Depreciating assets - Unit: 5 (FRA)

Andrew Harrington explains different accounting methods used to calculate depreciation

Financial statements are prepared in accordance with the accruals concept: income earned in a period is matched with the expenditure incurred to generate that income. As a consequence, the expenses in a profit and loss account represent the cost of resources used in the accounting period, rather than simply amounts paid during that period.

Fixed assets are intended for long-term use, often over a number of years. It would be inappropriate to charge their cost to profit and loss immediately on acquisition; rather, the cost should be spread over the periods benefiting from use of the asset.

Depreciation is an accounting estimate of the proportion of cost used up in each period over a fixed asset’s lifetime. When the asset is acquired, an estimate is made of the residual value when it is eventually disposed of. The difference between this and the original cost represents the lifetime cost to the business of using the asset. Additionally, an estimate is made of the asset’s useful economic life (i.e. how long the business will keep and use it). A policy is then adopted to spread the cost over the useful life, thus matching it with the benefits to be gained from the asset’s use.

Straight-line depreciation is the simplest approach – here, the cost of using the asset is shared equally over the accounting periods expected to benefit. For example, suppose an asset is purchased for £40,000, and the business expects to sell it after four years for £16,500. The total cost to the business is £23,500 (£40,000 - £16,500). Depreciation of £5,875 (£23,500 / 4) will be charged as an expense in the profit and loss account each year (and deducted from the asset’s cost in the balance sheet to give the net book value).

An alternative is the reducing balance method. This calculates depreciation as a constant percentage of the net book value of the asset (original cost less accumulated depreciation to date). The above asset could be depreciated at 20 per cent reducing balance as follows:

Depreciation is accounted for using the journal. Each year, the charge calculated is debited to a depreciation expense account and credited to an accumulated depreciation account (sometimes called the provision for depreciation). The expense account is written off to profit and loss, so will only show the charge for an individual year. The accumulated depreciation account is ongoing, and thus increases each year. In the balance sheet, it is offset against the fixed asset cost to reflect the falling value of the asset.

At some point, the business will probably dispose of the asset. This disposal must be accounted for, and there are two objectives:

• any account balances relating to the asset must be removed from the books; and
• the actual loss in value is now known, and any under- or over-provision for depreciation can be identified and dealt with.

The double entry is as follows:

The second and third journals achieve the first objective of removing the asset from the books. The balance held in the disposals account is the difference between the book value on disposal and the actual value (the sales proceeds). This represents either an under-provision of depreciation (known as a loss on disposal) or an over-provision (known as a profit on disposal), and is charged/debited or credited respectively to the profit and loss account.

In the example above, suppose the reducing balance method had been chosen, and that the asset was actually sold at the end of Year 3 for £18,000. The disposals account would be completed as follows:

The transfer from accumulated depreciation is the total depreciation charged to date (£8,000 + £6,400 + £5,120 = £19,520). The transfer to the profit and loss account is described as a loss on disposal, representing the fact that while the asset had a book value of £20,480, it actually realised only £18,000.

Andrew Harrington runs www.teachmenow.net and is a lecturer and author