Financial Statements: Depreciation (Copy)

10.1 Financial Statements

10.1.4 Depreciation

1. Role of Depreciation in Accounts

• Definition: Systematic allocation of the cost of a non-current asset over its useful life.
• Purpose:
  • Matches cost of using the asset to the revenue it generates (matching principle).
  • Reflects fall in asset value due to usage, wear and tear, or obsolescence.
  • Prevents overstatement of profit by spreading asset cost over multiple periods.
  • Provides a realistic value of assets in the statement of financial position.

2. Straight-Line Depreciation Method

• Definition: Equal depreciation charge allocated each year over the asset’s useful life.
• Formula:
  Depreciation per year = (Cost of Asset − Residual Value) ÷ Useful Life
• Example:
  • Cost of machine = $12,000
  • Residual value = $2,000
  • Useful life = 5 years
  • Depreciation = (12,000 − 2,000) ÷ 5 = $2,000 per year

3. Impact on Financial Statements

a) Statement of Profit or Loss

• Depreciation is recorded as an expense, reducing operating profit.
• Ensures profits are not overstated by accounting for asset usage.

b) Statement of Financial Position

• Reduces the carrying value of the asset each year.
• Accumulated depreciation is subtracted from the cost of the asset to show net book value.
• Ensures assets are reported at realistic values.

4. Key Points

• Straight-line method assumes equal utility per year.
• Does not account for more intensive use in early years (unlike reducing balance).
• Important for long-term planning, budgeting, and accurate profit measurement.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Business Full Scale Course