Depreciation: causes, reasons and methods

Causes and reasons

Causes of depreciation (why the asset loses value):

• Wear and tear through use (vehicles, machines).
• Obsolescence: newer technology or changes in demand make the asset out of date (computers).
• Passage of time: a lease or licence expires.
• Depletion: resources are used up (a mine or quarry).

The 2024 examiners' report noted that causes of depreciation were poorly known, so learn these four.

Reasons for charging depreciation:

• Accruals (matching): the cost is matched against the revenue the asset helps to earn in each year.
• Shows a more realistic carrying value in the statement of financial position.
• Prudence: profit is not overstated, so the owner does not draw out profits needed to replace the asset.

The three methods

• Straight line: (cost - residual value) / useful life. Same charge every year. Suits assets used evenly (buildings, office furniture).
• Reducing balance: a fixed % of the carrying value at the start of each year. Higher charges in early years. Suits assets that lose most value early or need more repairs later (vehicles, computers), so total cost (depreciation plus repairs) is roughly even.
• Revaluation: depreciation = opening valuation + purchases - closing valuation. Suits many small items that are hard to track individually (loose tools, crockery).

Machine costing £20,000, 5 years, nil residual. Reducing balance never reaches exactly nil: the £1,555 left after year 5 is written off when the machine is disposed of

Effect on profit, and changing method

Total depreciation over the asset's life is the same under each method (cost - residual, once any carrying value left at disposal is written off). Only the timing differs: reducing balance gives lower profits in early years and higher profits later than straight line.

Changing method: the consistency concept says methods should not be changed without good reason, such as a change in the pattern of use. A change alters reported profit (switching to a higher charge reduces profit) and makes comparison with earlier years harder, so the change and its effect should be disclosed. It does not change cash flow: depreciation is not a cash payment.

Worked example

A machine costs £50,000, has a residual value of £5,000 and a life of 6 years. Find the annual straight line charge, and the reducing balance charges for years 1 to 3 at 20%.

1. Straight line: (50,000 - 5,000) / 6 = 7,500 per year.
2. Reducing balance: year 1 = 20% x 50,000 = 10,000; year 2 = 20% x 40,000 = 8,000; year 3 = 20% x 32,000 = 6,400.
3. Carrying value after 3 years (reducing balance) = 25,600.

Answer: Straight line £7,500 a year; reducing balance £10,000, £8,000, £6,400.

Check yourself

1. Equipment costs £36,000, has a residual value of £4,000 and a useful life of 8 years. Calculate the annual straight line depreciation.
   Show answer

   £4000. (36,000 - 4,000) / 8 = 4,000.

2. A van costs £24,000 and is depreciated at 25% a year on the reducing balance. Calculate the depreciation charge for year 2.
   Show answer

   £4500. Year 1: 6,000; carrying value 18,000. Year 2: 25% x 18,000 = 4,500.

3. A computer system costs £16,000 and is depreciated at 25% reducing balance. Find its carrying value after 3 years.
   Show answer

   £6750. 16,000 x 0.75 x 0.75 x 0.75 = 6,750.

4. Loose tools were valued at £3,200 at the start of the year. Tools costing £1,100 were bought during the year and the tools were valued at £2,900 at the end. Calculate the depreciation for the year.
   Show answer

   £1400. 3,200 + 1,100 - 2,900 = 1,400.

5. A machine costs £20,000 with a 5-year life and nil residual value. By how much is year 1 profit higher using straight line than using 40% reducing balance?
   Show answer

   £4000. Reducing balance 8,000 - straight line 4,000 = 4,000.

6. Explain one cause of depreciation of a delivery van.
   Show answer

   Wear and tear: the more kilometres the van is driven, the more its parts wear out, so it is worth less each year.. Name the cause and say how it reduces the van's value.

7. A business changes from straight line to reducing balance depreciation, which gives a higher charge this year. Which statement is correct?
   • Profit and cash fall
   • Profit rises because the asset is worth less
   • Profit for the year falls but cash is unaffected
   • Total depreciation over the asset's life increases
   Show answer

   Profit for the year falls but cash is unaffected. Depreciation is a non-cash expense; only the timing of the charge changes.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting specification (issue 2), Unit 1 and Appendices 6 to 8

Last updated 8 November 2026. Spotted a mistake? Tell us.