Accounting for Depreciation and Disposal of Non-Current Assets (NCA)
Hello future accountants! This chapter might look complex, but it deals with a very simple truth: nothing lasts forever. When a business buys a machine, a van, or a building (these are Non-Current Assets), that asset loses value over time.
Learning this topic is crucial because it helps a business calculate its true profit and show the realistic value of its assets on the Statement of Financial Position (SFP). Let's dive in!
1. Understanding Depreciation: Why Assets Lose Value
A Non-Current Asset (NCA) is an asset owned by the business for long-term use (more than 12 months) and is not intended for immediate resale. Examples include machinery, vehicles, and furniture.
1.1 What is Depreciation?
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.
Simple Analogy: Think about buying a brand-new smartphone. The moment you open the box and start using it, its value starts dropping. That drop in value is depreciation. In accounting, we systematically record this drop as an expense.
Important Definition:
- Cost: The original amount paid for the asset, plus any costs needed to get it ready for use (e.g., delivery, installation fees).
- Residual Value (Scrap Value): The estimated selling price of the asset at the end of its useful life.
- Useful Life: The estimated period (in years or units of output) the business expects to use the asset.
- Depreciable Amount: Cost minus Residual Value. This is the total amount that will be depreciated over the asset's life.
1.2 Reasons for Accounting for Depreciation
Depreciation is essential because it applies two key accounting concepts (principles):
- Matching Principle: We need to match expenses to the revenue they help generate. A machine used for 5 years helps earn revenue for 5 years, so its cost must be spread out (matched) as an expense over those 5 years.
- Prudence Principle: Assets should not be overstated. If we show the machine on the SFP at its original cost forever, the accounts would look overly optimistic and misleading. Depreciation ensures assets are reported at a more realistic value (Net Book Value).
- Wear and Tear/Obsolescence: Physical use (wear and tear) or becoming outdated (obsolescence) causes the asset to lose value.
Quick Review: Depreciation is an expense, but it is not a cash expense. It reflects the cost of using the asset, not buying it.
2. Methods of Calculating Depreciation
The syllabus requires you to know and describe three main methods.
2.1 Straight-Line Method (SLM)
This is the simplest method. It assumes the asset is used evenly throughout its life, so the depreciation charge is the same amount every year. It is also known as the equal instalment method.
Formula: $$ \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life (in years)}} $$
Alternatively, if the business uses a percentage rate: $$ \text{Annual Depreciation} = \text{Cost} \times \text{Depreciation Rate} $$
Example: A machine costs $10,000, has a useful life of 5 years, and a residual value of $1,000.
Depreciable Amount = $10,000 - $1,000 = $9,000.
Annual Depreciation = $9,000 / 5 years = $1,800 per year.
2.2 Reducing Balance Method (RBM)
This method charges a higher depreciation expense in the early years and a lower expense in later years. It reflects the idea that assets (like cars) often lose most of their value when they are new.
The depreciation rate is applied to the Net Book Value (NBV), not the original cost.
Key Concept: Net Book Value (NBV) = Cost – Accumulated (Total) Provision for Depreciation.
Formula: $$ \text{Annual Depreciation} = \text{Net Book Value (NBV) at start of year} \times \text{Depreciation Rate} $$
Example: A machine costs $10,000. The rate is 20% per year.
- Year 1: NBV = $10,000. Depreciation = $10,000 x 20% = $2,000. (NBV End of Year 1 = $8,000)
- Year 2: NBV = $8,000. Depreciation = $8,000 x 20% = $1,600. (NBV End of Year 2 = $6,400)
- Year 3: NBV = $6,400. Depreciation = $6,400 x 20% = $1,280.
Did you know? Unlike the Straight-Line method, the Residual Value is ignored for the calculation under RBM, but the asset's NBV should generally not fall below the estimated residual value.
2.3 Revaluation Method
This method is typically used for assets where it is impractical or too difficult to track individual items and their usage, such as loose tools, spare parts, or livestock.
Depreciation is calculated by finding the difference between the value of the asset at the start of the year and the value at the end of the year.
Formula: $$ \text{Depreciation} = (\text{Opening Value} + \text{Additions}) - \text{Closing Value} $$
Example: Loose tools were valued at $500 at the start of the year. $200 worth of new tools were bought. At the end of the year, the remaining tools are valued at $450.
Depreciation = ($500 + $200) - $450 = $700 - $450 = $250.
Key Takeaway: Straight-line is based on cost; Reducing Balance is based on NBV; Revaluation is based on the change in value of a group of small assets.
3. The Double Entry for Depreciation (Provision Method)
To account for depreciation, we use two main accounts: the Depreciation Expense Account and the Provision for Depreciation Account (also called Accumulated Depreciation).
3.1 The Accounts Used
- Non-Current Asset Account (e.g., Vehicle Account): This ledger account records the original cost of the asset. Crucially, this account balance does not change due to depreciation.
- Provision for Depreciation Account (e.g., Provision for Depreciation - Vehicle): This account collects the total depreciation charged on the asset since it was purchased. It is a credit balance (as it reduces the asset value).
- Depreciation Expense Account: This is an expense account used only during the current year's accounting.
3.2 Recording Annual Depreciation
Recording depreciation involves two steps via the General Journal:
Step 1: Record the Depreciation Charge (The expense for the year)
We increase the expense and increase the accumulated depreciation (liability side account).
Journal Entry:
- Debit: Depreciation Expense Account (Increases the expense for the year)
- Credit: Provision for Depreciation Account (Increases the total accumulated depreciation)
Step 2: Transfer the Expense to the Income Statement
Like all expenses, the Depreciation Expense account must be closed off to the Income Statement at the end of the financial year.
Journal Entry:
- Debit: Income Statement
- Credit: Depreciation Expense Account (Clears the expense account to zero)
Don't worry if this seems tricky at first! Remember the Golden Rule:
The annual depreciation amount Debits the P&L (via the expense account) and Credits the SFP (via the provision account).
3.3 Presentation on the Statement of Financial Position (SFP)
The SFP shows the true position of the non-current assets:
| STATEMENT OF FINANCIAL POSITION (Extract) | | Non-Current Assets: | | Asset Name (at cost) .......................... $X,XXX | | Less: Provision for Depreciation ........... ($Y,YYY) | | Net Book Value (NBV) ........................ $Z,ZZZ |
Key Takeaway: Depreciation is calculated annually. The Provision for Depreciation account shows the total amount of depreciation since the asset was bought. The asset cost account remains unchanged.
4. Disposal of Non-Current Assets
Eventually, the business sells or scraps the non-current asset. This process requires closing the asset-related accounts and determining if the sale resulted in a Profit on Disposal or a Loss on Disposal.
4.1 The Disposal Account
The Disposal of Non-Current Assets Account is a temporary ledger account created specifically to handle the closing entries and calculate the profit or loss on the sale.
4.2 Step-by-Step Accounting for Disposal
Imagine selling a machine that originally cost $20,000, had accumulated depreciation of $14,000, and sold for $8,000 cash.
Step 1: Transfer the Cost of the Asset to the Disposal Account
We need to remove the original cost from the Asset Account (which is a Debit balance) and transfer it to the Disposal Account.
- Credit: Asset Account ($20,000) (To reduce its balance to zero)
- Debit: Disposal Account ($20,000) (To record the cost being disposed of)
Step 2: Transfer the Accumulated Provision for Depreciation
We need to remove the total accumulated depreciation from the Provision Account (which is a Credit balance) and transfer it to the Disposal Account.
- Debit: Provision for Depreciation Account ($14,000) (To reduce its balance to zero)
- Credit: Disposal Account ($14,000) (To remove the related depreciation)
Step 3: Record the Proceeds from the Sale
Record the money received from the sale.
- Debit: Cash/Bank/Trade Receivables ($8,000)
- Credit: Disposal Account ($8,000) (The money received related to the disposal)
Step 4: Calculate and Transfer the Profit or Loss on Disposal
The Disposal Account now contains all the figures necessary to calculate the profit or loss.
Disposal Account Summary:
| DISPOSAL ACCOUNT | | Debit Side (Costs Out) | Credit Side (Inflows) | | Cost of Asset ............ $20,000 | Acc. Depreciation . $14,000 | | Profit on Disposal ...... $2,000* | Sale Proceeds ..... $8,000 | | (Balancing figure) | | | Total .................... $22,000 | Total ................. $22,000 |
In our example: Total Credits ($14,000 + $8,000 = $22,000) are greater than Total Debits ($20,000).
- If Credit side > Debit side, there is a Profit on Disposal. (A profit is an income, so we credit the Income Statement). In this example: $22,000 - $20,000 = $2,000 Profit.
- If Debit side > Credit side, there is a Loss on Disposal. (A loss is an expense, so we debit the Income Statement).
Journal Entry for Profit ($2,000):
- Debit: Disposal Account ($2,000) (To balance the Disposal Account)
- Credit: Income Statement ($2,000) (To record the income/profit)
Common Mistake to Avoid: Do not mix up the Asset Account (Cost) with the Provision Account (Accumulated Depreciation). They are kept separate until the disposal.
Key Takeaway: The Disposal Account is the temporary place where the cost, the accumulated depreciation, and the sale proceeds meet to calculate the final profit or loss.