Depreciation and Disposal of Assets

Introduction
There is a time period attached to the useful life of all assets owned by a business. Since assets depreciates in value as it is being used it can no longer be valued at cost price. In this topic you will calculate depreciation and determine the disposal value of assets.

Objectives
Upon completion of this topic you should be able to
1. Define depreciation.
2. State reasons for depreciating assets.
3. Identify methods of calculating depreciation.
4. Determine book value and disposal value of assets.
5. Examine the different methods of calculating depreciation (straight line and diminishing balance method).
6. Show the treatment of depreciation in the financial statements.

What is Depreciation?
Let us begin by defining depreciation. According to Woods and Robinson (2007), Depreciation is the part of the original purchase cost of a fixed asset consumed during its period of use by the business. It is an expense for services consumed and will be charged to the income statement and will therefore, reduce net profit.

Depreciation is a process of allocation, not valuation. Eventually, all assets except land wear out or become so inadequate or outmoded that they are sold or discarded; therefore, firms must record depreciation on every plant asset except land. They record depreciation even when the market value of a plant asset temporarily rises above its original cost because eventually the asset is no longer useful to its current owner.

Causes of depreciation
Major causes of depreciation are:

• physical deterioration,
• inadequacy for future needs, and
• obsolescence.

Physical deterioration results from the use of the asset—wear and tear—and the action of the elements. For example, an automobile may have to be replaced after a time because its body rusted out.

Inadequacy of a plant asset is its inability to produce enough products or provide enough services to meet current demands. For example, an airline cannot provide air service for 125 passengers using a plane that seats 90.
Obsolescence of an asset is its decline in usefulness brought about by inventions and technological progress. For example, the development of the xerographic process of reproducing printed matter rendered almost all previous methods of duplication obsolete.

To compute depreciation expense, accountants consider four major factors:

• Cost of the Asset
• Estimated salvage value of the asset. Salvage value (or scrap value) is the amount of money the company expects to recover, less disposal costs, on the date a plant asset is scrapped, sold, or traded in.
• Estimated useful life of the asset. Useful life refers to the time the company owning the asset intends to use it; useful life is not necessarily the same as either economic life or physical life. The economic life of a car may be 7 years and its physical life may be 10 years, but if a company has a policy of trading cars every 3 years, the useful life for depreciation purposes is 3 years. Various firms express useful life in years, months, working hours, or units of production. Obsolescence also affects useful life.
• Depreciation method used in depreciating the asset. We describe the four common depreciation methods in the next section.

How is Depreciation Calculated?
In order to have free and fair view of the Balance Sheet it is important that the assets on the balance sheet are correctly valued.

Today, businesses can use many different methods to calculate depreciation on assets.This section discusses and illustrates the two most common methods—straight-line, and reducing balance method.

According to accounting theory, a business should use a depreciation method that reflects most closely their underlying economic circumstances. Thus, businesses should adopt the depreciation method that allocates asset cost to accounting periods according to the benefits received from the use of the asset.

Before studying some of the methods that companies use to depreciate assets, make sure you understand the following definitions.

• Useful life is an estimate of the productive life of an asset. Although usually expressed in years, an asset's useful life may also be based on units of activity, such as items produced, hours used, or miles driven.
• Salvage value equals the value, if any that a company expects to receive by selling or exchanging an asset at the end of its useful life.
• Depreciable cost equals an asset's total cost minus the asset's expected salvage value. The total amount of depreciation expense assigned to an asset never exceeds the asset's depreciable cost.
• Net book value is an asset's total cost minus the accumulated depreciation assigned to the asset. Net book value rarely equals market value, which is the price someone would pay for the asset. In fact, the market value of an asset, such as a building, may increase while the asset is being depreciated. Net book value simply represents the portion of an asset's cost that has not been allocated to expense. (CliffsNotes.com. Depreciation of Operating Assets. 18 Apr 2011)

Straight-line Depreciation
 

Straight-line Depreciation Formula

 This is the method most commonly used by businesses for financial reporting. In this method the assets annual depreciation expense is calculated by dividing the assets cost by the number of years of useful life of the assets. Equal amount is transferred to the income statement for depreciation each year. The assumption is that each accounting period equally benefits from the use of the asset. The straight line method calculates an annual charge by:
using a formula; or applying a fixed percentage to the depreciable amount of the asset.


Reducing Balance Method


 

Reducing Balance Method Calculation

In this method also called the diminishing balance, a different amount is charged to the Income Statement each year for depreciation. A fixed percentage is applied to the net book value of the asset at the beginning of each year. The net book value reduces as the asset ages and the depreciation charge diminishes

Recording Depreciation

Usually separate records of the cost of each type of non-current asset and the accumulating depreciation on each type of non-current assets are kept. The provision for depreciation account is updated at the end of each financial year with the annual depreciation charge. This is done as follows:

• Record the annual depreciation charge in the general journal
• Post the journal entries to the accounts
  • Debit Profit & loss Account
  • Credit Provision for Depreciation Account

The Profit & loss account section of the income statement is debited with the depreciation to ensure that profits are reduced for the year under review. The credit entry in the provision account has the effect of reducing the value of the non-current asset. (Austen et al 2011)

Let us now prepare the double entry records for the reducing balance example 3.1c

The journal entries are then posted to the accounts example 3.1 D

How Does Depreciation Affect the Balance Sheet?

