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Depreciation & Disposal of Fixed Assets

Depreciation is part of the original cost of a fixed asset consumed during its period if use by the
business.
Depreciation is an “EXPENSE”. It will have to be charged to the Profit and Loss Account in the same
way as expenses such as wages, rent, insurance etc. and will therefore reduce Profit.

Causes of Depreciation
Fixed assets such as machinery, motor vehicle, plant and equipment etc. tend to fall in value
(depreciate) for various reasons. These are given below:

Physical depreciation
1. Wear and tear
2. Erosion, rust, rot and decay – Land may be eroded or wasted away by the action of wind rain,
sun or the other elements of nature. Similarly, the metals in motor vehicles or machinery will
rust away. Wood will rot eventually. Decay is process which be present to the elements of
nature and lack of proper attention.
Economic factors
Economic factors may be said to the reasons for an asset being put out of use even though it is in good
physical condition. The two main factors are usually obsolescence and inadequacy.
1. Obsolescence: This occurs when an asset becomes out of date due to advanced technology or
a change in processes. For example, in the car industry much of the assembly work is now
done by robots.

2. Inadequacy: This arises when an asset is no longer used because of the growth and change in
the size of the business due to new regulations.

3. Time factor: There are some assets that have a legal life fixed in terms of years. E.g. lease.

4. Depletion: There are some assets are of a wasting nature such as the extraction of raw
materials from mines or quarries or oil from wells. To provide for the consumption of an asset
of a wasting character is called provision for depletion.

Methods of calculating depreciation charges


The two main methods in use for calculating depreciation charges are:
1. Straight Line method
2. Reducing balance method or Diminishing Balance method
Straight line method
The method involves
1. Cost price of an asset
2. Estimated years of its use
3. Expected disposal value
𝐶𝑜𝑠𝑡 𝑝𝑟𝑖𝑐𝑒 − 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑐ℎ𝑎𝑟𝑔𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑜𝑓 𝑢𝑠𝑒

e.g. If a car was purchased for $22000 and the business decided to keep it for four years and then sell
it for $2000, the depreciation to be charged would be:
22000−2000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑐ℎ𝑎𝑟𝑔𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = = $5000 depreciation per year
4

Reducing Balance Method


Depreciation to be charged involves deciding on a percentage amount to be used each year. This
percentage is then deducted from the cost price for the first year and in subsequent years from the
reducing balances.
*Reducing Balance Method is a depreciation calculation which is based on the net book value of the
asset brought forward from the previous year. Therefore, the depreciation charge falls each year.
*Net Book Value (NBV): The cost of the asset less depreciation charges to date, also known as “book
value”.
e.g.
If a machine is brought for $10,000 and depreciation is to be charged at 20%, the calculations for the
first three years would be as follows:
$
Cost 10,000
First year: Depreciation(20% of $10000) (2000)
NBV 8000
Second Year: Depreciation (20% of $8000) (1600)
NBV 6400
Third year: Depreciation (20% of $6400) (1280)
Net book value at the end of the third year 5120
DISPOSAL OF A FIXED ASSET
Recording purchase of a Fixed Asset
Debit – Asset Account
Credit – Bank Account (if paid)

Recording Depreciation Charges


Debit – Profit and Loss account
Credit – Provision for depreciation account
Or
Debit - Depreciation
Credit – Provision for depreciation account

Disposal account
Asset xxx Provision for depreciation xxx

Cash

I/S (profit) xxx I/S (loss) xxx


________ ________
________ ________
Questions:
(Depreciation)
1) A motorcycle manufacturer has bought a machine for $16000 with an expected life of 4 years and a
disposal value of $1000. The owner asks for a comparison of the depreciation to be charged using
both methods, with a percentage for 50% to be used for the reducing balance method.
(Requirements: Calculate the depreciation charge under both straight line method and reducing
balance method. Show your workings.
2) A machine cost $75000 and will be kept for 4 years when it will be traded in at an estimated value
of $30720. Show the calculations of the figures for depreciation for each of the 4 years using the:
a) Straight line method
b) reducing (diminishing) balance method, using a depreciation date of 20%.

3) A motor vehicle costs $19200 and will be kept for four years, and then sold for an estimated value
of $1200. Calculate the depreciation for each year using the:
a) reducing (diminishing) balance method, using a depreciation rate of 50%
b) straight line method

4) Computer equipment cost $4600, It will be kept for 4 years, and then sold at an estimated figure of
$600. Show the calculations of the figures for depreciation (to the nearest pound) for each year using
the:
a) straight line method
b) reducing balance method, using a depreciation rate of 25%

5) A dumper is bought for $18000. It will last for 3 years and will then be sold back to the supplier for
$3000. Show the depreciation calculations for each year using the:
a) reducing balance method with a rate of 40%
b) straight line method
Questions: Disposal
1) Mr. David purchased a car on 1st January, 2015 at a price of $10500. The Scrap value of the car was
$500 and the estimated useful life was 10 years. He sold the asset on 31st December, 2017 i.e. after 3
years at a price of $9000. What was the amount charged on the Income statement?
(Hint: Create a disposal account following the format of the disposal account and calculate the profit
or loss. For depreciation calculation use Straight Line Method)

2) Mr. Jon purchased a car on 1st January, 2015 at a price of $10500. The Scrap value of the car was
$500 and the estimated useful life was 10 years. He sold the asset on 31st December, 2017 i.e. after 3
years at a price of $9500. What was the amount charged on the Income statement?
(Hint: Create a disposal account following the format of the disposal account and calculate the profit
or loss. For depreciation calculation use Straight Line Method)
3) Andrew purchased a car on 1st January, 2013 at a price of $20,500. The Scrap value of the car was
$500 and the estimated useful life was 15 years. He sold the asset on 31st December, 2017 i.e. after 5
years at a price of $15,000. What was the amount charged on the Income statement?
(Hint: Create a disposal account following the format of the disposal account and calculate the profit
or loss. For depreciation calculation use Straight Line Method)

4) kate purchased a car on 1st January, 2013 at a price of $10000. The Scrap value of the car was nill
and the estimated useful life was 10 years. He sold the asset on 31st December, 2017 i.e. after 5 years
at a price of $7000.For depreciation, reducing balance method was used with a depreciation rate of
50%. What was the amount charged on the Income statement?
(Hint: Create a disposal account following the format of the disposal account and calculate the profit
or loss. For depreciation calculation use Reducing Balance Method)
5) kevin purchased a car on 1st January, 2013 at a price of $20,000. The Scrap value of the car was zero
(nill) and the estimated useful life was 10 years. He sold the asset on 31st December, 2017 i.e. after 5
years at a price of $7000.For depreciation, reducing balance method was used with a depreciation
rate of 30%. What was the amount charged on the Income statement?
(Hint: Create a disposal account following the format of the disposal account and calculate the profit
or loss. For depreciation calculation use Reducing Balance Method)