Copyright © 2019. Wiley. All rights reserved.

Birt, J. (2019). Accounting : Business reporting for decision making, 7th edition. Wiley.
Created from swin on 2023-02-10 13:17:39.
Copyright © 2019. Wiley. All rights reserved.

Birt, J. (2019). Accounting : Business reporting for decision making, 7th edition. Wiley.
Created from swin on 2023-02-10 13:17:39.
Copyright © 2019. Wiley. All rights reserved.

Birt, J. (2019). Accounting : Business reporting for decision making, 7th edition. Wiley.
Created from swin on 2023-02-10 13:17:39.
 Depreciation
There are other expenses recognised under accrual accounting that do not involve cash flows. For example,
depreciation and amortisation are expenses recognised in the statement of profit or loss that do not involve
any outflow of cash. All PPE assets must be depreciated and certain intangible assets must be amortised.
Depreciation (amortisation) is the systematic allocation of the cost of a tangible (intangible) asset over its
useful life. Depreciation (amortisation) expense recognises that the asset’s future economic benefits have
been used up in the reporting period. Depreciation and amortisation do not represent the reduction in the
asset’s market value from the start to the end of the reporting period. This is another reason why profit or
loss does not represent the change in an entity’s value from the start to the end of the reporting period.
Consider the following example of how depreciation can be calculated. An entity purchases a car for
$40 000, with an estimated useful life of four years and expected residual value of $8000. If we assume that
the benefits of using the car will be derived evenly over its useful life, then the straight-line depreciation
method is used. Other depreciation methods are discussed later in this chapter. Straight-line depreciation
results in the same depreciation expense being recorded each year for the asset’s useful life. Straight-line
depreciation is calculated using the equation below.
Cost of asset − Expected residual value
Annual depreciation expense =
Asset’s expected useful life (years)
$40 000 − $8000
=
4 years
= $8000
The annual depreciation expense to be recognised in the statement of profit or loss is $8000. The trans-
action will be recorded by increasing an expense (depreciation) and increasing accumulated depreciation.
Accumulated depreciation is the account used to capture the total depreciation that has been charged
to statements of profit or loss for a particular asset. The accumulated depreciation account is referred
to as a contra account. In the statement of financial position, the accumulated depreciation account is
deducted from the relevant asset account. Thus, when recording depreciation expense, the dual nature
of the transaction is represented by an expense account increasing, thereby reducing profit and hence
equity, and the contra account, the accumulated depreciation, increasing, thereby reducing assets. The
asset account, cash, is unaffected by the recording of depreciation expense. Referring back to the example,
after one year the carrying amount of the car reported in the statement of financial position is $32 000.
The $32 000 represents the car’s cost price ($40 000) less the accumulated depreciation expense ($8000).
The $32 000 is not necessarily equivalent to the market value of the car at the end of the reporting period,
so the financial statements do not reflect the change in the car’s market value. In the second year, another
$8000 depreciation expense is recognised in the statement of profit or loss. Hence, after two years the
carrying amount of the car reported in the statement of financial position is $24 000, being the car’s
cost price ($40 000) less the accumulated depreciation, which is now $16 000. The $16 000 accumulated
depreciation amount is the sum of the depreciation expense for the car in year 1 and year 2. After four years
the accumulated depreciation is $32 000, being four years of the annual depreciation charge of $8000. At
the end of year 4 the carrying amount of the car is $8000, being its cost price ($40 000) less the accumulated
depreciation ($32 000). Thus, at the end of the asset’s useful life, in this example four years, the asset’s
carrying value is its residual value. This accumulated depreciation represents the asset’s future economic
benefits that have been used up in the four years since its purchase.

6.3 Effects of accounting policy choices, estimates

and judgements on financial statements
Copyright © 2019. Wiley. All rights reserved.

LEARNING OBJECTIVE 6.3 Outline the effects that accounting policy choices, estimates and judgements
can have on financial statements.
As discussed in the statement of financial position chapter, even when preparing financial statements in
compliance with the accounting standards, these accounting standards provide preparers with choices.
Further, estimations and assumptions are necessary. Users of financial statements need to appreciate that
accounting flexibility and discretion exist, and they need to consider the potential impact of this on the
quality of the reported financial information.

196 Accounting: Business reporting for decision making

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Birt, J. (2019). Accounting : Business reporting for decision making, 7th edition. Wiley.
Created from swin on 2023-02-10 13:17:39.