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Obsolescence : There are some assets that may become out of date. We have seen over the years how technology has made some assets out of date.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)