Depreciation: methods, accounts and disposal

Last time

Before we start: last time, in Accruals and prepayments of expenses and income, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Assets wear out

A van bought for 20,000 dollars will not be worth that in five years. It wears out, becomes outdated, and is used up. Depreciation spreads the cost of the van over the years it is used, so each year's profit carries its fair share.

Why assets depreciate

Wear and tear from use. The passing of time, as with a lease. Obsolescence: newer, better technology makes the asset outdated. Depletion: a resource such as a mine is used up.

Why charge depreciation

Depreciation matches the cost of the asset with the revenue it helps to earn, year by year. That is the matching, or accruals, concept. Without it, profit in the year of purchase would be far too low, and later years too high. It also shows the asset at a more realistic value in the statement of financial position.

The straight-line method

Straight-line depreciation charges the same amount every year: cost minus residual value, divided by the useful life in years. A van costing 20,000 dollars, with a residual value of 2,000 and a life of 6 years, is depreciated by 18,000 divided by 6: 3,000 dollars a year. It suits assets used evenly over their life, such as fixtures and fittings.

The reducing balance method

Reducing balance charges a fixed percentage of the net book value each year, so the charge falls over time. At 20 per cent, year one is 20 per cent of 20,000: 4,000. Net book value is now 16,000. Year two is 20 per cent of 16,000: 3,200. It suits assets that lose value fastest when new, such as vehicles and computers.

Two methods compared

The same van under each method. Straight-line gives 3,000 each year; reducing balance gives 4,000 then 3,200, a net book value of 12,800 after two years.

Recording depreciation

Each year: debit the depreciation expense in the income statement; credit the provision for depreciation account. The asset account stays at cost. The provision builds up year by year: this is accumulated depreciation. Net book value is cost minus accumulated depreciation, shown in the statement of financial position.

Disposal of an asset

When an asset is sold, its cost and its accumulated depreciation are moved to a disposal account, with the sale proceeds. If the proceeds are more than the net book value, there is a profit on disposal; if less, a loss. The profit or loss on disposal goes to the income statement.

Recording a purchase

Buying an asset on credit is recorded in the general journal: debit the asset account, credit the supplier, with a narrative. The narrative explains the transaction briefly, such as 'purchase of hairdryers on credit'. If a question says a narrative is required, it carries a mark.

Mistakes that lose marks

Mistake one: crediting the asset account each year with depreciation. Credit the provision; the asset stays at cost. Mistake two: using reducing balance on the cost every year, instead of the net book value. Mistake three: forgetting the residual value in straight-line. The fix: the right formula, and the provision account.

The full-marks tip

The full-marks tip: for straight-line, take off the residual value first; for reducing balance, use the net book value each year. Record depreciation as debit expense, credit provision.

On one card

So, on one card: depreciation. Keep it for revision.