7.
1 CAUSES OF DEPRECIATION
Non-current assets such as machinery, motor vehicles, plant and equipment tend
to fall in value (depreciate) for various reasons. These reasons are described more
fully below.
PHYSICAL DEPRECIATION
1 Wear and tear. Non-current assets as described above eventually wear out.
Some last many years, while others wear out more quickly.
2 Erosion, rust, rot and decay. Equipment may be eroded or wasted away by the
action of wind, rain, sun or the other elements of nature. The metals in motor
vehicles or machinery will rust away. Wood will rot eventually. Decay is a
process caused by the elements of nature and a lack of proper attention.
ECONOMIC FACTORS
Economic factors are the reasons for an asset being put out of use even though it
is in good physical condition. The two main economic factors are obsolescence
and inadequacy.
1 Obsolescence. This occurs when an asset becomes out of date due to advanced
technology or a change in processes. For example, in the car industry much of the
assembly work is now done by robots. Computer hardware and software tend to
go out-of-date very quickly and need updating and replacing regularly.
2 Inadequacy. This arises when an asset is no longer used because of the growth
and change in the size of the business due to new regulations. The transport
industry is now able to use much larger vehicles than before, resulting in many
businesses selling off their smaller vehicles.
Both obsolescence and inadequacy do not necessarily mean that an asset is
destroyed. It is merely put out of use by the business. Another business will often
buy it.
THE TIME FACTOR
Some assets have a legal life fixed in terms of years, for example, a lease. A
business may decide to rent a property for ten years, so it takes out a lease. A
legal agreement is drawn up between the parties. Each year, a proportion of the
cost of the lease is depreciated until the lease expires and the value is nil. In such
cases, the term amortization may be used instead of the term depreciation.
DEPLETION
Some assets are of a 'wasting nature' such as the extraction of raw materials from
mines or quarries, or oil from oil wells. Such natural resources are often sold in
their raw state to other businesses for processing. Providing for the consumption
of an asset of a wasting character is known as provision for depletion.
Disposal value: Disposal value is the value of an asset when it is sold or scrapped,
or the lowest price at which a business can sell it. It is the value at which a
company can sell an asset without incurring a loss. To calculate disposal value,
subtract the depreciation cost from the original cost of the asset.
7.2 METHODS OF CALCULATING DEPRECIATION CHARGES
The two main methods used for calculating depreciation charges are the straight
line method and the reducing balance. Most accountants think that the straight
line method is usually most suitable, although other methods are needed in certain
cases.
STRAIGHT LINE METHOD
This method involves the cost price of an asset, the estimated years of its use and
the expected disposal value. The depreciation charge each year can be calculated
as:
For example, a business purchases a car for $22 000. It decides to keep it for
four years and then sell it for $2000. The depreciation to be charged is:
The depreciation charge of $5,000 will be charged for four years.
If, after four years, the car had no disposal value, the charge for depreciation
would be:
In the exam, you may be asked to calculate straight line depreciation using a
percentage. The percentage is derived from the number of years of use, and the
scrap value is taken into consideration, but it is just given as a percentage.
Example 1: A question may say:
Mic purchased a motor vehicle at a cost of $25 000. He wants to use the straight
line method at 20%.
You would therefore work out 20% of $25 000, which is $5000.
REDUCING BALANCE METHOD
Calculating the amount of depreciation to be charged involves deciding on a
percentage amount to be used each year. This percentage is deducted from the
cost price in the first year and deducted from the new (reduced) balance in
subsequent years. This is illustrated in Example 2.
Example 2: A machine is bought for $10000 and depreciation is to be charged at
20%. The calculations for the first three years are:
Hint: Carrying value = cost price -depreciation to date
The machinery is purchased on 1 January 2014 and paid for by cheque at $2000
At the end of the year, the asset is depreciated at 20% per annum using the
reducing balance method. First of all, the amount of depreciation to be charged
each year needs to be calculated:
To record the depreciation charge :
Debit the income statement with the amount of depreciation each year.
Credit the provision for depreciation machinery account with the amount
of the depreciation charged each year.
In the statement of financial position, the asset and total depreciation are shown
under the non-current asset section as follows:
The asset, i.e. machinery, is always shown at cost price, i.e. $2000.
The total depreciation to date, i.e. $400 + $320 + $256 = $976, is shown as
a deduction from the cost price of the machinery. This gives carrying value,
$2000-$976 $1024.
Ledger
7.4 THE DISPOSAL OF A NON-CURRENT ASSET
REASON FOR ACCOUNTING ENTRIES
When an asset is sold, it must be deleted from the accounts. This means that the
cost of the asset is taken out of the asset account. In addition, the depreciation of
the asset that has been sold from the depreciation provision needs to be removed.
Finally, the profit or loss on the sale must be calculated.
Depreciation charges can only be estimated. When a business purchases an asset,
they do not know exactly when they will dispose of the asset or how much they
will be able to sell the asset for, if anything. When they do eventually dispose of
the asset, the amount they receive for it is usually different from the original
estimate.
ACCOUNTING ENTRIES NEEDED
On the sale of a non-current asset, e.g. machinery, the following entries are
needed:
1. Transfer the cost price of the asset sold to an assets disposal account (in this
case, a machinery disposals account):
Debit the machinery disposals account
Credit the machinery account.
2. Transfer the depreciation already charged to the assets disposal account:
Debit the provision for depreciation machinery account
Credit the machinery disposals account.
3. Record the amount received on disposal:
Debit cash book
Credit machinery disposals account.
4. Transfer the difference (i.e. the amount to balance the machinery disposals
account) to the income statement.
a. If the machinery disposals account shows a difference on the debit side of
the account, there is a profit on the sale:
Debit the machinery disposals account
Credit the income statement.
b. If the machinery disposals account shows a difference on the credit side of
the account, there is a loss on the sale:
Debit the income statement
Credit the machinery disposals account.
Presume that the machinery shown is sold. The records to 31 December 2016
show that the cost of the machine was $2000. A total of $976 has been written
off as depreciation, leaving a carrying value of ($2000-$976) = $1024. If the
machine is sold on 2 January 2017 for more than $1024, a profit on sale will be
made. If the machine is sold for less than $1024, then a loss on disposal will be
incurred.
Shows the entries needed if the machine is sold for $1070 and a small profit is
made on sale. if the machine is sold for $950, incurring a loss on the sale. In both
cases the sale is on 2 January 2017 and no depreciation is charged for the two
days' ownership in 2017.
Figure1 : If Profit
Figure: If loss
