DEPRECIATION OF FIXED ASSETS

Introduction
Depreciation refers to the loss of value of fixed assets over a given period of
time. It is the wear and tear of assets as they age. The loss of value of
assets is an expense to the business which is shown in the profit and loss
account.

Causes of Depreciation
A number of factors contribute to depreciation of fixed assets. These factors
include:-

1. Wear and Tear

As an asset grows old, it wears out with time due to constant use. The
value of such an asset diminishes. The cost of repairs and maintenance
rises as a firm tries to keep the asset in use. Tangible assets like plant &
machinery motor vehicle etc. fall in this category.
2. Effusion of Time
Asset value diminishes due to passage of time even when the asset is not
being used. Intangible assets like copyrights, patent rights and leases
will decrease in values as time elapse.
3. Exhaustion
Some assets may lose value due to exhaustion. Assets like mines and
quarries, oil wells and forests may end up getting completely exhausted,
such assets and said to be depleted when exhausted.
4. Perishability
Some assets have a short life span. However this condition is most
applicable to inventory than fixed assets.
5. Obsolescence
This is the process in which an asset becomes obsolete or outdated.
There are two main types of obsolescence.

(a) Technical Obsolescence

This is where an asset becomes outdated as a result of introduction
of new better performing models. An example is the computers where
the old versions become outdated as a result of advancement in
technology.
(b) Market Obsolescence
This is where the goods produced by the asset become old fashioned
and no longer required in the market. For example video cassettes
are now outdated replaced by DVDs.

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6. Accident
An asset may reduce in value because of meeting of an accident. An
example is motor vehicles.

Reasons for Providing for Depreciation

1. To derive the correct profit or loss since depreciation amount is an
expense to the business to the business
2. It helps in determining the correct value of fixed assets shown in the
statement of financial position /statement of financial position.
Depreciation reduces the value of fixed assets.
3. It helps a business make provision of funds to replace the aged assets.
4. Facilitates efficiency in division making especially in determining which
assets to be replaced and at what time.
5. By computing depreciation it is possible to determine profit or loss on
disposal of fixed assets.

Appreciation of Fixed Assets

This is the reverse of depreciations some assets e.g. land increases in value
as opposed to loss of value.

Methods of Computing Depreciation

There are several methods used to provide for depreciation. These include:-
1. Straight line Method/Depreciation on Cost Method /Fixed
Installment Method
Under this method the same amount of depreciation is charged over the
assets life. Depreciation is computed as follows.

Cost of asset
This is the original price for which the asset was purchased

Residue / Scrap Value

This is the estimated value of the asset at the end of its useful life.
Normally the scrap value is assumed to be zero unless otherwise stated.

Estimated Useful Life

Just like a human being, an asset has a life within which it remains
useful to the business. The management will determine the estimated
useful life of an asset.

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Illustration 1
Achievers Limited purchased a motor vehicle on 1/1/2018 at a cost of
KES 1,000,000. The useful life of the asset is 5years with a residue value
of KES 200,000.

Required
Compute depreciation amount for 2018, 2019, 2020 and 2022

Solution

2018
Depreciation = (1,000,000 – 200,000)/5
= KES 160,000
2019
Depreciation = (1,000,000 – 200,000)/5
= KES 160,000
2020
Depreciation = (1,000,000 – 200,000)/5
= KES 160,000
2021
Depreciation = (1,000,000 – 200,000)
= KES 160,000
2022
Depreciation = (1,000,000 – 200,000)/5
= KES 160,000
NOTE
Depreciation is equal in all the 5years

Illustration 2:
Meru Ltd purchased office furniture on 1/1/2015 at a cost of KES
100,000. It is the policy of the company to depreciate assets at 20% p.a.
with no residue value.

Required
Compute depreciation for the years, 2015, 2016, 2017, 2018, 2019 and
2020.

Solution
Since the useful life is not given, the depreciation percentage is applied

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 2015
Depreciation = 20% x 100,000
= 20,000

2016
Depreciation = 20% x 100,000
= 20,000

2017
Depreciation = 20% x 100,000
= 20,000

2018
Depreciation = 20% x 100,000
= 20,000

2019
Depreciation = 20% x 100,000
= 20,000

2020
No depreciation is charged since the asset has exhausted its useful life of
5 years. The asset is losing value at 20% p.a. Therefore after 5years the
asset will be fully depreciated.

