Accounting for Depreciation and Disposal of Fixed Assets

Depreciation takes the form of a gradual and continuous decrease in the value of non-

current assets. Depreciation is the systemic allocation of the cost of non-current assets over

their estimated useful life. This is done by recognizing a calculated portion of their costs as

depreciation expense during each accounting period.

Causes of Depreciation

1. Physical factors such as dampness, floods and heat which may reduce the value of non-

current assets as it may cause the non-current assets to decay, rot and rust.

2. Passage of time: this is one of the causes of depreciation as assets such as copyrights;

patents depreciate as a result of time.

3. Wear and tear of non-current assets

4. Obsolescence resulting from changes in government policy, technology etc.

5. Inadequacy: assets may be out of use if the outputs of the firm increase.
 Accounting for Depreciation and Disposal of Fixed Assets… cont’d

In previous slides (last semester), we have looked at how to record for

depreciation in a company’s books of account.

Remember!

Dr Depreciation expense

Cr Accumulated depreciation / Provision for depreciation

Now we look at how to calculate depreciation.

 Accounting for Depreciation and Disposal of Fixed Assets… cont’d

Factors to be considered in the computation of depreciation

1. Historical cost of the non-current assets
2. Method of depreciation
3. Estimated useful life
4. Estimated scrap value

Methods of Depreciation
5. The following are the various methods used in computing for depreciation.
6. Straight line method
7. Reducing balance method
8. Revaluation method
9. Sum of the year digit method
10. Annuity method
11. Production unit method
12. Machine hour rate method
 1. Straight Line Method of Depreciation

This method allows equal amount to be charged as depreciation for each year of
expected useful life of the asset.

Scrap value also known as residual value is the amount the assets can be sold for
at the end of its useful life. If it is not given, it is assumed to be zero.

Worked Example
An equipment cost N3, 000,000 with a useful life of 4 years and it is expected to
generate a residual value of N200, 000. What is the amount of depreciation charge
using the straight line method?
Solution

= N 700,000
2. Reducing Balance Method

This method is also known as diminishing method. Under this method

depreciation expense is calculated as a percentage of net book value of the asset.
This method provides higher depreciation in the first year of an asset useful life
and lower depreciation for each subsequent year. The formula below is used to
calculate the annual depreciation rate.

Where: n= number of years

 Worked Example

Bimbo enterprises purchase a vehicle which cost N2,500,000. The vehicle has a useful life
for 4 years with a residual value of N 1,024,000. Using the reducing balancing method
calculate the depreciation rate.
Solution

depreciation rate= 1- 0.8 = 0.2 or 20%

The annual depreciation will then be calculated as 20% of the net book value
of the asset at the beginning of each period of the asset’s useful life.
3. Revaluation Method
This method involves revaluing the asset at the end of the accounting period as a result
of the nature and cost of the asset. E.g. spanners, livestock, tools etc.
Any reduction in the value of the asset is treated as depreciation.

Worked Example
A set of tools cost N70,000 as at January 1, 2008 with a revalued figure of
N60,000, N70,000 and N77,000 as at 31st December, 2008, 2009 and 2010 respectively.
Between these years new tools that cost N 25,000 and N 20,000 were purchased in 2009
and 2010 respectively.
Required:
Compute the depreciation using revaluation method for year 2008, 2009, and 2010.
Solution

Year Opening Addition Expected Revalued Depreciatio

value closing value Amount n

2008 70,000 - 70,000 60,000 10,000

2009 60,000 25,000 85,000 70,000 15,000

2010 70,000 20,000 90,000 77,000 13,000

 4. Sum of the year digit method
This is also a method where the depreciation rate decline with the years of the asset. Under this
method weight is attached to the useful life of the asset from the last year in ascending order.
Depreciation is determined using the proportion of the year’s weight to the total weight of all
the year’s weights.

