FRF7
Syllabus B. ACCOUNTING FOR TRANSACTIONS IN FINANCIAL STATEMENTS B1. Tangible non-current assets

B1e. Depreciation 5 / 7

Syllabus B1e)

Compute depreciation based on the cost and revaluation models and on assets that have two or more significant parts (complex assets).

Depreciation

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)

Year Cost Accum. Depn NBV
1 60,000 10,600 49,400
2 60,000 21,200 38,800
3 60,000 31,800 28,200
4 60,000 42,400 17,600
5 60,000 53,000 7,000

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

Year Cost/NBV b/d Depn Rate (%) Depn Expense Accum. Depn NBV c/d
1 17,000 35% 5,950 5,950 11,050
2 11,050 35% 3,868 9,818 7,182
3 7,182 35% 2,514 12,332 4,668
4 4,668 35% 1,634 13,966 3,034
5 3,034 35% 1,062 15,028 1,972

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.