Financial Statements: Depreciation (Copy)

10.1.4 Depreciation

Definition
- Depreciation is the systematic allocation of the cost of a non-current asset over its useful life.
- Non-current assets (e.g. machinery, vehicles, buildings, equipment) provide benefits over several years, so their cost must be spread across accounting periods.
Why Depreciation Is Necessary
- Matching principle (accruals concept)
  - Ensures that the expense of using an asset is matched against the revenue it helps generate.
  - Example: A delivery van used for 5 years should not have its entire cost recorded in year 1; instead, it is depreciated yearly.
- True and fair view
  - Without depreciation, profits would be overstated and asset values on the statement of financial position would be unrealistic.
- Asset valuation
  - Depreciation reduces the carrying amount of the asset on the statement of financial position, reflecting wear and tear, obsolescence, or usage.
- Funding replacement
  - By charging depreciation annually, businesses build reserves through retained earnings, enabling them to eventually replace the asset.
- Legal and accounting compliance
  - Required by International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP).
Non-Cash Expense
- Depreciation is a charge in the Statement of Profit or Loss, but it does not involve cash outflow in the period.
- The cash was spent when the asset was purchased; depreciation simply spreads the cost.

Definition
- Depreciation is charged evenly over the useful life of the asset.
- Each year, the same amount is deducted until the asset’s value reaches its residual (scrap) value.
Formula
$Annual Depreciation Expense=Cost of Asset – Residual ValueUseful Life (years)text{Annual Depreciation Expense} = frac{text{Cost of Asset – Residual Value}}{text{Useful Life (years)}}$
Key Assumptions
- The asset is used consistently each year.
- The benefit provided by the asset is equal in all years of use.
Example
- Cost of machinery = ₨100 000
- Residual value = ₨10 000
- Useful life = 5 years
- Annual Depreciation = (100 000 – 10 000) ÷ 5 = ₨18 000 per year
Depreciation Schedule

Year	Cost (₨)	Accumulated Depreciation (₨)	Net Book Value (₨)
1	100 000	18 000	82 000
2	100 000	36 000	64 000
3	100 000	54 000	46 000
4	100 000	72 000	28 000
5	100 000	90 000	10 000 (residual)

As An Expense
- Depreciation is recorded as an expense under operating costs.
- Reduces Operating Profit and ultimately Profit for the Year.
- Example: If revenue = ₨500 000, operating expenses (excluding depreciation) = ₨300 000, depreciation = ₨18 000 →
  - Gross Profit = ₨500 000 – 300 000 = ₨200 000
  - Operating Profit = ₨200 000 – 18 000 = ₨182 000
Non-Cash Impact
- Although it reduces reported profit, it does not affect cash flow.
- Important for decision-making: a business may still have strong cash flow even with high depreciation.
Comparability
- Depreciation allows fair comparison of profits between firms and periods by recognising asset usage as an expense.

Non-Current Assets
- Assets are shown at Net Book Value (NBV):
  - NBV = Cost – Accumulated Depreciation
- Reflects the current accounting value of assets after accounting for wear and tear.
Example
- Machinery cost = ₨100 000
- Accumulated depreciation after 3 years = ₨54 000
- NBV shown on Statement of Financial Position = ₨46 000
Effect On Equity
- Because depreciation reduces profits, it also reduces retained earnings in equity.
- Example: Net profit after depreciation = ₨182 000; without depreciation = ₨200 000 → retained earnings lower by ₨18 000.
No Effect On Cash Or Liabilities
- Depreciation does not reduce cash or create liabilities.
- It only adjusts asset valuation and retained earnings.

Accurate Profit Measurement
- Ensures profits are not overstated.
- Without depreciation, a business using expensive assets would appear falsely profitable.
Investment Decisions
- Helps managers plan when to replace assets.
- Investors assess whether profits reflect sustainable performance.
Pricing Decisions
- Depreciation as a fixed cost must be factored into pricing to ensure profitability.
Loan Agreements
- Lenders evaluate net profits (after depreciation) to assess repayment ability.
Taxation
- Depreciation reduces taxable profit, lowering corporate tax liability.
- Tax authorities allow depreciation as an expense, but may prescribe specific rates.

Assumes asset usage is constant, but some assets (e.g. vehicles, machinery) lose value faster in early years.
Ignores unexpected events such as breakdowns or rapid technological obsolescence.
Does not consider maintenance costs, which usually rise as assets age.
May misstate profits in industries with rapidly changing technology.

British Airways
- Uses straight-line depreciation for aircraft over their expected lifespan.
- Ensures accurate reporting of asset values and profits.
Hershey’s (USA)
- Depreciates machinery used in chocolate production to reflect usage and allocate costs fairly.
Toyota
- Uses depreciation to account for wear and tear on production machinery, ensuring costs are spread over useful life.
Local Example (Pakistan)
- Packages Ltd depreciates printing and packaging equipment on a straight-line basis.
- Ensures realistic reporting of asset values in financial statements.

Explain the purpose of depreciation in accounts.
Apply the straight-line formula with given cost, scrap value, and useful life.
Show depreciation in both SPL and Statement of Financial Position.
Analyse how depreciation impacts profit, asset values, and retained earnings.
Evaluate limitations of straight-line vs other methods (reducing balance, units of production).