Where there is scrap value, it is subtracted from the cost before applying the depreciation rate

This method allows higher depreciation to be charged in the first year and lower depreciation for each
subsequent year.
Worked Example
An equipment cost N3, 000,000 and it is expected useful life is 3 years. Calculate the depreciation to
be charged for each year using sum of the year’s digits method.
Solution
Year Weight Depreciation amount

1 3 3/6 * 3,000,000=1,500,000

2 2 2/6 * 3,000,000= 1,000,000

3 1 1/6 * 3,000,000= 500,000

Total 6 3,000,000
5. Annuity Method

This method adopts the formula of present value of an annuity to determine

depreciation amount. An annuity is the constant return that would be realized annually
by investing a given amount now at a specified rate of interest.
In the annuity method, depreciation is treated as the constant return while the cost of
the asset as the investment. It calculates the constant amount (annual depreciation)
that needs to be set aside each year to equal the book value (cost-scrap) of an asset in
the next n years (life span) given that the asset earns an interest rate of r% compounded
annually.
C = S(1+r)-n + d[

Therefore:

Where:
d= depreciation
c=cost of the asset
s=salvage value
n=number of years
r= interest rate
 Worked Example
Markivs ltd acquire a plant for N100,000. The expected useful life of the asset
after five years is N10,000. The asset is assumed to earn interest of 10% on net
book value.
Required:
Determine the annual depreciation charge using the annuity method?
r= 10%=0.1 c=100,000 s=10,000 n=5

Solution

0.1 x
 6. Production unit method
This is more applicable in a manufacturing firm. Under this method, a machine is
depreciated according to the number of units produced in a year. In production
unit method, higher depreciation is charged when their is higher production and
less is charged when there is low level of production. Depreciation is in N per
unit produced

Worked Example
A machine cost N300,000 with expected production of 100,000 units throughout its
useful life. The machine will generate a scrap value of N 10,000. What is the depreciation
charge per unit of production?
Solution

The implication for this is that depreciation to be charged for each year is a function of
the number of units produced for that period. E.g if 100,000 units were produced in
year 2016, depreciation will be N 2.9 X 100,000= N 290,000.
7. Machine hour method
This is similar to production unit method except that machine hour is used
instead of production units. In such case, the anticipated machine hours is
substituted for production unit. Depreciation is in N per machine hr

Worked Example
A machine cost N 200,000 with expected hours of 20,000 and N5,000 as
residual value. Determine the depreciation rate per hour.
Solution

Depreciation will be based on the actual machine hours used in the year .
 Acquisition and disposal of Non-Current Assets

Depreciation is usually charge (and accounted for) at the end of the financial year. However,
the depreciation charge for the period is assumed to occur evenly throughout the respective
financial period. As seen in previous slides, this doesn’t mean that the same amount is
charged across all the financial periods. That is a function of the chosen method of
depreciation.

The pattern of the annual depreciation charge can be affected when new assets are
acquired and old assets are disposed. These event can also happen either at the beginning,
within or at the end of the year.

When an asset is acquired at the beginning of the year (the earlier part of January, if the
year starts at January), the full depreciation amount is charged. If the asset is bought at the
end (late December), no depreciation is charged. If the asset is bought within the year, the
depreciation charge is pro-rated.
 Disposal of Non-Current Assets

In case of asset disposal, when a disposal occurs, the net book value of the asset to be
disposed is simply deducted from the net book value of the total asset account and debited
to an ‘asset disposal account’ which is an expense account (extraordinary expense) as at
the date of disposal. If depreciation for the year has been charged on assets, then the
depreciation charge should be eliminated from the depreciation expense account and
accumulated depreciation account (or provision for depreciation account). In a case where
the disposal occurs within the period, the pro-rated depreciation charge on the disposed
asset (from beginning of the year to the date of disposal) will be eliminated from the
depreciation expense account and accumulated depreciation account (since the asset that
incurred that depreciation charge no longer exists).

The asset disposal account is a miniature profit or loss account. The proceed from the
disposal is treated as an income on the credit side while the net book value is treated as an
expense on the debit side. The balancing profit or loss is transferred to the income
statement under the other comprehensive income statement.

Dr Asset disposal account with the Net book value of the asset to be disposed (and remove
the net book value from the non-current asset account and its accumulated depreciation).
and
Cr the asset disposal account with the proceed on disposal (and transfer the proceed to the
cash or account receivables a/c). The balance (profit or loss) goes to income statement
 Disposal of Fixed Assets
Assuming an equipment that cost $60,000 and accumulated depreciation of $10,000 is
disposed for $40,000. How would this be recorded.

At the point of decision to sell

$
Cr Non current asset (equipment) 60,000
Dr Accumulated depreciation 10,000
Dr Asset disposal account 50,000

At the point of actual sale

Dr Cash /Account receivable 40,000

Cr Asset disposal 40,000

The balance of the asset disposal account shows the profit on disposal (if credit side is
bigger than debit side) or loss on disposal (if debit side is bigger than credit side).

In this case, we have a profit/loss of 40,000 – 50,000 = -10,000 (loss)