Advantages of Straight line Method

1. Simple to understand
2. Simple to apply
3. It is commonly applied since it reduces the value of the asset to zero at
the end of its useful life
4. The method is suitable for assets with fixed life like furniture
5. The method is also suitable for assets with fixed life like furniture

Disadvantages
1. Difficult to compute when additional assets are acquired
2. It does not take into consideration the effective utilization of the asset
since depreciation remains constant.
3. The method tends to report on increasing rate of return on investment in
asset since the net balance of the asset is taken.

2. Reducing Balance Method/ Diminishing balance /Depreciation on

Written Down Value (WDV)

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In this method the amount, depreciation reduces with time a higher amount
is charged in the first years which continue to diminish as the asset ages.

Advantages
1. The method gives a fair charge of depreciation in each financial year.
2. Fresh calculation are not required when additions are made
3. This is the applicable method recognized by tax authorities in Kenya
(KRA) when computing capital deduction in taxation.

Disadvantages
1. Original asset cost is lost with time
2. The method do not consider an asset as an investment
3. Difficult to determine the rate of depreciation
4. It is not simple to apply

Illustration 3
Mr. Mworia purchased a motor vehicle at a cost of KES1, 200,000 on 1 st Jan
2015. The asset has no residue value.

Required
(a) Compute depreciation for 2015, 2016, 2017 and 2018 using straight line
method and reducing balance method. The rate of depreciation is 25%
per annum.
(b) Show the value of the assets in each of the years.

Solution

Straight Line Method

2015 Depreciation 25% x 1,200,000
= 300,000
Value of the asset 1,200,000 – 300,000
= 900,000

NOTE:
The value of the asset has reduced due to deprecation

2016
Depreciation 25% x 900,000
= 225,000
Value of MV = 900,000 – 300,000
= 600,000

2017

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Depreciation 25% x 1,200,000
= 300,000
Value of MV = 600,000 – 300,000
= 431,250

2018
Depreciation 25% x 1,200,000
= 300,000
Value of MV = 300,000 – 300,000
=0
Note
The asset will have a zero balance in 2018 since it is fully depreciated

Reducing Balance Method

2015
Depreciation 25% x 1,200,000
= 300,000
Value of MV = 1,200,000 = 900,000

2016
Depreciation 25% x 900,000
= 225,000
Value of MV = 900,000 - 225,000
= 675,000
2017
Depreciation 25% x 675,000
= 168,750
Value of MV = 675,000 – 168,750
= 506,250
2018
Depreciation 25% x 506,250
= 126,563
Value of MV = 506,250– 126, 562.5
= 379,687.5
NOTE
The amount of depreciation for the following year is based on the closing
balance of the asset in the previous year. The closing balance in the
previous year is called written down value (WDV).

3. Revaluation Method
In this method, depreciation is the difference between the opening and the
closing balance of the asset. This method is best applied to depreciate loose
tools kitchen utensils and other simple equipment.

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Depreciation = Opening value balance – Closing value balance
Illustration 4
The following information is provided
Loose tools 1/1/2017 KES 800,000
Loose tools 31/12/2017 KES 780,000

Required
Compute the depreciation amount chargeable in 2017
Depreciation = opening balance – closing balance
= 800,000 – 750,000
= 50,000

4. Sum of year’s Digits Method / Rule 78

Under this method the useful life of the asset is written in a descending
order to a maximum of 12 years and total sum is obtained. The sum of 12
years amounts to 78; hence Rule 78. To determine the depreciation amount
in year one take the 1st digit over the total multiplied by the cost of the asset.
Illustration 5
Stephen Gichuki purchased a computer on 1/1/2017 at a cost of KES
300,000. The estimated useful life of the compute is 5years.
Required:
Compute depreciation for the years 2017, 2018 and 2019 using sum of the
digits method.

Solution
Useful life is 5years. The digits are written in a descending order as follows
5 + 4 + 3 + 2 +1 = 15
2017
Depreciation 5/15 x 300,000 = 100,000
2018
Depreciation 4/15 x 300,000 = 80,000
2019
Depreciation 3/15 x 300,000 = 60,000

NOTE
A higher amount of depreciation is charged in the 1st year which continues
to diminish over time.

Ledger Accounts in Relation to Depreciation

Depreciation accounting follows the following double entry.

