Depreciation is the cost of allocating a non-current asset over its useful life. The purpose of depreciation is to make sure that profit is calclated accurately for the reporting period by calculating all of the expenses incurred in the current reporting period. This includes the cost of non-current assets that are used to earn revenue.

It is important to note that depreciation does not affect cash, because it is the allocation of a cost over a period of time. Depreciation only affects the Profit and Loss Statement and the Balance Sheet.

Straight-line depreciation

In VCE Unit 3 Accounting, you are only required to know the straight-line method of calculating depreciation. To calculate depreciation using this method we need to know three things:

Historical Cost (HC) – the original purchase price of the non-current asset

Useful Life (L) – the estimated period of time for which the non-current asset will be used by the business to earn revenue

Residual Value (RV) – the estimated value of the non-current asset at the end of its useful life

To calculate depreciation we use the following formula:

Depreciation expense = (HC – RV) / Life

Example

Maxwell Smart owns and operates Smarties Trading. On 1 July 2010 Smart purchased  a motor vehicle for $28,000. The vehicle will be traded in after three years, at which time it is estimated to have a residual value of $10,000.

1. Calculate the depreciation expense for the year ended 3o June 2011 on the vehicle.
2. How would you record this expense in the General Journal and the General Ledger of Smarties Trading?