Accounting for depreciation and disposal of non-current assets
Building on the concept of the matching principle, depreciation ensures that the cost of using the asset is matched against the revenue it helps generate in each financial year. Without depreciation, profits would be overstated in early years and understated in later years.
Why do we account for depreciation?
- To determine true profit: It ensures the income statement reflects the actual cost of using the asset.
- To show accurate net book value (NBV): The balance sheet must show the asset at its current estimated value, not its original purchase price.
- To provide funds for replacement: By charging depreciation, the business sets aside money to replace the asset when it wears out.
Net Book Value (also called Carrying Amount) is the value of a non-current asset at a specific date.
\text{NBV} = \text{Cost} - \text{Accumulated Depreciation}
Where:
- Cost: The original purchase price plus any costs to bring the asset to its intended location and condition.
- Accumulated Depreciation: The total depreciation charged on the asset from the date of purchase to the current date.
Depreciation is charged at a constant amount each year.
\text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life (years)}}
Note: If residual value is not given, it is assumed to be zero.
Depreciation is charged as a percentage of the Net Book Value at the start of the year. The charge decreases each year.
\text{Annual Depreciation} = \text{NBV at start of year} \times \text{Percentage Rate}
Used for assets that are numerous, low-cost, and difficult to track individually (e.g., loose tools). Depreciation is the difference between the opening value and closing value of the asset pool.
\text{Depreciation Charge} = \text{Opening Value} + \text{Additions} - \text{Closing Value}
| Method | Appropriate Asset Type & Reason |
|---|---|
| Straight-Line | Buildings, Fixtures & Fittings. These assets lose value evenly over time. The cost is used up at a constant rate. |
| Reducing Balance | Motor Vehicles, IT Equipment. These assets lose more value in the early years (higher maintenance costs and faster obsolescence). This method matches higher expenses with earlier revenue generation. |
| Revaluation | Loose Tools, Small Items. It is impractical to track each item individually. The total value is revalued at year-end. |
Straight-Line Calculation:
\text{Annual Depreciation} = \frac{20,000 - 4,000}{4} = \frac{16,000}{4} = 4,000 \text{ per year}</span></p> <p><strong>Reducing Balance Calculation (25% rate):</strong></p> <ul> <li>Year 1:20,000 \times 25% = 5,000 (NBV becomes 15,000)
Note: In the reducing balance method, you always apply the percentage to the remaining book value, not the original cost.
Correction: Always use the Net Book Value at the start of the year. For example, if Year 1 NBV is 15,000, Year 2 depreciation is 25% of 15,000, not 25% of 20,000.
Error: Ignoring the residual value in straight-line calculations when it is provided.
Correction: Subtract the residual value from the cost before dividing by the useful life. Depreciation stops once the NBV equals the residual value.
Correct Entry:
- Debit: Income Statement (Depreciation Expense)
- Credit: Provision for Depreciation of [Asset Name]
Why examiners accept this: The debit increases expenses in the income statement, reducing profit. The credit increases the contra-asset account (Provision), which reduces the NBV on the balance sheet without altering the original cost record.
Example Phrase: 'Dr Depreciation Expense 4,000; Cr Provision for Depreciation of Motor Vehicles4,000.'
When an asset is sold, three things must happen:
- Remove the Cost: The original cost is removed from the Non-current Asset account.
- Remove Accumulated Depreciation: The total provision for depreciation related to that specific asset is removed from the Provision account.
- Record Proceeds: The cash received (Bank) is recorded.
- Calculate Profit or Loss: The difference between the NBV and the Proceeds is the profit or loss.
Profit or Loss Calculation:
\text{Profit/Loss} = \text{Proceeds from Sale} - \text{Net Book Value at Date of Sale}
- If Proceeds > NBV = Profit on Disposal (Credit balance in Disposal Account)
- If Proceeds < NBV = Loss on Disposal (Debit balance in Disposal Account)
Structure:
- Debit Side: Cost of Asset, Accumulated Depreciation (to remove them), Profit on Disposal (balancing figure).
- Credit Side: Proceeds from Sale (Bank), Loss on Disposal (balancing figure).
Note: The final balance is transferred to the Income Statement.
Step 2: Calculate Profit/Loss
\text{Profit} = 9,500 - 9,000 = 500</span></p> <p><strong>Step 3: Prepare the Disposal Account</strong></p> <p>| <strong>Motor Vehicles Disposal Account</strong> | Debit () | Credit ($) |
| :--- | :--- | :--- |
| Motor Vehicles (Cost) | 16,000 | Bank (Proceeds) | 9,500 |
| Provision for Depreciation | 7,000 | Income Statement (Profit) | 500 |
| Total | 23,000 | Total | 23,000 |
Note: The Cost and Provision are debited to remove them from the books. The Bank is credited because cash comes in. The Profit balances the account.
Correction: You must remove both the Cost and the Accumulated Depreciation to clear the asset from the books. If you only remove the cost, the NBV will be wrong.
Error: Confusing Profit on Disposal with Revenue.
Correction: Profit on disposal is a non-operating income. It goes to the Income Statement but is not part of gross profit or operating profit calculations.
Correct Usage:
- Motor Vehicles Account: Debit with Cost (16,000) on disposal side to remove it. Balance c/d is the remaining cost of other assets.
- Provision for Depreciation Account: Credit with Accumulated Depreciation (7,000) on disposal side to remove it. Balance c/d is the total provision for remaining assets.
- Disposal Account: Ensure the balancing figure (Profit/Loss) is labeled correctly as 'Income Statement' or 'Profit on Disposal'.
Why examiners accept this: This clearly demonstrates the removal of the asset's historical cost and accumulated depreciation, isolating the gain/loss for the income statement. Use exact account titles like 'Motor Vehicles' and 'Provision for Depreciation of Motor Vehicles'.