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1. Asset Account
This is opened to show the value /cost of the asset purchased or sold. Asset
purchased is debited while asset sold is credited. The account is maintained
at original cost basis.
Format
Asset A/C
Year 1 KES Year 1 KES
1/1/Y1 Bank (asset bought) xxx 31/12/Y1 Bal. c/d xxx
xxx xxx
Year 2 Year 2
1/1/Y2 Bal. b/f xxx
Disposed
Bank (asset bought) xx 30/6/Y2 xxx
(asset sold)
31/12/Y2 Bal c/d xxx
xxx xxx
Year 3 Year 3
1/1/Y3 Bal. b/f xxx

NOTE:
The asset account is maintained on cost basis. When an asset is disposed,
the value of disposal in the asset account is the original cost and not book
value or cash/bank received.

2. Provision for Depreciation Account

This account is maintained to show cumulative depreciation of the asset
over the years.

Format
Provision for Depreciation A/C
Year 1 Year 1
P/L (Depreciation
31/12/Y1 Bal. c/d Xxx 1/1/Y1 charge for the xxx
year)
Xxx xxx
Year 2 Year 2
30/06/Y2 Disposal Xxx 30/6/Y2 Bal. b/f xxx
(accumulated
depreciation
of disposed P&L (Dep. Charge
31/12/Y2 xxx
asset since for the year)
date of
acquisition)

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31/12/Y2 Bal. c/d Xxx
Xxx xxx
Year 3 Year 3
1/1/Y3 Bal. b/d xxx

3. Disposal Account
This account is maintained to compute the profit or loss in disposal of fixed
assets. Double entry in this account is derived from the above two
accounts. The balancing figure in this account represents profit or loss on
disposal where is then transferred to P&L account.

Format
Disposal account
30/06/Y2 Asset xxx 30/06/Y2 Provision for xxx
account( c depreciation
ost of the account(Accumulated
disposed depreciation of the
asset) sold asset)
Bank (sale proceeds xxx
of the disposed asset)
P&L xxx P&L (balancing xxx
(balancing figure) – Loss on
figure) – disposal
Profit on
disposal
xxx xxx

Notes
1. The balancing figure in this account is transferred to the profit and
loss account
2. Where the balancing figure is in the debit side, this indicates a profit
on disposal of the fixed asset.
3. Where the balancing figure is in the credit side, this indicates a loss
on disposal of the fixed asset.

Illustration 1
Meru Nissan Sacco acquired and disposed vehicles as follows:

Vehicle Date Purchased Cost (KES) Date Sold Sale proceeds

(KES)

KCA 1/12/2016 1,000,000 1/1/2018 800,000

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KCB 1/7/2016 1,200,000 1/10/2018 700,000

KCC 1/1/2017 2,000.000 - -

KCD 1/9/2017 2,500,000 - -

KCE 1/1/2018 3,000,000 - -

The policy of the management on depreciation is as follows:-

1. Depreciation is on straight line method at 10% per annum
2. Full year depreciation is provided in the year of purchase with no
depreciation in the year disposal.
3. The motor vehicles have no residue value.

Required:
(a) Motor vehicle account
(b) Provision for depreciation account
(c) Disposal account
(d) Profit and loss extract
(e) Statement of financial position extract
Illustration 2
Arising from illustration 1, Meru Nissan Sacco acquired and disposed
vehicles as follows:

Vehicle Date Purchased Cost Date Sold Sale proceeds (KES)

(KES)
KCA 1/12/016 1,000,000 1/1/2018 800,000
KCB 1/7/2016 1,200,000 1/10/2018 700,000
KCC 1/1/2017 2,000.000 - -
KCD 1/9/2017 2,500,000 - -
KCE 1/1/2018 3,000,000 - -

The policy of the management on depreciation is as follows:-

1. Depreciation is computed using reducing balance method at 10% per
annum.
2. Full year depreciation is provided in the year of purchase with no
depreciation in the year disposal.
3. The motor vehicles have no residue value.

