Depreciation of non-current assets

Depreciation
Decrease in the value of non-current asset. It involves spreading the cost of non-current
asset over its useful life.
It is recorded as an expense in income statement

Causes of Depreciation

 Wear and tear

 Technological Obsolescence
 Time factor
 Depletion
 Damage

Why a business should record Depreciation?

1) Matching concept

According to matching concept expenses of an accounting period should be

matched against the revenues of that accounting period. Depreciation is an
expense so it should be matched against the revenues earned from the use of
non-current assets.

Example

We use a machine to produce a product -> Revenue/Earning

Depreciation, repair and other operating costs of machine -> Expenses

2) Prudence concept

According to prudence concept assets should not be overstated and if we don’t

record depreciation, the non-current assets will be overstated in statement of
financial position

3) Going concern concept

A business should continue to record its non-current assets at historical cost

less depreciation as long as the business is going concern. However, if a
business is not going concern the non-current are recorded at market value
instead of net book value.
Methods of Depreciation

1) Straight line method

In this method same amount of depreciation is charged each year in order to
spread the cost of a non-current asset equally over its useful life

Formula

cost−scrap ( residual ) value

Annual Depreciation =
us e ful life
Or
Annual Depreciation = % X Cost

Useful life
It refers to number of years a non-current asset is expected to be used by the
business

Scrap/Residual value
It refers to an estimated value at which a non-current asset is expected to be sold
at the end of its useful life

Benefits of Straight line method

 it is simple to use
 It is suitable for assets that provide equal/uniform benefits over the
life of the assets e.g. furniture, buildings

2) Reducing Balance Method

In this method the amount of depreciation charged in early years is higher than
later years.
This method equalizes the burden of non-current assets because when the asset
is new, it has little or no maintenance charges, and when the asset starts getting
older, the burden of repair and maintenance starts increasing e.g. machinery

Formula
Year 1 Annual Depreciation = % X Cost
Year 2 and onwards Annual Depreciation = % X net book value
Net book value = cost – accumulated/total depreciation
Benefits of reducing balance method
  It is more realistic.
 It is suitable for assets that depreciate by higher amount in early years
than later years.

3) Revaluation Method
In this method, value of non-current assets at year end is compared with the
value of non-current assets at start of the year. Any decrease in the value
represents depreciation of non-current assets.

Formula

Annual Depreciation
= value at start + purchase – value at year end – value of assets disposed

Benefits of Revaluation method

 it is more realistic as it is based on market value

 It is suitable for assets that are smaller in value e.g. loose tools

Journal Entry to record annual depreciation

Dr Cr
Income Statement √
Provision for depreciation √

Ledger Account for Depreciation

Provision for Depreciation Account

2015 $ 2020 $
Disposal √ Balance b/d √
December 31 Balance c/d √ December 31 Income Statement √
√ √

Journal Entry to record disposal of non-current assets

 Dr Cr
Disposal √
non-current assets (cost) √

Dr Cr
Bank/Cash/Receivable (sale price) √
Disposal √

Dr Cr
Provision for depreciation √
Disposal √

For disposal loss

Dr Cr
Income Statement √
Disposal √

For disposal profit

Dr Cr
Disposal √
Income Statement √

Disposal Account
2015 $ 2015 $
non-current assets (cost) √ Bank/Cash/Receivable √
Income Statement (profit) √ Provision for depreciation √
Income Statement (Loss) √
√ √

Non-current Asset Account

2015 $ 2015 $
Balance b/d √ Disposal √
Bank/Cash/Receivable √
Balance c/d √
√ √
Depreciation policies

There are two different policies that businesses usually adopt:

1. Full year’s depreciation in the year of purchase with no depreciation in the year of sale.

2. Depreciation is charged on monthly/proportionate basis.

If the question has not mentioned the policy, then depreciation will be charged on a monthly
basis

Depreciation must be charged at the end of each accounting period, not at the end of the calendar
year. The calendar year starts in January and ends in December, but the accounting period can
start any month and will end 12 months later, for example, Jan-Dec, April-March, July-June,
Oct-Sept, and so on.

Which Method of Depreciation is Best Suited for Different Assets?

• The straight-line method is best suited for those assets which provideequal/uniform
benefits over their useful life. For instance, furniture, buildings, and so on.

• Reducing balance method is best suited for high tech items, which lose their value
rapidly, such as Plant and machinery, equipment, and computers.

• Revaluation Method is best suited to those assets whose values cannot reliably be
measured and depends on market rates. Even those assets which do not have
significant value in isolation, but many items have a significant worth such as loose
tools.

Dr Cr
Rent 120000
Bank 120000

Closing entry
Dr Cr
Income Statement 120000
Rent 120000