Depreciation

-is an estimate of the loss in value of a non-current asset over its expected working life.

Causes of Depreciation
-Physical deterioration/wear and tear
-obsolescence/economic reasons/Obsolete
-passage of time
-Depletion-not a cause for a motor vehicle
-Technological advance/technological innovation-mainly a cause for a computer

Reasons why depreciation is charged

-To account for cost consumed / used during the financial year
-To charge a share of the cost to the income statement for the year
-To reduce the book value of non-current assets in the balance sheet
-To spread the cost over its useful economic life
-To comply with accounting principles and concepts, e.g. prudence, matching.
- Wear and tear, passage of time, obsolescence and depletion.

Accounting concepts applied when depreciation is charged in the accounting year

i. Matching– The cost of using the asset is matched against the income earned by the
asset each year over the life of the asset.
ii. Prudence – Spreading the cost of an asset over its useful life avoids overstating annual
profits / value of non-current assets.
iii. Consistency – using the same depreciation method each year to enable valid
comparison.
iv. Going concern- Continuity of the business is assumed for an indefinite period and
there is no intention close down the business.

Why depreciation is an application of the matching principle

-Matching the cost of non-current asset to the income earned in a given financial period.
-The cost of the non-current asset is spread over the life of the asset.
-An estimated cost of the non-current asset is included in the income statement as an expense
during the financial year over its useful life.
-Non-current assets are shown at their book value in the statement of financial position and
not their expected sale values.

Methods of calculating depreciation

1. Straight-line method
-The same percentage/ proportion of cost less estimated residual value is charged annually as
depreciation.
-It assumes that the asset depreciates by the same amount each year over its working life.

Calculation of depreciation for the year/Annual depreciation

%
Annual depreciation= x Cost of the non-current asset at the beginning of the year
100

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When a non-current asset was sold and another was bought
$
Cost of the asset at the start of the year xxx
Less Cost of the asset sold during the year (xxx)
xxx
Depreciation for the year (% x xxx) xxx
Add Depreciation of the non-current asset that was bought (% x Cost) xxx
Total Depreciation xxx

2. Reducing balance method

-The same percentage/proportion of net book value is charged annually as depreciation.
- It assumes that a non-current asset loses more value in the earlier years of its life and less
value in the later years.

Calculation of depreciation for the year/Annual depreciation

No assets purchased or sold during the year

%
Annual depreciation= x Net Book Value at the start of the year
100

Net Book Value at the start of the year=Cost at the start of the year-Accumulated
depreciation at start of the year

When a non-current asset was sold and another was bought

$
Cost (Cost at the start-Cost of the asset sold) xxx
Depreciation (Acc deprec at the start- Acc Deprec of the asset sold) (xxx)
Net Book Value at the start of the year xxx

Depreciation for the year (%x Net Book Value at the start of the year) xxx
¿
Depreciation of the asset bought (% x cost x months ¿ be used 12 ) xxx
Annual Depreciation xxx

Alternative method

Cost ($) Accumulated Net Book Depreciation for

Depreciation ($) Value(NBV) the year ($)
Values at the start xxx xxx
Non-current asset sold (xxx) (xxx)
xxx xxx xx X % xxx
Non-current asset bought xxx xx X % xxx
Total xxx xxx

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3. Revaluation Method
$
Cost of the asset at the start of the year xxx
Add Cost of the asset bought during the year xxx
xxx
Less Cost of the asset sold during the year (xxx)
xxx
Annual Depreciation (Valuation amount-xxx) xxx
Valuation of the assets at the end of the year xxx

How the annual depreciation would be calculated using the revaluation method.
-At the end of each year the closing valuation is compared with the opening valuation.
-The difference represents the depreciation for the year.

Analysing methods of depreciation

Advantages of using the straight-line method to depreciate non-current assets

-The business will get equal usage from the non-current asset each year.
-Apportions an equal amount of depreciation to each year of ownership- There is an equal
charge for depreciation in each year for equal benefit received.
-More appropriate to fixed assets that depreciate by an equal amount each year

Advantages of using the reducing balance method to depreciate the non-current asset
-The net book value of the non-current asset will be closer/ nearer to the market value than
the straight line method.
-The profits will be more accurate.
- Non-current asset such as motor vehicles depreciate more in the early years

Advantages of the revaluation method of depreciation

-A more realistic depreciation expense used is charged to income statement.
-Value in the statement of financial position is realistic market value
-It is simple and straight forward to use
-Avoids the need for keeping detailed records.

The most appropriate method of depreciation for different non-current assets

Buildings/Office furniture
-Straight-line method
Reason
-Building/Office furniture is used consistently over a long period so they lose value evenly
over its life.
-Buildings tend to lose value more consistently over their lifetime.

