2. Explain the causes of depreciation 3. Calculate depreciation using straight line and reducing balance methods 4. Record the purchase, depreciation and disposal of non-current assets
DEPRECIATION OF NON-CURRENT ASSETS
DEFINITIONS
Depreciation is the systematic allocation of the depreciable amount of an asset
over its useful life. It is that part of the original cost of a fixed asset that is consumed during its period of use by the business. The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life. Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value. Useful life is: (a) the period over which an asset is expected to be available for use by an entity; or (b) the number of production or similar units expected to be obtained from the asset by an entity.
Causes of depreciation
Physical deterioration 1 Wear and tear. When an asset is used, eventually wear out. Some assets last only a few years (e.g. motor vehicles) but others a long time e.g. buildings 2 Erosion, rust, rot and decay. Land may be eroded or wasted away by the action of wind, rain, sun and other elements of nature. Similarly, the metals in motor vehicles or machinery will rust away. . Economic factors The two main factors are usually obsolescence and inadequacy.
1 Obsolescence. This is the process of becoming out-of-date through technological
changes.
2 Inadequacy. This arises when an asset is no longer used because of the growth and changes in the size of the business.
Time Time is needed for wear and tear, erosion, etc., and for obsolescence and inadequacy to take place but other assets such as leases and licences expire over time. Depletion Other assets are of wasting character, perhaps due to the extraction of raw materials from them e.g. a mine or a quarry.
Methods of Calculating Depreciation
The two main methods are:
1. Straight Line/ Equal Instalment Method
2. Reducing/Diminishing Balance Method
Formula: Straight Line Method
Depreciation= Cost – Residual Value
Estimated Useful Life
Formula: Reducing Balance Method
r 1 n Rate of Depreciation (R) = c
Where: R =Rate of depreciation
r = Residual value n = Number of years
DOUBLE ENTRY FOR NON-CURRENT ASSETS
RECORDING PURCHASE OF AN ASSET
DR Asset account CR Cash or Bank or Accounts Payable account
RECORDING DEPRECIATION The depreciation is posted directly into the cumulative provision for depreciation account. The double entry is: DR Profit or Loss account CR Accumulated Provision for Depreciation account
RECORDING DISPOSAL OF AN ASSET
On the sale of a non-current asset the following entries are needed:
(A) Transfer the cost price of the asset sold to an assets disposal account
DR: Disposal account
CR: Asset account
(B) Transfer the depreciation already charged to the assets disposal account: DR: Accumulated Provision for Depreciation account CR: Disposal account (C) For the amount received on disposal:
DR: Cash or Bank
CR: Disposal account (D) Transfer the difference (i.e. the amount needed to balance the disposal account) to the profit or loss account.
(i) If the disposal account shows a credit balance (i.e. if more has been credited to the account than has been debited to it), there is a profit on the sale:
DR: Disposal account
CR: Profit or loss account
(ii) If the disposal account shows a debit balance, there is a loss on sale:
DR: Profit or loss account
CR: Disposal account
QUESTION
AJ Stores is proposing to depreciate its motor vehicles using a method called tonne- kilometres, an output method that considers the number of kilometres travelled by the truck and the tonnes loaded.
REQUIRED:
Discuss the advantages and disadvantages of this method over straight line or reducing balance method.
ANSWER
This method uses the following formula as with other output methods
Cost – Residual Value x Tonnes-Kilometres per period
Total tonnes-kilometres during life of asset Cost – Residual Value (i.e. the depreciable amount) is allocated over the life of the asset according to the kilometres travelled during a certain period. The advantage of charging depreciation according to kilometres is that it is a more realistic method. The more you use the vehicle, the more it depreciates. Straight line or reducing balance assumes that the asset is being used at a constant rate throughout the year. This is not realistic as in some cases the vehicle or asset may be lying idle and yet it is depreciated. Not only does it charge depreciation according to kilometres but also according to the load. It charges depreciation more if the load increases. That means the tonne- kilometre method is more accurate and prudent. The disadvantages are that this method requires very accurate estimations of total tonne-kilometres over the useful life of the asset. Such estimations are not easily available as compared to the straight line method that just estimates the useful life of the asset. The next problem is how do you keep records of kilometres travelled and the total load carried during a period? This requires more record keeping.
