Accounting For Depreciation

We can all agree that when you use an asset e.g. a car then over time there will be a reduction in the value of the asset over time. Depreciation is therefore an acknowledgement in the books of accounts of that reduction in value. It is a charge that posted to the statement of comprehensive income to reflect this consumption of the asset.

Why Should I Care About Depreciation?

You cannot run away from depreciation because one of the important concepts in accounting is the Accruals concept. The Accruals concept requires preparers of accounts to record revenue when they are earned and not when they are received in cash and also recording expenses when they are incurred and not when they are paid. 

This therefore means that as an accountant you need to acknowledge all the expenses and income for a particular period. To fulfill this you have to estimate some expenses and revenue where these have not been recorded in the books of accounts for all sorts of reasons. 

An example would be for instance a water bills for a particular month as the bills normally reach you after month end. In this case you may have to estimate the cost based on past experience and post a reversing journal into the books of accounts. 

Accruals accounting differs from cash accounting in that in cash accounting you only acknowledge expenses and sales when cash is exchanged.As an Accountant you cannot run away from accruals accounting as it is requirement for all accounting work.

Causes of depreciation

Wear and tear : When you use an asset it wears out over time. This is true of all assets whether it is motor vehicles or buildings. They wear out or parts of it wear out and may need to be replaced. At a certain point they wear out completely that they cannot be repaired anymore but have to be disposed of.

Erosion, rust , rot and decay : Wood will eventually rot, metals rust and land can be eroded or wasted away by rain or the sun.

Obsolescence : There are some assets that may become out of date. We have seen over the years how technology has made some assets out of date. This is especially true of electronic gadgets. The equipment may not have worn out but due to advancements may no longer be needed.

Inadequacy : An example would be an airline that suddenly discovers that certain jets are inadequate due to an increase in number of passengers. In this case the airline may stop using certain jets. They can of course offload these planes to other smaller airlines.

Depletion : This applies mostly to natural resources such as oil and gas reservoir. These are wasted due to extraction and in this case we use the word depletion instead of depreciation. To provide for the consumption of an asset such as mines is called provision for depletion.

Accounting For Depreciation

Once you have determined the charge for depreciation then they need to be entered into the books of accounts as follows:

Dr Depreciation expense (Statement of Comprehensive Income)

Cr Accumulated Depreciation (Statement of financial Position)

In the Statement of financial position the non current assets are shown at their carrying value as shown below:

Statement of Financial Position as at 31 December 2019

                                   Cost       Accumulated Carrying

Depreciation Value

$000        $000 $000

Non Current Assets

Property 150000 (12,000) 138000

Plant and Machinery 45000 (11,250) 33750

Motor Vehicles 26000 (13,260) 12740

221,000 (36,510) 184490

Methods of Depreciation

There are two methods of depreciation i.e. straight line and reducing balance.

Straight line depreciation

In this case an equal amount is charged in every accounting period over the life of the asset.

To calculate depreciation using the straight line method you use the following formula:

Depreciation per year = Original cost - estimated residual value

                                                Estimated Useful life

An example would be where you buy a car for $20,000 which has a useful life of 5 years and residual value of $5000. To calculate the depreciation charge using the straight line method you would do it as follows:

200000- 5000/5 =$3000

Reducing Balance Depreciation.

This method of depreciation usually applies to assets that tend to lose more value in the initial years and require greater maintenance in the later years.

In the case a fixed percentage is applied to the carrrying value of the asset on an annual basis. Therefore because of this as the value of the asset reduces so does the depreciation charge. This is because as it has already been stated the percentage is charged to the carrying value which is decreasing as you apply the depreciation charge.

The formula for the reducing balance is as follows:

Depreciation per year/annum = % x carrying value

One thing that you may have noticed in our study today is that the depreciation charge is an estimate. Therefore you need to review it and change over time if circumstances change.

Disposal of Non Current Assets

It is highly unlikely that when you dispose of an asset that the sale proceeds will match the carrying value of the asset at the date of disposal. Therefore more likely there will be either a loss or profit on disposal which you need to calculate and account for.

Sale Proceeds                                                      x

Carrying value of asset at the date of disposal        x

Difference = Profit/(loss) on disposal                    x/(x)

Accounting for a disposal

Step 1: Remove the asset from the books

Dr Disposals

Cr Non Current asset cost

Step 2 : Remove the accumulated depreciation

Dr Non-current asset accumulated depreciation

Cr Disposals

Step 3 :Deal with the sale proceeds

Dr Bank (Cash proceeds)

Cr Disposals

Alternative step 3 : part-exchange proceeds

Dr Asset cost

Cr Bank

Cr Disposals (with part exchange allowance)

Concept and Meaning of Value Added Tax

What is Value Added Tax?

Value Added Tax (VAT), also known as goods and services tax in other jurisdictions, is a tax charged on the supply of most goods and services in a number of countries such as those in the European Union.

It should also be pointed out that some persons and business es are exempted, and these include those with low levels of turnover.

This tax is kind of a subtle tax to many  consumers who rarely think about it when buying their goods. This is because goods have to clearly indicate the total price to pay. Therefore the final consumer rarely notices the VAT component in the total price.

