Always link your reason back to the specific asset in the question — generic answers about "the method" score less.

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