ACCA FR Syllabus B. Accounting For Transactions In Financial Statements - Depreciation - Notes ^{5 / 7}

Where assets held by an enterprise have a limited useful life, it is necessary to apportion the value of an asset used in a period against the revenue it has helped to create.

Therefore, with the exception of land held on freehold or very long leasehold, every non-current asset has to be depreciated.

A charge is made in the income statement to reflect the use that is made of the asset by the business.

This charge is called depreciation.

The need to depreciate non-current assets arises from the accrual assumption.

If money is spent on an asset, then the amount must be charged against profits.

Some key terms are:

• Depreciation

  the allocation of the depreciable amount of an asset over its estimated useful life.

• Useful life

  the period over which a depreciable asset is expected to be used by the enterprise; or the number of production or similar units expected to be obtained from the asset by the enterprise.

• Depreciable amount

  cost/revalued amount –less residual value

• Residual value

  the amount the asset is expected to be sold for at the end of its useful life. It is also known as scrap value

2 Methods of Depreciation

1. Straight line method

2. Reducing balance method

1) Straight line method

The depreciation charge is the same every year.

• Formula

  (Cost of asset -– residual value) / expected useful life of asset
       
                              OR

  (Cost –- Residual value) × %

  This method is suitable for assets which are used up evenly over their useful life, e.g. fixtures and fittings in the accounts department.

Illustration

A non-current asset costing $60,000 has an estimated life of 5 years and a residual value of $7,000.

Required:
(a) Calculate the annual depreciation charge.
(b) Calculate the cost, accumulated depreciation and net book value (NBV) for each year of the asset’s life.

• a) ($60,000 - $7,000) / 5 years = $10,600 depreciation charge per year

• b)

2) Reducing balance method

This method is suitable for those assets which generate more revenue in earlier years than in later years; for example machinery in a factory where productivity falls as the machine gets older.

Under this method the depreciation charge will be higher in the earlier years and reduce over time.

• Formula:

  Depreciation rate (%) × Net Book Value (NBV)

  Net book value (NBV) = cost – - accumulated depreciation to date

  This method ignores residual value.

Illustration

A business buys a lorry costing $17,000. 
After 5 years, it is expected to be sold for scrap for $2,000. 
The depreciation rate is 35% on a reducing balance basis.

Required:
Calculate depreciation expense, accumulated depreciation and net book value of the machine for these five years using the reducing balance basis.

• Solution

Double-Entry for Depreciation

Depreciation has a dual effect which needs to be accounted for:

1. It reduces the value of the asset in the statement of financial position.

2. It is an expense in the income statement.

The double-entry for depreciation is:

• Dr Depreciation expense (I/S)
  Cr Accumulated Depreciation (SFP)

  with the depreciation charge for the period.