224 Accounting: Business Reporting for Decision Making
The annual depreciation expense to be recognised in the statement of profit or loss is $8000. The trans-
action would 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 balance sheet, the accumulated depreciation account is deducted from the relevant
asset account. Thus, when recording depreciation expense, the dual nature of the transaction is repre-
sented by an expense account increasing, thereby reducing profit and hence equity, and the contra account,
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 balance sheet 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 balance sheet 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 an annual depreciation charge
of $8000. At the end of year four, 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 Effect of accounting policy choices, estimates
and judgements on financial statements
LEARNING OBJECTIVE 6.3 Outline the effect that accounting policy choices, estimates and judgements
can have on the financial statements.
As discussed in chapter 5, even when preparing financial statements in compliance with the accounting
standards, the accounting standards provide preparers with choices. Further, estimations and assump-
tions are necessary. Users of financial statements need to appreciate that accounting flexibility and dis-
cretion exist, and they need to consider the potential impact this has on the quality of the reported
financial information.
Just as some of the permissible choices in the recording of transactions and estimations and judge-
ments required by preparers of balance sheets were explored in chapter 5, in this section we focus on
the pertinent elements of the statement of profit or loss where similar considerations may be required.
Earlier in this chapter we discussed the straight-line method of depreciation; however, this is not the only
depreciation method permitted under approved accounting standards. An entity can select the straight-
line, diminishing balance or units of production depreciation method. The method selected should
be representative of the pattern by which the asset’s benefits are expected to be consumed. Further,
when selecting the depreciation method, estimates and judgements need to be made in relation to the
asset’s useful life and residual value. Consider an asset that is purchased for $30 000 at the start of the
reporting period and has an estimated useful life of three years, with $3000 residual (salvage) value.
Employing straight-line depreciation (where the annual depreciation on the asset is the same each
year), an expense of $9000 would be recognised in the statement of profit or loss for each of the next
three reporting periods. Using the calculation formula provided above, the annual depreciation expense
is the asset’s cost price less residual value divided by the useful life (($30 000 − $3000)/3 years). If the
asset is acquired part way through a reporting period, the annual depreciation is pro-rata. For example, if
the asset was purchased at the start of the seventh month of the reporting year, the depreciation expense
for that reporting period would be $4500 ($9000 annual depreciation charge × 6 months/12 months).