What you'll learn
This revision guide covers two essential topics in IGCSE Accounting: how businesses account for the loss in value of fixed assets over time, and how to distinguish between spending on assets and day-to-day running costs. You'll learn calculation methods, ledger entries, and how these treatments affect financial statements—all tied directly to Pearson Edexcel International IGCSE specification requirements.
Key terms and definitions
Capital expenditure — spending on fixed assets that will be used in the business for more than one accounting period, or spending that increases the earning capacity of an existing fixed asset.
Revenue expenditure — spending on day-to-day running costs of the business, including the maintenance of fixed assets and the purchase of goods for resale.
Depreciation — the allocation of the cost of a fixed asset over its useful economic life to match expense with revenue earned.
Straight-line method — a depreciation calculation method that spreads the cost of an asset evenly over its expected useful life.
Reducing balance method — a depreciation calculation method that applies a fixed percentage to the diminishing net book value each year.
Net book value (NBV) — the cost of a fixed asset minus accumulated depreciation; also called carrying amount or written down value.
Residual value — the estimated amount an asset will be worth at the end of its useful life to the business.
Accumulated depreciation — the total depreciation charged on a fixed asset from the date of purchase to the present.
Core concepts
Capital expenditure vs revenue expenditure
The distinction between capital and revenue expenditure is fundamental to accurate financial reporting.
Capital expenditure includes:
- Purchase of fixed assets (machinery, vehicles, buildings, office equipment)
- Legal fees and delivery costs associated with purchasing fixed assets
- Installation costs of new machinery
- Extension or improvement of existing fixed assets that extend useful life or increase capacity
- Significant alteration to a building that increases its value
Revenue expenditure includes:
- Purchase of inventory (goods for resale)
- Wages and salaries
- Rent, rates, insurance
- Repairs and maintenance that keep an asset in working order
- Running costs (electricity, fuel, stationery)
- Carriage inwards on goods purchased for resale
The significance of correct classification:
Misclassification affects both the statement of financial position and the income statement. Capital expenditure appears as a fixed asset (increasing total assets), while revenue expenditure appears as an expense (reducing profit). Treating revenue expenditure as capital expenditure overstates both profit and asset values—a serious accounting error.
Why businesses depreciate fixed assets
Depreciation serves several accounting purposes:
Matching principle: Depreciation spreads the cost of an asset over the periods that benefit from its use, matching expense with revenue generated.
True and fair view: Without depreciation, assets would remain at original cost indefinitely, failing to reflect their declining value. This would overstate asset values and profit.
Asset replacement: Regular depreciation charges build up funds (in the form of retained profit) to enable eventual replacement of worn-out assets.
Causes of depreciation:
- Physical deterioration through wear and tear
- Economic factors (obsolescence due to newer technology)
- Time-related factors (passage of time, as with leases)
- Depletion (extraction of natural resources)
Straight-line method of depreciation
This method charges equal amounts each year throughout an asset's useful life.
Formula:
Depreciation per annum = (Cost – Residual value) ÷ Expected useful life in years
Alternatively, this may be expressed as a percentage:
Annual percentage = (1 ÷ Useful life) × 100
Key features:
- Simple to calculate and understand
- Predictable annual charge aids budgeting
- Suitable for assets that provide similar benefits each year
- Commonly used for buildings, office furniture, and fixtures
Example calculation:
A business purchases machinery for £12,000. Expected useful life is 5 years with a residual value of £2,000.
Annual depreciation = (£12,000 – £2,000) ÷ 5 = £2,000 per year
After 3 years:
- Accumulated depreciation = £2,000 × 3 = £6,000
- Net book value = £12,000 – £6,000 = £6,000
Reducing balance method of depreciation
This method applies a fixed percentage to the diminishing net book value each year, producing higher charges in early years.
Formula:
Depreciation for the year = Net book value at start of year × Depreciation rate %
Key features:
- Higher depreciation in early years when asset is most productive
- Better matching for assets that lose value rapidly or require increasing maintenance
- Never reduces an asset to zero value (mathematically)
- Commonly used for vehicles and computer equipment
Example calculation:
A vehicle costs £20,000. The business applies 25% reducing balance depreciation.
Year 1:
- Depreciation = £20,000 × 25% = £5,000
- NBV at year end = £20,000 – £5,000 = £15,000
Year 2:
- Depreciation = £15,000 × 25% = £3,750
- NBV at year end = £15,000 – £3,750 = £11,250
Year 3:
- Depreciation = £11,250 × 25% = £2,813 (rounded)
- NBV at year end = £11,250 – £2,813 = £8,437
Ledger entries for depreciation
Depreciation requires entries in three accounts within the general ledger.
The three-account system:
Fixed asset account at cost — records the original purchase price and remains unchanged unless the asset is disposed of
Provision for depreciation account (or Accumulated depreciation account) — a credit balance that accumulates all depreciation charged; shown as a deduction from the asset in the statement of financial position
Depreciation expense account — records the annual charge; transferred to the income statement as an expense
Year-end journal entry:
Dr Depreciation expense
Cr Provision for depreciation
This entry:
- Records the expense for the period (debit reduces profit)
- Increases accumulated depreciation (credit increases the provision)
Presentation in financial statements:
Income statement (extract):
- Depreciation appears as an expense, reducing gross profit to net profit
Statement of financial position (extract):
Fixed assets £
Machinery at cost 12,000
Less: Provision for depreciation (6,000)
Net book value 6,000
Partial year depreciation
When assets are purchased or sold during an accounting period, depreciation must be calculated on a time-apportioned basis.
Method:
Calculate annual depreciation, then multiply by the fraction of the year the asset was owned.
Example:
A business with a year-end of 31 December purchases equipment for £8,000 on 1 May 2023. Depreciation policy: 20% straight-line.
