Provision for Depreciation

How Non-current assets should be valued?

Non-current assets should be valued at cost or Net Book value.
Net book value = Cost – Accumulated depreciation
Cost- means the amount paid to purchase the asset plus any capital expenditure
in respect to the asset value.
Accumulated depreciation – it is the sum of all depreciation incurred on the
assets
What is depreciation?
It is the cost of using a non-current asset over its estimated. It is also referred as
the loss in value of a non-current assets.
Why a business must depreciate its non-current asset?
It is an application of prudence concept, Accruals and matching concept and
consistency concept.
Prudence concept states that a business must not overstate its assets and profit.
However, it should make provision for losses (anticipate losses). In another
words, assets should reflect their fair value (it should be relatively same to the
market, but is not the market price)
Accruals and matching concept- means the cost of using the assets should be
charged against the revenue earned for each year.
Consistency- means the same method of depreciation should be used for the
same assets over its estimated life.
Causes of depreciation:
 Wear and tear
 Obsolescence
 Passage of time
 Change in technology
 Rust and rot
To calculate depreciation the following information should be available:
1. Cost
2. Rate of depreciation
3. Method of depreciation
4. Basis of depreciation
 Basis of depreciation
There are 2 bases of depreciation:
1. Full year basis
2. From date of purchase
Full year basis- means the asset will be depreciated irrespective of the date
of purchase. Usually for 12 months
From date of purchase- it means the asset will be depreciated only for
period it had been purchased and used for a given financial year.
For example, let say the business prepare its financial statement for the year
ended 31 Dec 2005 and has purchased Motor car on 1 September 2005.
Therefore depreciation will be calculated only for 1 September 2005 to 31
December 2005.

Method of depreciation:
There are 3 methods of depreciation:
 Straight line
 Reducing (diminishing) balance
 Revaluation
Double Entry for depreciation charged for the year
Dr- Income Statement Cr Provision for depreciation
Straight line method
It means a fixed rate of depreciation is charged on cost. This process reduces
the cost of an asset by an equal amount each year over the estimated useful
life of the asset.

Formula:
Advantages
1. It is easy to use
2. It is easy to calculate and understand
3. Each year the same amount is taken as depreciation in income statement,
4. Does not reduce the asset value drastically

Disadvantages
1. It is not appropriate for all type assets.
2. It should not be used when the useful life of an asset is unpredictable.

Reducing Balance (diminishing)

It means to charge a fixed rate of depreciation on the net book value (written
down value) of the asset. It is a method use for asset that lose a high portion
of their value at start of their early life (because of technology, for example
computer, motor car etc….)

Formula
The main advantages of reducing balance method of depreciation are listed
below
1. Reducing balance method is easy to understand and simple to implement.
2. Reducing balance method equalizes the yearly burden on profit and loss
account in respect of both depreciation and repairs. The amount of
depreciation goes on decreasing while the expenses on repairs goes on
increasing, so that the total charge against revenue over different years
remains more or less the same.
3. Reducing balance method matches the cost and revenue of the business.
The greater amount of depreciation provided in initial years is matched
against the higher amount of revenue generated by increased production
by the use of new asset.

Disadvantages Of Reducing Balance Method Of Depreciation

The main demerits of reducing balance method are as follows:

1. Reducing balance method charges heavy amount of depreciation in
earlier years.
2. The formula to obtain rate of depreciation can be applied only when there
is residual value of the asset.

Revaluation method
Revaluation depreciation method is usually used to calculate depreciation of
assets where, there are numerous small identifiable assets of low value but
nevertheless of lasting value such as loose tools.
Under revaluation depreciation method, the asset is valued at the end of each
financial period and this revalued amount is compared with the value in the
beginning of the period. The reduction in the value is recorded as
depreciation for that year.

Formula: