IB Business Management HLTopic 3 — Final AccountsPaper 1, 2 & 3HL only~12 min read
Working Out Depreciation
A machine bought five years ago is not worth what it cost. Depreciation is how the accounts admit that. It spreads the cost of a non-current asset across the years it is actually used, so the profit figure and the asset value both tell the truth. Two methods, both easy once you see the logic.
📚 What you need to know
Depreciation is an accounting technique that recognises the falling value of non-current assets over time.
Value falls because of wear and tear and because of obsolescence (the asset becoming out of date).
The two methods you need are straight line and units of production.
Straight line depreciation = (historic cost − residual value) ÷ life expectancy.
Units of production charges depreciation per unit used: (historic cost − residual value) ÷ expected lifetime units.
Depreciation is an expense in the statement of profit or loss and it reduces the book value in the statement of financial position.
No cash actually leaves the business when depreciation is charged.
The three figures you always need
Historic cost — what the asset originally cost to buy.
Life expectancy — how many years (or how many units of use) it is expected to last.
Residual value — the scrap or resale value at the end of its useful life.
Subtract the residual value from the historic cost and you have the amount that actually gets used up. That is the amount to be spread out. Everything else is just deciding how to spread it.
Straight line method
Annual depreciation = (historic cost − residual value) ÷ life expectancy
Straight line: the same amount every year
Take a machine bought for $46,000 that will last 5 years and then be sold for scrap at $6,000. The amount used up is $46,000 − $6,000 = $40,000, spread over 5 years, so $8,000 a year. Every single year the charge is the same, which makes budgeting simple.
The green dashed line is the residual value. Depreciation only ever writes off the gap between the purchase price and that floor.
WORKED EXAMPLE
Annual depreciation, book value and accumulated depreciation
Alderton Joinery buys a cutting machine for $46,000. It expects to use it for 5 years and then sell it for $6,000. Calculate the annual depreciation, then show the book value and accumulated depreciation for each year of its useful life.
Step 1: Take the residual value off the historic cost$46,000 − $6,000 = $40,000Step 2: Divide by the life expectancy$40,000 ÷ 5 years = $8,000 per yearStep 3: Take $8,000 off the book value each yearYear 1: 46,000 − 8,000 = 38,000, then keep going down the table.Annual depreciation = $8,000check: after 5 years the book value is exactly the residual value
Year
Depreciation charged
Book value at year end
Accumulated depreciation
0
$0
$46,000
$0
1
$8,000
$38,000
$8,000
2
$8,000
$30,000
$16,000
3
$8,000
$22,000
$24,000
4
$8,000
$14,000
$32,000
5
$8,000
$6,000
$40,000
Two columns, two different jobs. Book value is what the asset is worth now. Accumulated depreciation is the running total written off so far. Add them together at any point and you get back to the original $46,000.
Units of production: charge by how much it is used
Some assets do not wear out with time, they wear out with use. A delivery van that sits in a yard barely ages; one that covers 60,000 km a year does. The units of production method links the charge to actual usage, so a busy year costs more than a quiet one.
Units of production method
Depreciation per unit = (historic cost − residual value) ÷ expected lifetime units
Depreciation for the year = depreciation per unit × units used this year
WORKED EXAMPLE
Depreciating a delivery van by distance
Alderton Joinery also buys a delivery van for $28,000. It expects the van to cover 150,000 km before being sold for $4,000. In its first year the van covers 32,000 km. Calculate the depreciation expense for year one and the book value at the end of that year.
Step 1: Amount to be written off$28,000 − $4,000 = $24,000Step 2: Depreciation per kilometre$24,000 ÷ 150,000 km = $0.16 per kmStep 3: Depreciation for year one$0.16 × 32,000 km = $5,120Step 4: Book value at the end of year one$28,000 − $5,120 = $22,880Depreciation $5,120 · Book value $22,880a quieter second year would give a smaller charge — that is the whole point of this method
Where depreciation shows up
This is why depreciation is a favourite exam topic: it links the two final accounts together, and it separates profit from cash.
The point most students miss. Depreciation reduces profit but no money is paid to anybody. The cash left the business on the day the machine was bought. This is exactly why a profitable firm and a cash-rich firm are not the same thing.
Why bother depreciating at all?
To value the business honestly. Recording a ten-year-old machine at its original price would overstate what the firm is worth.
To plan replacements. Knowing how fast assets lose value lets a firm budget for replacing them instead of being caught out by a breakdown.
To report performance fairly. Using an asset has a cost, so that cost belongs in the years the asset is being used.
For tax. Many countries prefer the straight line method because the deduction is the same each year.
Choosing between the two methods
Point of comparison
Straight line
Units of production
How the charge behaves
The same every year
Rises and falls with actual usage
Main strength
Simple to calculate and easy to budget for
Matches the expense to how hard the asset was worked
Main weakness
Ignores whether the asset was used heavily or barely at all
Harder to calculate, and usage must be measured accurately
Effect on the accounts
Predictable, stable profit figures
Less predictable profit from year to year
Best suited to
Assets with a steady, predictable decline in value
Machinery and vehicles whose value depends on use
🧩 Method for any depreciation question
Pull out the three figures: historic cost, residual value, life (in years or in units).
Subtract residual from cost. This is the amount to be written off.
Divide by the life — by years for straight line, by expected units for units of production.
For units of production, multiply by the units actually used this year.
Take the charge off the book value and, if asked, keep a running total for accumulated depreciation.
💡 Exam tip
Never forget to subtract the residual value first. Dividing the full cost by the life is the most common error in this topic.
In a 2-mark calculation there is usually one mark for the subtraction and one for the division, so show both lines.
If you are asked for a table, give all the columns asked for and fill in year 0 with the historic cost.
Check your final book value equals the residual value. If it does not, you have made a slip.
For an evaluation, argue from the asset itself: does its value fall with time or with use? That decides the method.
⚠ Common mix-up
Depreciating down to zero. The asset stops at its residual value.
Confusing book value with accumulated depreciation. One goes down each year, the other goes up.
Thinking depreciation is a cash payment. It is a non-cash expense.
Using book value instead of historic cost in the formula. The formula always starts from what the asset originally cost.
Applying units of production without converting properly, for example mixing kilometres with hours.
Assuming all assets depreciate. Land and property often rise in value instead.
Up next: Profitability and Liquidity Ratio Analysis — taking the two final accounts you have just learned to read, and turning them into ratios that judge how the business is really doing.
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