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CHAPTER OBJECTIVES

At the end of the lecture you should be able to:

1. Define depreciation and other relevant terms


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 This is the process of becoming out-of-date through technological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.

THE END