👋 Welcome to the World of Depreciation!
Hello! This chapter might sound complicated—"Non-current assets? Disposal?"—but don't worry. This is one of the most practical and essential parts of accounting. We are going to learn how businesses account for the large items they buy, like machines or delivery vans, and how these items lose value over time.
Understanding this is crucial for the Development of the Accounting Model because it ensures our financial statements show a true and fair view of a business's health. It helps us match the cost of using an asset with the revenue it helps generate.
🛠️ Section 1: Non-Current Assets (NCA) - The Basics
What are Non-Current Assets?
Think of things a business buys that they plan to keep and use for a long time—usually more than one year.
Non-Current Assets (NCA) (sometimes called Fixed Assets) are items:
- Owned by the business.
- Used to help run the business (e.g., manufacture goods, transport products).
- Expected to last for several years.
- Not bought for the purpose of immediate resale (that would be Inventory).
Examples: Machinery, Factory Buildings, Motor Vehicles, Computer Equipment, Fixtures and Fittings.
Key Accounting Principle: The Cost Concept
In accounting, we record all NCAs at their Historical Cost. This is the original price paid, plus any extra costs needed to get the asset ready for use (like delivery fees or installation costs).
If a business buys a machine for \$10,000, pays \$500 for delivery, and \$200 for installation, the Historical Cost recorded in the books is:
\$10,000 + \$500 + \$200 = \$10,700
📉 Section 2: What is Depreciation and Why Do We Need It?
The Concept of Depreciation
Have you ever bought a brand new phone or a car? The moment you start using it, its value starts to drop. Depreciation is the accounting way of recognizing this loss of value.
Depreciation is the systematic allocation of the cost of a Non-Current Asset over its useful life.
Why do assets lose value?
- Wear and Tear: Physical use of the asset (e.g., a delivery van racking up mileage).
- Obsolescence: Becoming outdated due to new technology (e.g., an old computer system).
- Time: Even if not used, assets like copyrights or leases expire over time.
The Matching Principle
Depreciation is vital because of the Matching Principle. If a delivery van lasts 5 years and helps the business earn revenue for 5 years, we shouldn't charge the entire cost of the van as an expense in year 1. We should spread that cost across all 5 years.
By doing this, we match the expense (depreciation) with the revenue earned in that period, giving a much more accurate picture of the business's profitability.
Net Book Value (NBV)
The value of an asset recorded in the Statement of Financial Position (Balance Sheet) is called the Net Book Value (NBV) or Carrying Amount.
NBV is calculated simply as:
Historical Cost – Accumulated Depreciation = Net Book Value
Depreciation is an estimate and a non-cash expense. No cash leaves the bank when depreciation is recorded; it is purely an adjustment in the accounts to follow the matching principle.
📊 Section 3: Calculating Depreciation (The Two Main Methods)
Businesses need to choose a method that best reflects how the asset is used up. We focus on two main methods: Straight Line and Reducing Balance.
1. Straight Line Method (SLM)
This is the simplest method. It assumes the asset is used up evenly over its life. The depreciation charge is the same every single year.
Analogy: It’s like paying an equal instalment loan every month.
You need three pieces of information for this method:
1. Cost of the Asset (C)
2. Estimated Useful Life (N, in years)
3. Estimated Residual Value (R) (or Scrap Value) – the amount the business expects to sell the asset for at the end of its useful life.
The formula for the annual depreciation charge is:
$$
\text{Annual Depreciation} = \frac{\text{Historical Cost} - \text{Residual Value}}{\text{Estimated Useful Life (years)}}
$$
Alternatively, the business may use a percentage rate on the historical cost:
$$
\text{Annual Depreciation} = \text{Rate (\%)} \times \text{Historical Cost}
$$
Example: A machine costs \$10,000. Expected life is 5 years. Residual value is \$2,000.
$$
\text{Annual Depreciation} = \frac{\$10,000 - \$2,000}{5} = \frac{\$8,000}{5} = \$1,600
$$
The depreciation charge is \$1,600 every year for 5 years.
2. Reducing Balance Method (RBM)
This method charges a higher depreciation amount in the early years and a lower amount in later years. It is often used for assets like computers or vehicles that lose most of their economic value quickly.
Analogy: Like watching your car value drop sharply in the first year, then slow down later.
This method ignores the residual value when calculating the annual charge, but the asset’s NBV should never fall below the residual value.
The formula uses a fixed percentage applied to the Net Book Value (NBV) at the beginning of the year:
$$
\text{Annual Depreciation} = \text{Rate (\%)} \times \text{Net Book Value (at start of year)}
$$
Example: Motor Vehicle cost \$30,000. Depreciation rate is 20% using RBM.
