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Chapter 4

ACCOUNTING FOR NON CURRENT ASSETS

Learning Objectives
At the end of this chapter, you should be able to:

1. define depreciation
2. explain why do we have to include depreciation in the balance sheet and profit and loss account?
3. outline the causes of depreciation
4. explain factors used for calculation of depreciation
5. calculate depreciation by using different depreciation methods.
6. differentiate between depreciation and provision for depreciation.
7. prepare journal entries and open ledger accounts for recording depreciation

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Depreciation

‘Depreciation’ is an example of the ‘matching’ principle in action. It represents

f
De ine it !
the diminution in value of a fixed asset over a period of time. Depreciation is
Depreciation is
the allocation of
the cost of an recorded as an expense in the income statement to spread the original cost of an
asset over its
estimated life. asset over its useful life to match the revenue it is generating.

The Net Book Value is the reduced fixed asset value at any point in time after depreciation.

As a fixed asset has a life of over 1 year and is expected to produce revenue over a number of years,

it is important to spread the cost of the fixed asset over these years.

Why do we have to include depreciation in the balance sheet and profit and loss account?

The depreciation charge in the profit and loss account represents a cost of expense and can be viewed as

the cost of using the fixed asset over the period that the profit and loss account covers. This follows the

matching concept which requires that revenues are matched with expenses in the year they are incurred.

Causes of depreciation

Fixed assets are those assets bought by the company for the intention to be used for a long period of time.

Fixed assets are said to depreciate over a period of time due to the following factors:

1) Physical deterioration

i) Wear and tear – When a motor vehicle or machinery or fixtures and fittings are used, they eventually
wear out. Some last many years, others last only a few year.

ii) Erosion, rust, rot and decay – Land may be eroded or wasted away by the action of wind, rain, sun
and other elements of nature. Similarly, the metals in motor vehicles or machinery will rust away.

2) Economic factors

i) Obsolescence – This is the process of becoming out of date.

ii) Inadequacy – This arises when an asset is no longer used because of the growth and changes in

the size of the firm.

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3) The time factor

Some assets might have a legal life fixed in terms of years. For example, the patents, and leasehold.
You may agree to rent some buildings for 10 years. This is normally called a lease. When the years
are finished, the lease is worth nothing to you, as it has finished. Whatever you paid for the lease is
now of no value.

4) Depletion

Other assets are of wasting character, perhaps due to the extraction of raw materials from them. These
materials are then either used by the firm to make something else, or are sold in their raw state to other
firms. Natural resources such as mines, quarries and oil wells come under this heading.

Factors for Calculating Depreciation

1) Cost of asset non-current assets includes all amounts incurred in acquiring the asset and to bring it into
working condition. The cost of asset include capital expenditure incurred eg. Delivery or
transportation charges, import duties, installation cost, the legal fees.
2) Estimated useful life of asset

This is the number of years that the asset is expected to be use

3) Residual or scrap value of the asset

This is the value of the asset at the end of its life.

Method of calculating depreciation

a) Straight-line method or Original Cost Method

Straight-line method of depreciation is based on the cost of an asset that is then depreciated, by the same
amount, over the estimated useful life of the asset.
Under this method the difference between the original cost of an asset and its estimated scrape value is
divided by its estimated useful life
Cost – Estimated Residual Value
Depreciation per annum =
Estimated life (in years)
Or
Fixed Percentage on original cost is written off the asset every year.
Depreciation per annum = Cost x Rate

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Example

ABC Ltd. Bought a machine at a cost of £80,000. The machine has an expected useful life of 5 years and at
the end of the 5th year, it can be sold for £10,000.
Cost – Estimated Residual Value
Depreciation per annum =
Estimated life (in years)

80,000 – 10,000
Depreciation per annum =
5
Depreciation per annum = £14000

Depreciation for 5 years would be:

b) Reducing balance method

Depreciation is calculated on a fixed percentage on the Diminishing Balance of the Asset (the NBV).
This results in a higher depreciation charge in the earlier years of the asset’s estimated useful life.
Example

A machine costs £50,000 is to be depreciated at 15% on Reducing Balance Method.

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c) Revaluation Method

Sometimes it is not possible to maintain detailed records of certain types of fixed Assets, such as
very small items of equipment packing cases and hand tools. In such case the revaluation method
is used.
Under this method the assets are revalued at the end of each year and this value is
compared with the value at the beginning of the period. The difference is treated as depreciation
for that year.

Depreciation = Value of assets at the beginning + purchases of assets during the period –
disposals at book value –value of asset at the end.

If Deprecation rate is not given then

Rate of Depreciation= Last year Deprecation x 100

Net Book value/Cost of Asset held at the End of last year

Difference between Depreciation and Provision for Depreciation.

Depreciation is an expense which is charged in the income statement for the current year; however it is not
deducted from non-current assets directly. It is instead recorded in contra asset account namely provision for
depreciation or accumulated depreciation. This provision for depreciation is then subtracted from the
original cost of a non-current to calculate its net book value.

Provision in a balance sheet represents total reduction in the value of non-current assets from their dates of
acquisition to the end of the current year.

Annual depreciation charge is an expense and has a debit nature whereas provision for depreciation as contra
asset has a credit balance.

The Disposal of an Asset

Upon the sale of an asset, we will want to delete it from our accounts. This means that the cost of that asset
needs to be taken out of the asset account. In addition, the depreciation of the asset which has been sold will
have to be taken out from the provision for depreciation. Finally, the profit and loss on sale, if any, will have
to be calculated.

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Double Entry Used:

(1) Debit: Non-current asset Account

Credit: Cash/Bank Account
(to record purchase of non-current asset)
(2) Debit: Income statement
Credit: Provision for Depreciation Account
(to record annual depreciation of non-current assets)

(3) Debit: Disposal Account

Credit: Asset account at cost
(on disposal of non-current asset)

(4) Debit: Provision for Depreciation Account

Credit: Asset Disposal Account
(to transfer all the provision for depreciation on asset sold to the disposal A/c).

(5) Debit: Cash/Bank Account

Credit: Asset Disposal Account
(to record the sales proceeds of the asset sold in the asset disposal account)

Part Exchange of an asset for another.

An old asset is traded for a new asset. The value agreed for the exchange of the asset exchanged is known as
part exchange or trade in allowance.

(6) Debit: New Non-current asset Account (purchase price)

Credit: Asset Disposal Account (trade in value of the old asset)
Credit: Cash/Bank Account (difference paid by cheque or in cash)
(to record part exchange of an asset for another)

(7) Debit: Asset Disposal Account

Credit: Income statement (profit)
(to close credit balance (profit) in the asset disposal account)

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(8) Debit: Income statement (loss)

Credit: Asset Disposal Account
(to close debit balance (loss) in the asset disposal account)

Depreciation and Accounting Concept

 According to “Prudence Concept” we should not overstate the value of our assets.
 “Matching Concept” which states that while preparing the income statement, revenues of the

business are matched with the related expenses incurred in earning these revenues.

 Once a depreciation method is chosen, it should not be changed. This is in accordance with the
“consistency Concept”.

Practice Questions

Review Questions 26.1, 26.2, 26.3, 26.4A, 26.5A, 26.6A, 26.7, 26.8, 26.9, 26.10A, 26.11A

Review Questions 27.1, 27.2, 27.3A, 27.4, 27.5, 27.6, 27.9A, 27.10, 27.11A, 27.12, 27.13A,

27.14, 27.15A, 27.16, 27.17A, 27.18.

( Business Accounting by Frank Wood & Alan Sangster )

Chapter 11

Exercise 1,2,3

( As and A Level Accounting by Harold Randall (Black )

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