from the current period.
We have to make sure that the expenses shown in the financial summary cover only the stated period, neither more nor less than that. This is due to the application of the accruals principle, which states that all income and related expenditure for a specified period should be included, not simply cash paid or received.
Non-current assets, with the exception of most freehold land, are usually subject to depreciation. Depreciation is officially defined as 'the systematic allocation of the depreciable amount of an asset over its useful life'. The appreciable amount refers to the loss of value that the asset suffers due to factors
such as wear and tear, passage of time and obsolescence due to changes in technology.
Due to the accruals and prudence principles, accountants have to make an estimate of the amount of depreciation which has been suffered by non-current assets during the financial period. This is then included within the income statement as an expense. This estimate is based on three components, the last two of which are 'best guesses':
• The cost of the non-current asset, which is easily determined if purchased from an outside supplier. However, any installation costs incurred to bring the asset into a working condition should also be included as part of the cost. For example, if a factory wall had to be dismantled and rebuilt to allow the installation of a large machine, the building costs would be included as part of the cost of the non-current asset. If the non-current asset is built by the business itself, then labour costs and other directly attributable costs would be included as part of the cost of the asset.
• The useful life of the asset, which is the estimate of how long the non-current asset will continue to provide economic benefits to the organisation.
• The residual value, which is the estimate, based on prices prevailing at the date of acquiring the asset, of the value which the asset may have at the end of its useful life. In many cases, it is assumed that the asset will have 110 residual value.
For example, a welding robot is bought by a car manufacturer for £200,000 on
1 January 2008. It costs £40,000 to install the robot and it is expected to be
used for a period of 10 years, after which it is expected to be sold to an industrial
museum for £4,000.
• The cost is £240,000 (£200,000 + £40(000).
• The useful life is 10 years.
• The estimated residual value is £4,000.
A variety of methods can be used to calculate the amount of depreciation to be allocated to a specific financial period. The two most common methods are the straight line method and the diminishing balance method.