- Year 1: Depreciation = 20% of \$30,000 = \$6,000. (NBV = \$24,000)
- Year 2: Depreciation = 20% of \$24,000 = \$4,800. (NBV = \$19,200)
- Year 3: Depreciation = 20% of \$19,200 = \$3,840. (NBV = \$15,360)
In RBM, you must remember to use the NBV (Cost minus all previous depreciation). If you apply the rate to the original cost, you are accidentally using the Straight Line Method!
ledger-entries Section 4: Accounting for Depreciation (The Ledger Entries)
When recording NCA transactions, we use two main ledger accounts for the asset itself: the Asset Account (Cost) and the Provision for Depreciation Account.
The Provision for Depreciation Account (P for D)
This is the key account that makes accounting for NCAs simpler.
The Asset Account (e.g., Motor Vehicles Account) always remains at Historical Cost. This keeps the original cost clearly visible.
The Provision for Depreciation Account (also known as Accumulated Depreciation) records the total depreciation charged on that asset since it was purchased. This account is a Contra-Asset Account, meaning it reduces the value of the asset.
Recording the Annual Charge
Two entries are required every year:
Step 1: Record the Expense
The depreciation charge is an expense for the year. This expense is recorded in the Depreciation Expense Account (which closes to the Income Statement/Profit and Loss Account).
Debit: Depreciation Expense Account (Increases the Expense)
Credit: Provision for Depreciation Account (Increases the Accumulated Depreciation)
Step 2: Transfer the Expense
At the end of the year, the Depreciation Expense is transferred out to calculate profit.
Debit: Income Statement / Profit and Loss Account
Credit: Depreciation Expense Account (Closes the expense for the year)
In the SFP, Non-Current Assets are presented as follows:
Cost of NCA (e.g., Motor Vehicles Account balance)
Less: Provision for Depreciation (e.g., P for D Account balance)
Equals: Net Book Value (NBV)
🗑️ Section 5: Disposal of Non-Current Assets
Eventually, assets wear out, become obsolete, or are sold because the business needs an upgrade. When an asset is sold or scrapped, we must remove it from our books. This process is called Disposal.
The goal of disposal accounting is to calculate whether the business made a Profit or Loss on Disposal.
The Disposal Account (The Calculation Tool)
To manage the disposal process, we use a temporary account called the Disposal of Non-Current Assets Account. This account brings together the cost, the accumulated depreciation, and the selling price to calculate the final profit or loss.
Step-by-Step Disposal Process
Assume a business sells equipment that originally cost \$20,000, for which \$14,000 depreciation has already been provided. They sell it for \$7,000 cash.
Step 1: Transfer the Historical Cost to the Disposal Account
We need to remove the asset from the Asset Account (e.g., Equipment Account).
Debit: Disposal of NCA Account (\$20,000) (Cost enters the calculation)
Credit: Equipment Account (\$20,000) (Asset Account is cleared)
Step 2: Transfer the Accumulated Depreciation to the Disposal Account
We need to clear the depreciation provided for this specific asset from the Provision for Depreciation Account.
Debit: Provision for Depreciation Account (\$14,000) (Provision is cleared)
Credit: Disposal of NCA Account (\$14,000) (Accumulated depreciation enters the calculation)
Step 3: Record the Sale Proceeds
Record the cash or credit received from the sale.
Debit: Bank/Cash Account or Trade Receivables (\$7,000)
Credit: Disposal of NCA Account (\$7,000) (Sale revenue enters the calculation)
Calculating Profit or Loss on Disposal
The final balance (the balancing figure) in the Disposal Account is the Profit or Loss.
Remember, the Net Book Value (NBV) of the asset at the time of sale was:
$$
\text{Cost} - \text{Accumulated Depreciation} = \text{NBV} \\
\$20,000 - \$14,000 = \$6,000
$$
If the Sale Price is greater than the NBV, there is a Profit.
If the Sale Price is less than the NBV, there is a Loss.
In our example:
Sale Price (\$7,000) is greater than NBV (\$6,000).
$$
\text{Profit} = \text{Sale Price} - \text{NBV} \\
\$7,000 - \$6,000 = \$1,000 \text{ Profit}
$$
Step 4: Transfer the Profit or Loss
This balance is transferred to the Income Statement/Profit and Loss Account.
- If Profit (Disposal Account has a Credit balance):
Debit: Disposal of NCA Account (\$1,000)
Credit: Income Statement / Profit and Loss Account (\$1,000) - If Loss (Disposal Account has a Debit balance):
Debit: Income Statement / Profit and Loss Account
Credit: Disposal of NCA Account
Think of the Disposal Account like a bathtub that needs to be perfectly balanced:
- Debit Side: The Cost (what you paid)
- Credit Side: The Depreciation (what you’ve covered) + The Sale Price (what you received)
If the Credit Side > Debit Side: You received more than the cost you still needed to cover → PROFIT.
Don't worry if the ledger entries seem intimidating. Practice transferring the three main figures (Cost, P for D, Sale Proceeds) into the T-account structure, and the final profit or loss will reveal itself!