Required:
(a) Motor vehicle account
(b) Provision for depreciation account
(c) Disposal account

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(d) Profit and loss extract
(e) Statement of financial position extract

Arising from illustration 2, Meru Nissan Sacco acquired and disposed

vehicles as follows:

Cost
Vehicle Date Purchased Date Sold Sale proceeds (KES)
(KES)
KCA 1/1/2016 1,000,000 1/1/2018 800,000
1/10/201
KCB 1/7/2016 1,200,000 700,000
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KCC 1/1/2017 2,000,000 - -
KCD 1/9/2017 2,500,000 - -
KCE 1/1/2018 3,000,000 - -

The policy of the management on depreciation is as follows:-

1. Depreciation is on straight line method at 10% per annum on pro-rata
basis
2. Full year depreciation is provided in the year of purchase with no
depreciation in the year disposal.
3. The motor vehicles have no residue value.

Required:
(a) Motor vehicle account
(b) Provision for depreciation account
(c) Disposal account

Pro-rata Basis
When depreciation is computed on pro-rata basis it means that the dates of
acquisition and disposal are taken into consideration for example if an asset
is acquired on July 31, and the year is ending in December, 6 month’s
depreciation is computed and not full year depreciation. Effectively,
provision for depreciation amount transferable to disposals account covers
the date of acquisition through the date of disposal, for purposes of
determining profit or loss on disposal.
Trade in
This is where a person gives out an old asset for a new asset then pays extra
amount of money. It is also called part exchange of assets. The end result
is that one asset is disposed at some value and another one is purchased at
the old asset’s valuation plus the extra amount paid.

Illustration 9

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Mr. Wanjohi traded in his old car for a new one with CMC motors on April
30, 2018. The new car was to cost at KES 1,000,000 while the old car was
valued at KES 300,000. The balance was settled by cheque.

Required:
Show the asset A/C to record the above transaction given that Mr. Wanjohi
writes his books to June 30.

Solution
Motor Vehicle A/C
2018 KES ‘000 2018 KES ‘000
April Bank a/c (amount Dec
700 Bal. c/d 1,000
30 paid by cheque) 31
April Disposal a/c (value
300
30 of old vehicle)
1,000 1,000

Note: As usual, the disposal value of KES 300,000 (treated as disposal

proceeds) is credited to the disposal account to complete the double entry.
Since the asset cost and the accumulated depreciation provision have
already been transferred from the Motor vehicle account and the provision
for depreciation account respectively to the disposal account, the balance in
the disposal account represents profit or loss on disposal to be transferred
to profit and loss account.

Insurance Compensation Received

In some cases an insured asset may be involved in an accident such that it
is written off. The insurance company may compensate the insured fully or
partly. The amount received from the insurance company is treated as sale
proceeds in the disposal account as the asset is deemed to have been
disposed of.
Trade in
This is where a person gives out an old asset for a new asset then pays extra
amount of money. It is also called part exchange of assets. The end result
is that one asset is disposed at some value and another one is purchased at
the old asset’s valuation plus the extra amount paid.

Illustration 9
Mr. Wanjohi traded in his old car for a new one with CMC motors on April
30, 2018. The new car was to cost at KES 1,000,000 while the old car was
valued at KES 300,000. The balance was settled by cheque.

Required:

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Show the asset A/C to record the above transaction given that Mr. Wanjohi
writes his books to June 30.

Solution
Motor Vehicle A/C
2018 KES ‘000 2018 KES ‘000
April Bank a/c (amount Dec
700 Bal. c/d 1,000
30 paid by cheque) 31
April Disposal a/c (value
300
30 of old vehicle)
1,000 1,000

Note: As usual, the disposal value of KES 300,000 (treated as disposal

proceeds) is credited to the disposal account to complete the double entry.
Since the asset cost and the accumulated depreciation provision have
already been transferred from the Motor vehicle account and the provision
for depreciation account respectively to the disposal account, the balance in
the disposal account represents profit or loss on disposal to be transferred
to profit and loss account.

Insurance Compensation Received

In some cases an insured asset may be involved in an accident such that it
is written off. The insurance company may compensate the insured fully or
partly. The amount received from the insurance company is treated as sale
proceeds in the disposal account as the asset is deemed to have been
disposed of.

Change in Depreciation Policy

The management may decide to change the method of depreciation or the
rate of depreciation to reflect market estimate rates. Evidently, the methods
used in illustrations 1 – 3 have resulted in losses on disposal; suggesting
that possibly, the 10% rate is low. Change in depreciation policy is done to
enable the accounts to reflect accurate estimates of depreciation. An
adjustment is made to adjust for under or over depreciation assets in the
previous years which in turn affects the profits reported

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