The balance sheet at the end of each financial year should show the noncurrent assets at cost less the balance on the provision for depreciation account. At the end of each year that year’s depreciation is charged to the Profit & loss account but it is the accumulated depreciation to date that is charged to the balance sheet. Let’s have a look at the balance sheet extract for the example completed.

Balance Sheet (extract) as at 31 December 2011
		Cost	Accumulated Depreciation	Net Book Value
		$	$	$
Motor Vehicle		50,000	10,000	40,000
Balance Sheet (extract) as at 31 December 2012
		Cost	Accumulated Depreciation	Net Book Value
		$	$	$
Motor Vehicle		50,000	18,000	32,000
Balance Sheet (extract) as at 31 December 2013
		Cost	Accumulated Depreciation	Net Book Value
		$	$	$
Motor Vehicle		50,000	24,400	25,600
Balance Sheet (extract) as at 31 December 2014
		Cost	Accumulated Depreciation	Net Book Value
		$	$	$
Motor Vehicle		50,000	29,520	20,480
Balance Sheet (extract) as at 31 December 2015
		Cost	Accumulated Depreciation	Net Book Value
		$	$	$
Motor Vehicle		50,000	33,616	16,384

The Sale of an Asset
When an asset is sold it should be deleted from your records. This is done by take out the cost from the asset account, the amount of accumulated depreciation removed from the provision for depreciation account, and then the profit or loss on sale is calculated. These entries are record in the asset disposal account.

The Account Entries Needed
On the sale of non-current asset, example Motor Vehicle, the following entries are needed.

1. Transfer the cost of the asset to be sold to an asset disposal account (for this example a Motor Vehicle Disposal Account).

• Debit Motor Vehicle Disposal Account
• Credit Motor Vehicle Account

2. Transfer the accumulated depreciation to the asset disposal account.

• Debit Provision for Depreciation – Motor Vehicle
• Credit Motor Vehicle Disposal Account

3. Record the funds received from the sale of the asset.

• Debit Cash Book
• Credit Motor Vehicle Disposal Account

4. Transfer the balance on the asset disposal account to the Profit & loss account.

a) If the Motor Vehicle Disposal Account show a balance on the debit side of the account then it is a profit on sale.

• Debit Motor Vehicle Disposal Account
• Credit Profit & loss Account

b) If the Motor Vehicle Disposal Account shows a balance on the credit side of the account then it is a loss on sale.

• Debit Profit & loss Account
• Credit Motor Vehicle Disposal Account

Now let us assume that the motor vehicle in the example above was disposed of at the end three years. Assume that on the 1st January 2014 the Motor Vehicle was sold for $20,000 by cheque, then the following entries would be made to record this disposal.

	Motor Vehicle
2011		$	2011		$
1-Jan	Bank	50,000	31-Dec	Balance c/d	50,000
2012			2012
1-Jan	Balance b/d	50,000	31-Dec	Balance c/d	50,000
2013			2013
1-Jan	Balance b/d	50,000	31-Dec	Balance c/d	50,000
2014			2014
1-Jan	Balance b/d	50,000	1-Jan	Motor Vehicle Disposal Account	50,000
Provision for Depreciation of Motor Vehicle
2011		$	2011		$
31-Dec	Balance c/d	10,000	31-Dec	Profit & loss	10,000
2012			2012
31-Dec	Balance c/d	18,000	1-Jan	Balance b/d	10,000
			31-Dec	Profit & loss	8,000
		18,000			18,000
2013			2013
31-Dec	Balance c/d	24,400	1-Jan	Balance b/d	18,000
			31-Dec	Profit & loss	6,400
		24,400			24,400
2014			2014
1-Jan	Motor Vehicle Disposal Account	24,400	1-Jan	Balance b/d	24,400
		24,400			24,400

	Cash Book
Date		Cash	Bank	Date		Cash	Bank
2014		$	$	2014		$	$
1-Jan	Motor Vehicle Disposal		20,000

	Motor Vehicle Disposal Account
2014		$	2014		$
1-Jan	Motor Vehicle	50,000	1-Jan	Provision for Depreciation	24,400
			1-Jan	Cash Book	20,000
			1-Jan	Profit & loss (loss on Sale)	5,600
		50,000			50,000
Profit & loss Account (extract) for the year ended 31 December 2014
					$
	Gross Profit				x xxxx
	Less Loss on sale of Motor Vehicle				5,600

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Topic Summary
You have just looked at the entries necessary to record depreciation of non-current assets and the disposal of non-current assets. You should remember that the depreciation for the current year is charged to Profit & loss account but the accumulated depreciation is charged to the balance sheet each year.
You will now continue by look at other necessary adjustment that are required before the final accounts can be prepared.