topic 10 adjustment for depreciation charges

• Depreciation is the fall in value of NCA due to:

  • time
  • use/wear and tear
  • obsolescence
• Annual depreciation = (Cost of the asset - residual value) / Expected useful life of the asset
• SOFP figure is calculated by: The provision for depn figure in the trial balance + The depn figure in the IS = The total depn so far to date
• Reducing (diminishing) balance method:

  • using this method the value of the asset depreciates most rapidly in the early years of its life - a more realistic method of valuing assets
  • instead of calculating annual depn as a % of the original cost, annual depn is calculated as a % of the reduced balance on the asset, so that the annual charge decreases each year
• Preparing financial statements from a trial balance:

  • depn was a credit balance in the trial balance, this figure is the balance bd at the beginning of the year, added to expenses in the IS to give the final SOFP figure
• The provision for depn account:

  • this is an account in the general ledger which shows the depn on each type of asset
  • provision - an amount set aside out of profits for a known expense or liability of an uncertain amount
• Reducing balance depn - the provision for depn account is completed in exactly the same way as for straight line depn, only this time the annual charge figure will change each year
• Disposal of NCA:

  • when an asset has a finite life it will be disposed of, either for cash (cheque) or traded in for a more up to date version
  • the amount of cash or trade in which the business receives is known as 'the disposal proceeds'
• Profit (loss) on the disposal of a NCA:

  • depn is an estimate and it would be unusual for a business to sell an asset for exactly its NBV
  • if the proceeds on disposal are greater than NBV there is a profit on disposal and vice versa
• Ledger accounts to record disposals:

  Example:

  • a business bought a vehicle costing £10000 three years ago
  • the car was sold in december 2017
  • the total depn on the car at the time of disposal was £5780
  • the car was sold for £4000 - paid by cheque

  10000 (cost) - 5780 (depn) = NBV - 4000 (disposal proceeds) = 220 (loss on disposal)
• Profit (loss) on disposal in the disposals account:

  • any profit (loss) on sale is entered in the disposals account to make it balance
  • the double entry is:

  DR Income statement CR Disposals (loss on sale)

  DR Disposals (profit on sale) CR Income statement
• Trade in:

  • the provision for depn will be unaffected whether or not the business sells an old asset for money or obtains a trade in against the new asset, but the narrative in the asset account and the disposals account will be slightly different
  • where an old asset is traded in for a new asset, bank/cash does not go in the disposals account instead the trade in value is entered as: DR Asset account CR Disposals account
• Depreciation and cash:

  • depn is not a cash expense - it is only a book entry
  • only the purchase and sale of assets involves any change in cash
  • depn will not provide cash to replace an asset, however it indirectly keeps more cash in the business
  • by reducing profit it discourages the owner from taking out too much in drawings
• State and explain three reasons why it is important to depreciate NCAs:

  • value of NCA lose value over time, were a higher value at an earlier point in time
  • value of NCA lose value due to wear and tear, not as high quality as it was before
  • value of NCA lose value over time due to it becoming obsolete or out of date
• Explain all of the accounting entries that are needed to record the transactions resulting from a disposal of NCA:

  • at cost is recorded on the debit side of the disposal account
  • total depn is recorded on the credit side of the disposal account
  • proceeds on disposal is recorded on the credit side of the disposal account
  • profit on disposal is recorded on the debit side of the account and loss on disposal is recorded on the credit side of the account
• Explain the various factors which should be considered when deciding upon the method to use for calculating depn:

  • straight line depn is a suitable method for assets which depreciate at a constant rate, such as buildings and fixtures and fittings but it is unrealistic for other types of assets
  • reducing balance method depreciates assets most rapidly in the early years of its life - a more realistic method of valuing assets such as machinery and vehicles