Annual depreciation = £8,000 × 20% = £1,600
Months owned in 2023 = May to December = 8 months
Depreciation for 2023 = £1,600 × 8/12 = £1,067 (rounded)
This principle applies to both straight-line and reducing balance methods.
Worked examples
Example 1: Classification of expenditure (4 marks)
Question: Classify each of the following items as capital expenditure or revenue expenditure:
(a) Purchase of a new delivery van — £15,000 (b) Repainting the exterior of the business premises — £2,500 (c) Legal fees for purchasing new premises — £800 (d) Wages paid to the office assistant — £18,000
Solution:
(a) Capital expenditure [1 mark] — purchase of a fixed asset
(b) Revenue expenditure [1 mark] — maintenance that keeps the asset in existing condition
(c) Capital expenditure [1 mark] — costs associated with acquiring a fixed asset
(d) Revenue expenditure [1 mark] — day-to-day running cost
Example 2: Straight-line depreciation calculation (6 marks)
Question: Haynes Ltd purchased office equipment on 1 January 2021 for £24,000. The business estimates a useful life of 8 years and a residual value of £4,000. Depreciation is charged using the straight-line method.
Required: (a) Calculate the annual depreciation charge. (2 marks) (b) Calculate the net book value at 31 December 2023. (2 marks) (c) State one advantage of the straight-line method. (2 marks)
Solution:
(a) Annual depreciation = (£24,000 – £4,000) ÷ 8 [1 mark] = £2,500 per year [1 mark]
(b) Years owned by 31 December 2023 = 3 years Accumulated depreciation = £2,500 × 3 = £7,500 [1 mark] Net book value = £24,000 – £7,500 = £16,500 [1 mark]
(c) Any one valid advantage [2 marks for correct statement and brief explanation]: - Easy to calculate and understand - Provides a consistent annual charge which aids budgeting - Suitable for assets that provide equal benefits each year
Example 3: Reducing balance calculation and ledger entries (10 marks)
Question: Khan Enterprises purchased a computer system on 1 January 2022 for £6,000. The business depreciates computer equipment at 40% per annum using the reducing balance method.
Required: (a) Calculate depreciation for the year ended 31 December 2022. (2 marks) (b) Calculate depreciation for the year ended 31 December 2023. (2 marks) (c) Show the computer equipment account and provision for depreciation account as they would appear at 31 December 2023. (6 marks)
Solution:
(a) Depreciation 2022 = £6,000 × 40% [1 mark] = £2,400 [1 mark]
(b) NBV 1 January 2023 = £6,000 – £2,400 = £3,600 Depreciation 2023 = £3,600 × 40% [1 mark] = £1,440 [1 mark]
(c)
Computer Equipment Account
£ £
1 Jan 2022 Bank 6,000 31 Dec 2023 Balance c/d 6,000
----- -----
1 Jan 2024 Balance b/d 6,000
[2 marks for correct format and entries]
Provision for Depreciation – Computer Equipment
£ £
31 Dec 2023 Balance c/d 3,840 31 Dec 2022
Depreciation 2,400
31 Dec 2023
Depreciation 1,440
----- -----
3,840 3,840
1 Jan 2024
Balance b/d 3,840
[4 marks: 2 for correct figures, 2 for correct format including balance brought down]
Common mistakes and how to avoid them
Confusing capital and revenue expenditure on repairs: Remember that repairs maintaining an asset's existing condition are revenue expenditure, while improvements extending life or increasing capacity are capital expenditure. Repainting a van is revenue; converting a van to increase carrying capacity is capital.
Forgetting to deduct residual value in straight-line calculations: The formula requires (Cost – Residual value) ÷ Useful life, not Cost ÷ Useful life. Always check whether the question provides a residual value.
Applying the depreciation percentage to cost in reducing balance method: After year 1, always apply the percentage to the net book value at the start of the year, not the original cost.
Incorrectly treating the provision for depreciation account: This is a credit balance account that accumulates. Don't clear it to zero each year—only the depreciation expense account transfers to the income statement.
Errors in partial year calculations: When an asset is purchased mid-year, use months owned ÷ 12. For an asset purchased on 1 April with a 31 December year-end, depreciation is 9/12 of the annual charge, not 3/12.
Showing depreciation on the wrong side of accounts: Depreciation expense is a debit entry (expense increases); provision for depreciation is a credit entry (contra-asset increases).
Exam technique for "Depreciation and Capital vs Revenue Expenditure"
Command word precision: "State" requires a brief answer without explanation (1 mark). "Explain" requires a statement plus reasoning (2 marks). "Calculate" requires workings shown—even if you reach the wrong answer, method marks are available.
Show all workings for calculations: Write formulae before substituting numbers. Examiners award method marks. For a 4-mark calculation, typically 2 marks are for method and 2 for the correct answer.
Classification questions: Read carefully to distinguish between maintenance (revenue) and improvement (capital). Use the key test: does it provide future economic benefit beyond one year? Justify your answer if marks allow.
Ledger account questions: Use correct account names (e.g., "Provision for depreciation – Motor vehicles" not just "Depreciation"). Balance accounts properly with c/d and b/d, and ensure dates match the question requirements.
Quick revision summary
Capital expenditure purchases fixed assets or improves them; revenue expenditure covers day-to-day costs. Depreciation allocates fixed asset costs over useful life. Straight-line method charges equal annual amounts: (Cost – Residual value) ÷ Useful life. Reducing balance applies a fixed percentage to diminishing NBV each year. Ledger entries: debit depreciation expense, credit provision for depreciation. NBV = Cost – Accumulated depreciation. For mid-year purchases, time-apportion the annual charge. Correct classification and depreciation calculation are essential for accurate financial statements.