When a business buys a delivery van, a machine or a building, the purchase is not an expense of that day. The asset will be used for years, so its cost is spread over the periods that benefit from it. That systematic allocation is depreciation. It matches the cost of using the asset with the revenue it helps to earn, and it shows the asset at a realistic carrying amount on the balance sheet.
Under IFRS, depreciation of property, plant and equipment is governed by IAS 16. Intangible assets with finite lives are amortised in the same way under IAS 38.
What you will learn
- Explain why assets are depreciated and what the key inputs are
- Calculate depreciation with the straight-line, reducing balance and units-of-production methods
- Record depreciation and read accumulated depreciation and carrying amount
- Understand changes in estimates, disposals and the difference from tax depreciation
The inputs
Every depreciation calculation needs three things:
- Cost — the purchase price plus costs directly attributable to bringing the asset to working condition (delivery, installation, testing), less trade discounts.
- Residual value — the amount the entity expects to obtain from disposal at the end of the asset’s useful life, net of disposal costs.
- Useful life — the period (or number of units) over which the asset is expected to be used by the entity. This can be shorter than its physical life.
The depreciable amount is cost minus residual value. Land is normally not depreciated because it has an unlimited useful life; buildings on the land are.
Straight-line method
The depreciable amount is spread evenly over the useful life.
Straight-line depreciation
Annual depreciation = (Cost − Residual value) ÷ Useful life in years
Worked example: straight line
A machine costs 500,000, has an estimated residual value of 50,000 and a useful life of 5 years (illustrative figures).
- Depreciable amount: 500,000 − 50,000 = 450,000.
- Annual depreciation: 450,000 ÷ 5 = 90,000.
- Carrying amount after year 1: 500,000 − 90,000 = 410,000; after year 5: 500,000 − 450,000 = 50,000, equal to the residual value.
Straight line suits assets that provide roughly equal benefit each year, such as buildings and office furniture. It is simple and the most widely used method.
Reducing balance (diminishing balance) method
A fixed percentage is applied each year to the opening carrying amount, so the charge is highest in the first year and declines afterwards.
Reducing balance depreciation
Depreciation for the year = Opening carrying amount × Rate
A rate that brings the asset to its residual value at the end of its life is Rate = 1 − (Residual value ÷ Cost)^(1 ÷ n). In practice a rounded policy rate is often set.
Worked example: reducing balance at 40%
The same machine (cost 500,000) depreciated at a policy rate of 40%:
| Year | Opening amount | Depreciation (40%) | Closing amount |
|---|---|---|---|
| 1 | 500,000 | 200,000 | 300,000 |
| 2 | 300,000 | 120,000 | 180,000 |
| 3 | 180,000 | 72,000 | 108,000 |
| 4 | 108,000 | 43,200 | 64,800 |
| 5 | 64,800 | 14,800 | 50,000 |
In year 5 the charge is limited to 14,800 so that the carrying amount does not fall below the 50,000 residual value. Total depreciation is again 450,000 — only the timing differs.
Reducing balance suits assets that lose value quickly or are most productive when new, such as vehicles and computer equipment.
Carrying amount under two methods
Show the data
| End of period | Straight line | Reducing balance (40%) |
|---|---|---|
| Start | 500,000 | 500,000 |
| Year 1 | 410,000 | 300,000 |
| Year 2 | 320,000 | 180,000 |
| Year 3 | 230,000 | 108,000 |
| Year 4 | 140,000 | 64,800 |
| Year 5 | 50,000 | 50,000 |
Units-of-production method
Depreciation follows actual use rather than time.
Units of production
Depreciation per unit = (Cost − Residual value) ÷ Total expected units
Depreciation for the period = Units produced in the period × Depreciation per unit
If the machine is expected to produce 900,000 units over its life, the rate is 450,000 ÷ 900,000 = 0.50 per unit. In a year when it produces 240,000 units, depreciation is 240,000 × 0.50 = 120,000. This method suits assets whose wear depends on output, such as mining equipment or aircraft engines measured in flight hours.
Recording depreciation
Dr Depreciation expense / Cr Accumulated depreciation
Accumulated depreciation is a contra-asset account. The balance sheet shows cost less accumulated depreciation, which gives the carrying amount (book value). Depreciation is recorded as a year-end adjustment — see trial balance and adjusting entries.
Reviewing estimates
IAS 16 requires the residual value, useful life and depreciation method to be reviewed at least at each financial year end. A change is a change in accounting estimate: it is applied from that point forward, without restating earlier years. If, after two years of straight-line charges, the machine’s remaining life is revised from three years to four, the remaining depreciable amount (320,000 − 50,000 = 270,000) is spread over four years at 67,500 a year.
Disposals
When an asset is sold, its cost and accumulated depreciation are removed, and the difference between sale proceeds and carrying amount is a gain or loss. Selling the machine for 200,000 when its carrying amount is 230,000 produces a loss of 30,000. In the cash flow statement the 200,000 proceeds appear under investing activities.
Accounting depreciation versus tax depreciation
Tax law usually sets its own capital allowance rules, which may differ from the accounting method and life. The resulting difference between accounting profit and taxable profit is a timing difference, accounted for as deferred tax under IAS 12. Tax rules vary by country and change over time, so the applicable law should always be checked.
Choosing a method
| Method | Pattern of expense | Suits |
|---|---|---|
| Straight line | Equal each year | Buildings, furniture, assets used evenly |
| Reducing balance | High early, declining | Vehicles, IT equipment |
| Units of production | Varies with use | Machinery, mining and transport assets |
The method should reflect the pattern in which the asset’s benefits are consumed, and must be applied consistently.
Common mistakes
- Depreciating land, which normally has an unlimited useful life.
- Forgetting the residual value and depreciating the full cost.
- Applying the reducing balance rate to cost every year instead of to the opening carrying amount.
- Treating depreciation as a fund of cash set aside for replacement — it is an allocation of cost, not savings.
- Restating prior years when an estimate changes.
Key terms
- Depreciable amount — cost less residual value.
- Residual value — expected net disposal proceeds at the end of the useful life.
- Useful life — the period or output over which the entity expects to use the asset.
- Accumulated depreciation — total depreciation charged to date, shown as a deduction from cost.
- Carrying amount — cost less accumulated depreciation and impairment.
Frequently asked questions
Does depreciation reduce cash?
No. It is a non-cash expense. Cash left the business when the asset was bought; depreciation spreads that cost over the asset’s life.
Can a company switch depreciation methods?
Only if the new method better reflects how the asset’s benefits are consumed. The change is treated as a change in estimate and applied prospectively, with disclosure.
What is the difference between depreciation and amortisation?
Depreciation applies to tangible assets such as machinery; amortisation applies to intangible assets with finite lives, such as software licences.
Key takeaways
- Depreciation allocates the cost of an asset, less residual value, over its useful life.
- Straight line gives equal charges; reducing balance front-loads them; units of production follows usage.
- All methods depreciate the same total — only the timing differs.
- Estimates are reviewed annually and changes apply prospectively.
- Depreciation is a non-cash expense and is not a replacement fund.