Plant and machinery

-Reducing balance method
Reasons

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-Machinery loses a high proportion of its value in the early years
-Low maintenance costs in early years, higher in later years
-Changes in technology may outdate the machinery
NB: Plant and machinery often loses more value in the earlier years of its life due to usage
and maintenance costs may be higher in the later years.

Loose tools
-Revaluation method
Reasons
-Small items value varies each year and is difficult to measure
-Loose tools are usually represented by a large number of small value items. They are
difficult to track and account for separately.
-Loose tools may or may not remain in the business for more than a year. It is cost-effective
to value them annually.

Computers
-Reducing balance method
Reasons
-Computers lose large value in early years.
-Technical improvements make computers rapidly out of date.

Reasons why Land is not depreciated

-Land does not wear out, so there is no need to match cost with use.
-it is a limited resource with an infinite life
-It can be used for a range of purposes.
-Land may go up in value/Land may gain value.

Reasons why inventory is not depreciated

- It is not a non-current asset so it is bought for resale.
- It is expected to be used in the business within a year so there is no asset to depreciate over
several years.

Ledger accounts and Journal entries of accounts

Ledger accounts and journal entries for the non-current asset

Non-Current Asset account

Date Details Amount Date Details Amount
2016 $ 2016 $
1 Jan Balance b/d xxx 31 Jun Disposal xxx
7 Jul Bank/cash xxx
13 Aug Motor Suppliers xxx 31 Dec Balance c/d xxx
2017 xxx xxx
1 Jan Balance b/d xxx

Jan 7 A non-current asset was bought/ purchased on cheque/cash for $5000.

31 Jan A non-current asset which had been bought for $2000 was sold for $3000.

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 13 Aug A non-current asset was bought on credit for $2500 from Motor Suppliers.

Journal entries for Non-Current asset

Date Details Debit ($) Credit($)

7 Jan Non-current Asset account xxx

Bank/Cash account xxx
(Using the cost of the non-current asset $5000)

31 Jun Non-Current Asset Disposal acc xxx

Non-current Asset account xxx
(Using the cost of the non-current asset sold $3000)
13 Aug xxx
Non-Current Asset account xxx
Moto Suppliers account
(Using the amount the asset was bought for)

Ledger accounts and journal entries for the provision of depreciation

Provision for Depreciation Account

Date Details Amount Date Details Amount
2016 $ 2016 $
31 Jun Disposal xxx 1 Jan Balance b/d xxx
31 Dec Balance c/d xxx 31 Dec Income statement xxx
xxx 2017 xxx
1 Jan Balance b/d xxx

Journal entries for Provision for Depreciation

Date Details Debit ($) Credit($)

31 Jun Provision for Depreciation account xxx

Non-current Asset Disposal xxx

31 Dec Income statement xxx

Provision for Depreciation xxx

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Ledger accounts and journal entries to record the disposal of non-current assets

Non-current Disposal Account

Date Details Amount Date Details Amount
2016 $ 2016 $
31 Jun Non-current asset xxx 31 Jun Provision for Depreciation xxx
31 Jun Income statement* xx 31 Jun Bank*/Cash/Trade receivables* xxx
xxx xxx

Bank*- the amount the non-current asset was sold for.

Income statement*-is the balancing figure. It can be on the credit.
Trade receivable*-when the non-current asset was sold on credit.

Journal entries to record the disposal of non-current assets

Debit ($) Credit($)
Disposal xxx
Non-current Asset xxx
(using cost of the asset that was sold)

Provision for Depreciation xxx

Disposal xxx
(using accumulated Depreciation of the asset that was
sold at the date of sale)

Bank/Cash/Person’s name* xxx

Disposal xxx
(Using the amount the asset was sold for)

Income statement (Loss on Disposal) xxx

Disposal xxx

Disposal xxx
Income statement (Profit on disposal) xxx

*If the non-current asset was sold on credit, Debit the person’s name.

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Calculation of profit/loss on disposal using reducing balance method
The cost, accumulated depreciation and NBV relate to the non-current asset that was sold

Profit/loss on disposal =Sale Price (the amount asset was sold for) - NBV at the date of sale
Positive answer= Profit
Negative answer =Loss

NBV at the date of sale= NBV at the start of the year- accumulated depreciation at the
date of sale

Accumulated depreciation at the date of sale= Accumulated depreciation the start of the
year+ Annual depreciation

%
Annual depreciation= xNBV at start of t h e year
100

NBVat the start of the year= Cost at the start of the year -Accumulated depreciation at the
start of the year

Statement of Financial Position Extract at ......(Date)

Non-current assets Cost Accumulated Net book value
depreciation
$ $ $
Delivery vehicles xxx xx x
Office equipment xxx xx x
xxx xx x

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