Though simple in most cases, it can be a headache to orgianisations that are involved in goods and services which attract different rates and some exempt goods. These organisations have to be careful so as not to charge wrong rates.

History of VAT in the UK

It is easy to forget that VAT is a relatively new tax in the United Kingdom. It came into being with the United Kingdom entry into the European Union in 1973.

Before this the UK had a tax called the Purchases tax which was only applied to manufacturers and wholesalers whose goods were liable to this tax.

This tax was operational from 1940 to 1973. It was initially created to raise funds for the war effore during the Second World War.

Because of VAT wide application, many organisations overnight discovered  that they had to worry about VAT returns to be completed every quarter i.e. every three months. There was initially an uproar from many business that were not subject to the old Purchases tax.

Who Pays VAT

Ultimately the underlying VAT is paid by the final consumer of the goods. However, the tax like income tax, is based on the increase in value for a product or service at each stage of production or distribution. Therefore everyone in the supply chain must account for and settle up the net amount of VAT they have received in the VAT tax period, usually three months. 

This means that if they have received more VAT than they have paid over that period they pay the difference to HMRC if a United Kingdom resident. If however they have paid more than they have received they will be reimbursed the difference.

When the goods or services reach the final consumere the intermediate stages VAT payments will be cancelled out. Therefore if you review the stages you will see that only the ultimate consumer actually paid any VAT without claiming anything in return.

Value Added Tax Exempt Goods in UK

There are a few goods and services that are exempt in the United Kingdom as shown below:

• Insurance, finance and credit.
• Education and training
• fundraising events by charities.
• Subscriptions to membership organisations.
• Selling, leasing and letting of commercial land and buildings.

The above are known as exempt goods and services and should not be included in taxable turnover for VAT purposes.

VAT Rates in the United Kingdom

The standard rate for VAT in the United Kingdom is currently at 20%

The standard rate has changed over the years. In 1973 it was at 10% then it was reduced to 8% in 1974. In 1991 the rate was raised to 17.5%.

The reduced rate of VAT is currently at 5%. Besides this there is also the zero rate of VAT.

The reduced rate usually applies to a few products like children car seats at the moment.

An Example of a standard rate of tax application:

A supermarket sells groceries worth £100 to a customer.

The sales receipt will show the following:

Price                100

VAT @20%      20.

Total Price       120.

In this case the supermarket at the end of the quarter report will pay £20 to HMRC. Ofcourse this will be included with all the VAT  collected during that period which will be netted off from the VAT they have paid to their suppliers.

In this case the accounting for this transaction is as follows.

Credit  Sales 100

Cr       VAT 20

Dr       Cash 120

However if it was a credit sale, which is rare when dealing with supermarkets, it will be accounted for as follows:

Cr Sales   100

Cr  VAT    20

Dr Debtors 120

What is Output VAT?

The value of goods and services supplied by a business are know as outputs. The VAT on such goods and services is known as Output VAT.

What is Input VAT

The value of goods and services bought or procured is known as inputs.The VAT on inputs is known as Input VAT.

VAT Exempt Businesses

Some business are exempted from accounting fore VAT and therefore exempted from registering for VAT. These business do not therefore  charge VAT and cannot claim the VAT charged on their purchases.

The exempt business include small businesses  within a specified range of turnover as set by parliament. These can however choose to register in that case they will be subject to the requirement of the act and be able to charge and claim VAT.

Some businesses do not have to add VAT on their goods and services. These include banks which cannot charge VAT on bank charges etc.

Zero Rated Businesses

These businesses do not have to add VAT to the selling price of their products or services but are able to obtain a refund of all VAT paid on purchases of goods and services.

This is an advantage for these zero rated businesses as they can claim the input VAT whereas exempt businesses cannot.

Accounting For Bad Debts and Provision for Doubtful Debts

For most business, except supermarkets and cash intensive business, most of the  sales are on credit. As a result there is always a risk of default. Customers may fail to pay for so many reasons including cash flow issues and sometimes they may collapse before they make their payments. In the case where it is established that the customer will never pay for the goods that were sold to them then the business needs to recognise this as a bad debt.

Scenarios That May Lead To Customers Defaulting

• The customers business may collapse and therefore they are only able to pay part of what they ower or they can altogether not be able to pay anything.
• The customer may refuse to pay for the supply of goods for instance because they are disputing it. This could a whole invoice or part of an invoice.

A bad debt needs to be recognised as an expense and charged to the profit and loss statement (income statement). This is because initially this was recognised as revenue but now that revenue needs to be "derecognised" in calculating the profit and loss for the period.

Besides charging it to the profit and loss we also need to get rid of it from the debtors ledger. In other words the asset that was recognised when we sold the goods needs to go. The asset that was recognised in the debtor's account is now worthless. It needs to be eliminated.

In summary you clear bad debts by crediting the debtor's account to cancel the asset and increasing the expense account of bad debts by debiting it there.

Dr. Bad Debts (P/L)

Cr. Debtors. (BS)

At the end of the period the balance in the Bad debts account will be transfered to the profit and loss account

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