Depreciation and disposal of non-current assets

Welcome to the World of Depreciation!

Imagine you buy a brand-new smartphone today for \( \$1,000 \). If you try to sell it in three years, will you get \( \$1,000 \) back? Of course not! It will be worth much less because you’ve used it, and newer models have come out. In accounting, we call this loss in value depreciation.

In this chapter, we will learn how businesses record this loss for their non-current assets (like machinery, vehicles, and equipment) and what happens when they finally sell those assets. Don't worry if it seems technical at first; we will break it down step-by-step!

1. What is Depreciation?

Depreciation is the systematic allocation of the cost of a non-current asset over its useful life. Essentially, it is an expense that represents how much of an asset's value has been "used up" during an accounting period.

Why do we charge depreciation?

It’s not just because things get old. Accountants follow two very important rules (concepts):

• The Accruals Concept: We must match the cost of the asset against the income it helps generate. If a delivery van helps a business earn money for five years, its cost should be spread over those five years.
• The Prudence Concept: We must not overstate the value of our assets. By subtracting depreciation, we show a more realistic carrying value (the value it is currently worth in our books).

What causes depreciation?

There are four main "culprits" that steal value from assets:

1. Physical Deterioration: Simple wear and tear from use (e.g., a van driving thousands of miles).
2. Economic Factors (Obsolescence): The asset becomes out of date because new technology is better or faster (e.g., computers).
3. Passage of Time: Some assets have a legal time limit, like a 10-year lease on a building.
4. Depletion: Used for natural resources like mines or quarries; the more you take out, the less the asset is worth.

Key Takeaway: Depreciation is an application of the accruals and prudence concepts, ensuring profits and assets aren't overstated.

2. Methods of Calculating Depreciation

The syllabus requires you to master three specific methods. Each method affects the business's profit differently.

A. Straight Line Method

This is the simplest method. The asset loses the same amount of value every year. It is best for assets that provide equal benefit over time, like a building or a piece of office furniture.

Formula 1: \( \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Expected Useful Life}} \)

Formula 2: \( \text{Annual Depreciation} = \text{Cost} \times \text{Percentage Rate} \)

Example: A machine costs \( \$10,000 \) and has a residual value (scrap value) of \( \$1,000 \). It will last 5 years.
\( \text{Depreciation} = \frac{\$10,000 - \$1,000}{5} = \$1,800 \text{ per year.} \)

B. Reducing Balance Method

This method applies a fixed percentage to the carrying value (cost minus depreciation already taken) of the asset. This results in higher depreciation in the early years and lower depreciation later. It is perfect for assets that are most efficient when new, like motor vehicles or high-tech machinery.

Formula: \( \text{Annual Depreciation} = \text{Carrying Value} \times \text{Percentage Rate} \)

Example: A car costs \( \$20,000 \). Depreciation is \( 20\% \) reducing balance.
Year 1: \( \$20,000 \times 20\% = \$4,000 \)
Year 2: \( (\$20,000 - \$4,000) \times 20\% = \$3,200 \)

C. Revaluation Method

This is used for "small" non-current assets like loose tools, packing cases, or livestock. Instead of a complex formula, we simply value the items at the start and end of the year.

Formula: \( (\text{Opening Value} + \text{New Purchases}) - \text{Closing Value} = \text{Depreciation Expense} \)

Key Takeaway: Choose Straight Line for consistent use, Reducing Balance for assets that lose value quickly at the start, and Revaluation for small, numerous items.

3. Recording Depreciation in Ledger Accounts

To keep our records clean, we use two separate accounts for each type of asset. This is part of the Historic Cost concept—we keep the asset account at its original price.

1. Non-current Asset Account (at cost): This account only changes if we buy a new asset or sell an old one.
2. Provision for Depreciation Account: This is where we "accumulate" the yearly depreciation. It is a credit balance.

The Yearly Journal Entry:

Debit: Statement of Profit or Loss \( \dots \) (The expense for the year)
Credit: Provision for Depreciation \( \dots \) (Increasing the total saved up)

Common Mistake: Never subtract depreciation directly from the Asset Account unless you are disposing of the asset!

4. Disposal of Non-current Assets

When we sell or scrap an asset, we need to close its accounts and find out if we made a profit or loss on disposal. We use a temporary Disposal Account to do this.

The Step-by-Step Disposal Process:

1. Transfer the Original Cost:
   Debit: Disposal Account
   Credit: Non-current Asset Account
2. Transfer the Total Depreciation (up to the date of sale):
   Debit: Provision for Depreciation Account
   Credit: Disposal Account
3. Record the Sale Proceeds (Money received):
   Debit: Cash / Bank (or Trade Receivable)
   Credit: Disposal Account
4. Balance the Disposal Account:
   If the Credit side is heavier, you made a Profit (transfer to Statement of Profit or Loss).
   If the Debit side is heavier, you made a Loss.

Key Takeaway: The Disposal Account is just a "matching box" where we put the cost, the saved-up depreciation, and the cash received to see the final result.

5. Changing Methods and Profit Impact

Sometimes a business changes its depreciation method (e.g., from Straight Line to Reducing Balance). This usually happens to ensure the Consistency concept is balanced with a "truer and fairer" view.

How does it affect profit?

• If you switch to a method that charges more depreciation this year, your Profit for the Year will decrease.
• If you switch to a method that charges less depreciation, your Profit for the Year will increase.
• This also changes the Carrying Value of assets in the Statement of Financial Position.

6. The Schedule of Non-current Assets

In your exam, you might be asked to prepare or complete a Schedule of Non-current Assets. This is a summary table that helps management see the "big picture."

It usually looks like this:

Note: "Carrying Value" is the modern IAS term for "Net Book Value." Always use this term in your exam!

Quick Review Quiz

• Q: Which concept says we should not overstate asset values?
  A: Prudence.
• Q: Which method is best for small tools?
  A: Revaluation method.
• Q: If an asset costing \( \$5,000 \) with \( \$3,000 \) accumulated depreciation is sold for \( \$2,500 \), is there a profit or loss?
  A: Profit of \( \$500 \). (Carrying value was \( \$2,000 \), sold for \( \$2,500 \)).

Don't worry if the ledger entries for disposal feel like a puzzle. Just remember: you are simply moving the "Cost" and the "Provision" into one place (the Disposal Account) to see what's left over!