Depreciation and disposal of non-current assets

Introduction to Depreciation

Imagine you buy a brand-new smartphone today for \$1,000. If you try to sell it in three years, will you still get \$1,000 for it? Probably not! It might be scratched, the battery might be weaker, or a newer model might have made yours "old news." In accounting, we call this loss of value Depreciation.

In this chapter, we will learn how businesses record the "wearing out" of their non-current assets (like vans, machinery, and equipment) to ensure their financial statements are accurate and honest.

What is Depreciation?

Depreciation is the systematic allocation of the cost of a non-current asset over its useful life. It is not a way to find out how much an asset is worth if we sold it today; rather, it is a way to spread the cost of the asset across the years that it helps the business earn money.

Why do we charge depreciation?

There are two main accounting concepts that require us to charge depreciation:

1. Prudence: We must not overstate the value of our assets or our profits. By recording depreciation, we show a more realistic (lower) value for our assets on the Statement of Financial Position.

2. Accruals (Matching): We should match the cost of using an asset against the revenue it helps generate in that same period. If a delivery van helps us earn money for five years, its cost should be spread over those five years.

Causes of Depreciation

Why do assets lose value? Common causes include:

• Physical wear and tear: Damage from use (e.g., a van driving thousands of miles).
• Obsolescence: Newer, better technology makes the old asset less useful (e.g., old computers).
• Passage of time: Some assets, like a 10-year lease on a building, lose value as time runs out.
• Depletion: Used for natural resources like mines or quarries as the minerals are taken out.

Key Takeaway: Depreciation is an expense that represents the use of a non-current asset. It ensures the Statement of Profit or Loss and the Statement of Financial Position follow the rules of Prudence and Accruals.

Methods of Calculating Depreciation

The Edexcel syllabus requires you to master three specific methods. Don't worry if the math seems scary—once you see the patterns, it becomes much easier!

1. Straight Line Method

This method charges the same amount of depreciation every year. It is best for assets that provide equal benefit every year, like a building or a piece of furniture.

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

Formula B: \( \text{Annual Depreciation} = \text{Cost} \times \% \text{ rate} \)

Note: "Residual Value" is what we expect to sell the asset for at the very end of its life.

2. Reducing Balance Method

This method applies a fixed percentage to the Carrying Value (the cost minus any depreciation already charged). This results in a higher depreciation charge in the early years and a lower charge in later years. It is perfect for assets like cars or computers that lose value quickly at the start.

Formula: \( \text{Annual Depreciation} = \text{Carrying Value} \times \% \text{ rate} \)

Remember: \( \text{Carrying Value} = \text{Original Cost} - \text{Accumulated Depreciation} \)

3. Revaluation Method

This is used for small items that are difficult to track individually, like loose tools or packing crates. We look at what we had at the start, what we bought, and what we have left at the end.

Formula: \( (\text{Opening Value} + \text{Purchases during the year}) - \text{Closing Value} = \text{Depreciation} \)

Quick Review:
- Straight Line: Same amount every year.
- Reducing Balance: Based on Carrying Value; decreases over time.
- Revaluation: Difference between start/purchases and the end value.

Ledger Accounts for Depreciation

To record depreciation, we use two separate accounts. We never take the depreciation directly out of the Asset Account until the asset is sold.

1. The Non-Current Asset Account (at cost)

This account stays at the original historic cost of the asset. We only enter numbers here when we buy a new asset or dispose of an old one.

2. The Provision for Depreciation Account

This is where we keep a "running total" of all depreciation charged so far.
- Debit: Nothing usually (unless we sell the asset).
- Credit: The annual depreciation expense at the end of the year.

The Year-End Double Entry:

To record the annual depreciation charge:
Debit: Statement of Profit or Loss (as an expense)
Credit: Provision for Depreciation Account

Disposal of Non-Current Assets

When we sell or scrap an asset, we must remove it from our books. We use a special Disposal Account to calculate if we made a profit or a loss on the sale.

Step-by-Step Guide to Disposal:

1. Remove the Cost: Transfer the original cost from the Asset Account to the Disposal Account.
\( \implies \) Debit Disposal, Credit Asset Account.

2. Remove the Accumulated Depreciation: Transfer the total depreciation for that specific asset to the Disposal Account.
\( \implies \) Debit Provision for Depreciation, Credit Disposal Account.

3. Record the Sale Price: Record the money received (or the trade-in value).
\( \implies \) Debit Cash/Bank, Credit Disposal Account.

4. Find the Profit or Loss: Balance the Disposal Account.
- If the Credit side is bigger = Profit on Disposal (Finance Income).
- If the Debit side is bigger = Loss on Disposal (Other Operating Expense).

Common Mistake: Students often forget to remove the depreciation from the Provision account. Remember: the asset is gone, so its depreciation must go too!

The Schedule of Non-Current Assets

A Schedule of Non-Current Assets is a table that summarizes all the movements in our assets during the year. It usually includes:

• The cost at the start and end of the year.
• Any additions (purchases) or disposals.
• The accumulated depreciation at the start and end.
• The Carrying Value (the final "book value" shown on the Statement of Financial Position).

Effect on Profit and Changes in Method

The method a business chooses has a direct impact on its reported profit:

• Higher Depreciation = Lower Profit.
• Lower Depreciation = Higher Profit.

In the early years of an asset's life, the Reducing Balance Method usually results in a lower profit compared to the Straight Line Method because the depreciation expense is much higher at the start.

Changing Methods

According to the Consistency concept, a business should use the same method every year. However, if a change is necessary (e.g., to give a "fairer view"), the business must explain the effect on profit. A change in method will change the depreciation expense, which in turn changes the profit for the year and the carrying value of assets.

Summary Checklist

Check your understanding:
- Can you define depreciation using the Prudence and Accruals concepts?
- Can you calculate Straight Line vs. Reducing Balance?
- Do you know the 4 steps of a Disposal Account?
- Can you identify the difference between "Cost" and "Carrying Value"?

Don't worry if this seems tricky at first! The best way to learn is to practice drawing the T-accounts for the Asset, Provision for Depreciation, and Disposal. You've got this!