Calculating and recording depreciation of non-current assets using the straight-line and reducing balance methods, and explaining the effect of depreciation on the accounting reports

What this dot point is asking

VCAA wants you to calculate and record depreciation using the straight-line and reducing balance methods, distinguish them, and explain the effect on the Income Statement and Balance Sheet through accumulated depreciation and carrying amount.

Why depreciate

Depreciation is a non-cash expense. The cash outflow happened when the asset was purchased; depreciation simply spreads that cost across the periods that benefit from using the asset.

The two methods

Straight-line method

The straight-line method charges an equal amount each period:

Depreciation per year = (Cost minus Residual value) divided by Useful life in years

It is appropriate when the asset delivers benefits evenly across its life, such as office furniture.

Reducing balance method

The reducing balance method applies a fixed percentage to the carrying amount (cost less accumulated depreciation):

Depreciation = Carrying amount times depreciation rate

The expense is highest in the first year and falls each year. It suits assets that are most productive early and that incur rising repair costs later, such as some vehicles and technology.

Recording depreciation

The balance day entry is the same regardless of method:

• Debit Depreciation Expense
• Credit Accumulated Depreciation

Accumulated Depreciation is a negative asset (contra asset). It is deducted from the asset's cost in the Balance Sheet to give the carrying amount. The original cost stays on the books so users can see both the historical cost and the amount consumed to date.

Effect on the reports

Each period, depreciation lowers net profit in the Income Statement. In the Balance Sheet, accumulated depreciation grows and the carrying amount of the asset falls. Because depreciation is non-cash, it does not appear as a cash outflow in the Cash Flow Statement, which is one reason net profit and net operating cash flow differ.

Depreciation relies on estimates of useful life and residual value. If these estimates prove inaccurate, the carrying amount will not reflect the asset's remaining benefit, and a gain or loss on disposal will arise when the asset is sold.