Depreciation can be defined as the writing off (to Profit and Loss Account) of the cost of a fixed asset over its estimated useful life.
Virtually every business has fixed assets and therefore depreciation applies to almost every set of accounts produced.
The most common method of depreciation is the straight line method. By this method the cost of a fixed asset (less any estimated residual sales value to be received at the end of its useful life) is written off to the profit and loss account in equal annual instalments as follows:
COST OF FIXED ASSET 100,000
ESTIMATED RESIDUAL SALES VALUE 20,000
AMOUNT TO BE WRITTEN OFF 80,000
ESTIMATED EXPECTED USEFUL LIFE
OF THE FIXED ASSET 4 YEARS
(UNDER THE STRAIGHT LINE METHOD) 20,000
At the end of the four years the asset would appear in the balance sheet with a net book value of £20,000 as follows:
FIXED ASSET AT COST 100,000
DEPRECIATION PROVISION (4 X 20,000) 80,000
NET BOOK VALUE 20,000
If the asset is sold for £20,000 the fixed asset would disappear from the balance sheet and the current asset of cash would increase by £20,000.
The accounting entries for depreciation are as follows:
(i) debit a depreciation (expense) account with the annual depreciation – close off the depreciation (expense) account at the end of the financial period and transfer the charge to the profit and loss account.
(ii) credit a depreciation (provision) account with each year’s depreciation
NOTE :- The fixed asset account remains at cost.
The accounting entries for the above would appear as follows:-
FIXED ASSET ACCOUNT
Year 1 Cash at bank 100,000
DEPRECIATION (EXPENSE) ACCOUNT
DEPRECIATION (PROVISION) ACCOUNT
Year 1 Depreciation 20,000
PROFIT AND LOSS ACCOUNT
Year 1 Depreciation 20,000
Year 2 Depreciation 20,000
Year 3 Depreciation 20,000
Year 4 Depreciation 20,000
BALANCE SHEETS (EXTRACTS)
Year 1 Year 2 Year 3 Year 4
£ £ £ £
FIXED ASSET 100,000 100,000 100,000 100,000
PROVISION (20,000) (40,000) (60,000) (80,000)
NET BOOK VALUE 80,000 60,000 40,000 20,000
REDUCING BALANCE METHOD
Under the straight line method the amount to be written off (£80,000) was charged to profit and loss account in equal annual sums of £20,000. In other words, a depreciation rate of 25% per annum was used.
Under the reducing balance method a fixed percentage is applied to the net book value (amount still to be written off).
Applying a fixed percentage of 60% to the above example gives the following:-
Amount to be written off 80,000
The differences between the two methods are as follows:
(i) Under the reducing balance method the majority of the depreciation has been charged in the earlier years of the life of the asset
(ii) Under the reducing balance method the depreciation period carries on for more than 6 years.
The reducing balance can be said to be more prudent than the straight line method as the depreciation is weighted in favour of the earlier years.
The main advantages of the straight line method are its simplicity and its consistency in charging fixed annual amounts of depreciation.
SALE OF AN ASSET
The residual value estimated will probably never equate to that actually received and the asset may well be sold during its estimated useful life. Consider the following:-
1ST JANUARY – YEAR 1 MOTOR VAN
BOUGHT FOR £10,000
ESTIMATED USEFUL LIFE 4 YEARS
ESTIMATED RESIDUAL VALUE
AT THE END OF 4 YEARS £2,000
AMOUNT TO BE WRITTEN OFF £8,000
ANNUAL DEPRECIATION CHARGE (STRAIGHT LINE) £2,000 (£8,000/4)
Let us suppose that on 1st January in year 3 the motor van is sold for £3,500. The various accounting entries would be as follows:-
Motor van account
Depreciation (expense) account
|2,000||31/12/X1||Profit & loss a/c|
|2,000||31/12/X2||Profit & loss a/c|
Motor van disposal account
Cost of motor van
|1/1/X3||Loss on disposal|
Profit & loss account
Loss on disposal
Depreciation provision account
The sequence of the above entries is as follows:-
(A) The initial purchase of the asset
(B) The charging (to the profit and loss account) and the allocation to the provision for depreciation account, the annual depreciation charge for each of years one and two.
(C) The transfer of the cost of the asset from the motor van account to the disposal account.
(D) The transfer of the total depreciation charged (from the date of acquisition of the asset to the date of disposal) from the provision for depreciation account to the disposal account.
(E) The allocation to the disposal account of the proceeds received for the asset.
- The transfer of the loss on disposal to the profit and loss account.
NOTE :- During the period that the asset was held the total charge to the profit and loss account is £6,500.
This represents the cash loss as follows:
Initial costs 10,000
Sale proceeds 3,500
SUMMARY OF ACCOUNTING ENTRIES ON SALE OF A FIXED ASSET
These are summarised as follows:
(i) Transfer the cost of the asset being sold to the asset disposal account-
debit Asset Disposal account
credit Asset Account
(ii) Transfer the total depreciation charged on the asset being sold to the disposal account:-
debit Provision for Depreciation Account
credit Asset Disposal Account
The net book value (cost less total depreciation charged) of the asset being sold is now transferred to the disposal account.
(iii) Allocate the sales proceeds received on the sale of the asset to the disposal account:- debit Cash credit Disposal Account
(iv) Balance off the disposal account. A profit on disposal arises if the sales proceeds are in excess of the net book value. A loss on sale arises if the sales proceeds are less than the net book value of the asset.
If a profit arises: debit Disposal Account credit Profit and Loss Account
If a loss arises: debit Profit and Loss Account credit Disposal Account
Depreciation as an accounting policy
The depreciation policy used by a business must be stated in the notes to the final accounts and the method of depreciation used must be consistent from year to year.
Up to now the examples have assumed that one asset only was held, but let us now look at a more realistic example:-
A firm undertakes the following transactions:
|1/1/X1||Purchases a motor van for £8,000|
|1/7/X1||Purchases a motor van for £10,000|
|1/10/X1||Purchases a motor van for £10,000|
|1/7/X2||Purchases a motor van for £15,000|
|1/1/X3||Sells the van purchased on 1/1/X1 for £2,000|
|1/1/X4||Purchases a motor van for £16,000|
The firm’s depreciation policy is to write off its motor vans at 25% per annum (straight line) assuming no residual value. The accounting transactions for years 1 – 4 (inclusive) are as follows:-
Motor van (at cost) account
Profit & loss account (extract)
Provision for depreciation account
Motor vans disposal account
Cost of van
Loss on sale
|8,000 x 25%||=||2,000|
|10,000 x 25% x 6/12||=||1,250|
|10,000 x 25% x 3/12||=||625|
|28,000 x 25%||=||7,000|
|15,000 x 25% x 6/12||=||1,875|
|Year 3||35,000 ( 43,000 – 8,000) x 25%||=||8,750|
|Year 4||51,000 x 25%||=||12,750|
The balance sheet extracts for years 1-4 (inclusive) are as follows:
Motor van at cost
Net book value
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