4.2 Accounting for depreciation and disposal of non-current assets
Depreciation
Definition:
Depreciation is an estimate of the loss in value of a non-current asset over its estimated useful life. Estimates must be reasonable and will depend on the type and use made of each non-current asset.
Causes of depreciation
Non-current assets such as machinery, motor vehicles, plant and equipment tend to fall in value (depreciate) for various reasons. These reasons are explained below.
Physical Depreciation
Wear and Tear: Non-current assets wear out over time; some last longer, others wear out quickly.
Erosion, Rust, Rot, and Decay: Assets can be damaged by natural elements like wind, rain, and sun. Metals rust, wood rots, and lack of maintenance accelerates decay.
Economic Factors
Obsolescence: Assets become outdated due to technological advances or changes in processes, like robots in car manufacturing or constantly updating computer hardware/software.
Inadequacy: Assets become unsuitable due to business growth or new regulations, like small vehicles being replaced by larger ones in the transport industry.
The Time Factor
Legal Life: Some assets have a fixed legal lifespan, like leases. The cost is depreciated over its term until the asset's value is nil. This is sometimes called amortization.
Depletion
Wasting Assets: Natural resources like minerals or oil are used up over time. The consumption of these resources is accounted for as depletion.
Methods of Depreciation
1. Straight Line Method:
This method involves the cost price of an asset, the estimated years of its use and the expected disposal value. The depreciation charge each year can be calculated as:
Depreciation charge per year= cost price - disposal value
number of years of use
*Disposal value means after 4 years use of an asset, business will sell it at that value. (in some books you may find it as salvage value or residual value)
It could be defined as “the value of a non-current asset at the end of its useful economic life”
For example, a business purchased a car for £25 000. It decides to keep it for
4 years and then sell it for £5000. The depreciation to be charged is:
Solution: depreciation charge per year= £25000 - £5000 = £ 5000 depreciation per year
Sometimes percentage could be given in the questions instead of numbers of years and disposal value.
In fact the percentage is derived from the number of years of use, and the disposal value is taken into consideration, but it is just given as a percentage.
Using the same example above:
A business purchased a car for £25 000. It’s a business policy to charge 20% of depreciation every year using the straight line method
Solution: depreciation charge per year= 20% of £25 000 = £ 5000 depreciation per year.
2. Reducing Balance Method:
Definition
A method of depreciation based on the carrying value of the non-current asset.
*carrying value (net book value) the current value of a noncurrent asset after accumulated depreciation is deducted.
Calculating the amount of depreciation to be charged involves deciding on a percentage amount to be used each year. This percentage is deducted from the cost price in the first year and deducted from the new (reduced) balance in next year.
3. Revaluation Method:
Definition:
Revaluation method calculates the annual depreciation charge based on a year-end annual valuation of the assets.
Description:
It bascially adjusts the asset's value to its market value at the end of each period.
Formula:
Annual Depreciation = Value at Beginning+Additions−Value at End
Question:
Which type of non-current assets are most suited for the revaluation method for depreciation?
A loose tools
B motor vehicles
C office equipment
D plant and machinery
Answer: loose tools
Why?
Loose tools are highly suited for the revaluation method because they experience frequent use and wear and they are subject to frequent additions and disposals, have fluctuating market values, and benefit from simplified accounting processes. This method ensures the book values of these tools are current and accurate, aiding in better financial reporting and decision-making.
Revaluation Method of Depreciation
Example
At the start of the year the business had loose tools valued at £10,000.
During the year, new tools worth £3,000 are added or purchased
At the end of the year, the market value of the tools is assessed at £9,000.
Formula
Annual Depreciation = Value at Beginning + Additions − Value at End
= £10,000 + £3,000 − £9,000
Annual Depreciation = £4,000
The annual depreciation for the loose tools is £4,000, reflecting the updated market value and additions throughout the year.
This method helps in presenting a true and fair view of the tools' worth, which is crucial for accurate financial reporting and efficient resource management.
Provision an expected future liability or future expectation of expenditure that is uncertain.
Provision for depreciation: is the account where the accumulated depreciation is recorded.
<< Disposal (Sale) of non-current asset >>
Question:
An extract from Jas’s statement of financial position at 31 December 2019 showed the following:
During the year ended 31 December 2020 the following transactions took place.
On 1 January 2020 fixtures, $30000, were purchased by cheque.
On 30 June 2020 fixtures were sold for $6000, which was received by cheque. These fixtures had
originally purchased on 1 January 2018 for $20000.
Jas depreciates fixtures on a straight-line basis. She assumes fixtures will have a useful life of four years, at which time the residual value will be 10% of original cost. Depreciation is charged for each part of the year for which the fixtures are owned.
Solution
