Depreciation is the loss of noncurrent assets and is charged to spread the cost of an asset over its useful life. In accordance with prudence and matching concept. Since a non-current asset is used over a certain time frame, therefore it is advisable to charge the cost of the asset over that time frame.
Why Does An Asset Lose Its Value?
• Technological Advancement
• Wear and tear
• Time factor
Methods of Charging Depreciation:
In order to charge depreciation and record the loss in the value of a non-current asset. The following methods are applicable:
This school of thought suggests that the same amount of depreciation must be changed each year in order to equally distribute the burden of a non-current asset. Formula to calculate depreciation using the straight-line method is,
(COST – SCRAP VALUE) / ESTIMATED USEFUL LIFE = DEPRECIATION
*Cost = Purchase Price+ All capital expenditures
Scrap Value/ Salvage Value/ Residual Value:
Value of asset that remains after the asset has been completely used and in no more under the useable condition.
*Estimated useful life means for how long the business plans do to use this asset.
The straight-line method is also called depreciation on cost. This is because the rate of depreciation is charged on the cost of the asset and the formula to calculate the rate of depreciation is,
Rate of Depreciation = Depreciation/Cost X 100
This method is called the straight-line method because if the graph of depreciation against time is made, it will result in a straight line.
EXAMPLE: Straight-line Method
Q. A company brought 2 machines worth $10,000; each was paid by cheque on 1st Jan 2015. The company’s policy is to charge depreciation at the rate of 20% per annum at the end of each year. After allowing the second-year depreciation, the company disposed of one of the machines for $5000. The company is applying the straight-line method. You are required to prepare to show all workings clearly the following account:
1. Machine Account
2. Provision for depreciation of machine Account.
3. Disposal Account.
4. Income Statement extract.
If NBV > Sales Proceeds = Loss on Disposal
If NBV < Sales Proceeds = gain on Disposal
If NBV = Sales Proceeds = No gain no loss
Cost - accumulated depreciation = NBV/ RC/ WDV
A disposal Account is a temporary account, which means that it will open and close on the same date. Income statement extracts are not totaled.
Reducing Balance Method:
This school of thought suggests that more amount of depreciation must be charged in the initial years than in the later years. This is because when the asset is new, it has little or no maintenance charges, and when the asset starts getting older, the burden of repair and maintenance starts increasing thus in order to equalize the overall burden of a non-current asset. More depreciation should be charged in the initial years when repair and maintenance are low, and less should be charged in the later years when the repair and maintenance are high. This is called the reducing balance method because the value of depreciation is falling with the passage of time. The reducing Balance method is also called the diminishing balance method of depreciation on net book value, reduced cost, written down value.
In the reducing balance method, the rate of depreciation is charged on the Net Book Value or written down value or reduced cost, which is calculated by subtracting accumulated depreciation from the cost as written below:
Netbook value/ written down value/ reduced cost = Cost – Accumulated Depreciation
The formula to calculate the rate of depreciation in reducing balance method is:
where R is the residual value
C is the cost
n is the life in years
A company bought a machine for $50,000, and its depreciation is to be charged at the rate of 10% per annum for five years of its lifetime. Do the calculation as per the reducing balance method.
It shows a continuous downward trend.
This school of thought suggests that depreciation should be based on the market value of assets and any change in the market value will determine the amount of depreciation and the formula to calculate depreciation using the revaluation method is as follows:
Following is the format of calculating depreciation and an example of how the figures are to be placed. (the figures are just an example)
• The straight-line method suggests some amount of depreciation must be charged each year to equally distribute the cost of assets over its useful life but doesn’t equally distribute the burden.
• Reducing balance method suggests more depreciation should be charged in the initial years than later. It equally distributes the burden of the asset, but depreciation is to be calculated every year.
• Revaluation Method suggests that depreciation on land and loose should be based on the market value of an asset, and though realistic depreciation is charged, sometimes market value may be wrongly determined.
Which Method of Depreciation is Best Suited for Different Assets?
• The straight-line method is best suited for those assets which lose their value slowly and gradually and almost equally with the passage of time. For instance, furniture, buildings, and so on.
• Reducing balance method is best suited for high tech items, which lose their value rapidly, such as Plant and machinery, equipment, and computers.
• Revaluation Method is best suited to those assets whose values cannot reliably be measured and depends on market rates. Even those assets which do not have significant value in isolation, but many items have a significant worth such as loose tools.
Double Entries to Record Depreciation
Deprecation → Current Year’s Expense
Provision for depreciation → Accumulated Depreciation, i.e., sum of all years depreciation contra asset.
Income Statement Debit
Provision for Depreciation Credit
*NOTE: The question will always mention the method and the rate of depreciation.
There are two different policies that businesses usually adopt:
1. Full year’s depreciation in the year of purchase with no depreciation in the year of sale.
2. Depreciation is charged on a pro-rata basis, i.e., a monthly basis.
If the question has not mentioned the policy, then depreciation will be charged on a pro-rata basis.
Depreciation must be charged at the end of each accounting period, not at the end of the calendar year. The calendar year starts in January and ends in December, but the accounting period can start any month and will end 12 months later, for example, Jan-Dec, April-March, July-June, Oct-Sept, and so on.