Depreciation of Fixed Assets Prepared by Lucky Yona

Contents Definition of Deprectiation Understand the REASONS for depreciation: Major Method Of Depreciation: Double entry for depreciation of fixed assets: Learn to deal with Disposal Of Fixed Asset

What is Depreciation Depreciation is the permanent and continuing diminution in the quality, quantity or value of an asset. Simply, depreciation is the loss of value due to fixed assets being consumed in order to earn a profit. Therefore depreciation figure is merely the DIFFERENCE BETWEEN COST & BOOK VALUE of assets during the financial year.

For example, when we buy fixed asset like factory machinery, this is merely an advance payment of which we expect that this fixed asset is able to enhance or earn certain earnings for the business. Over a period of time, the fixed asset we buy will become valueless or unable to generate the necessary earnings. To reflect this continuing diminution in the value of the factory machinery, we need to apply depreciation accounting.

Reasons for Depreciation REASONS for depreciation –Wear and tear, –Erosion, rust, rot and decay –obsolescence, –fall in market price, –physical factors, –inadequacy – when an asset is no longer used because of the growth and changes in the size of the firm.

Major Methods Of Depreciation Straight line Method – Number of years of use is estimated – The cost is divided by number of years to give the depreciation charge each year.

Example If the Motor Lorry was bought for $ 22,000 and we thought we would keep it for four years and sell it for $ 2,000 the depreciation charge would be Cost – Estimated Disposal Value Number of Expected years of Use = 22,000- 2,000 4 = $ 5,000 depreciation for each year for four years

Example Suppose, after 4 Years, the motor lorry had no disposal value, the charge for depreciation would have been – Cost Number of years = $ 22,000 4 = $ 5,500 depreciation each of the four years

Reducing Balance Method By this method a fixed percentage of depreciation is deducted from the cost in the first year. In the second or later years the same percentage is taken of the reduced balance ( i.e cost less depreciation already charged) This method is also known as the diminishing balance method.

Example If the machine is bought for $ 10,000 and depreciation is to be charged at 20% the calculation for the first 3 years would be Cost $ 10,000 First Year: Depreciation (20% of 10,000) 2,000 8,000 Second Year Depreciation ( 20% of 8,000) 1,600 6,400 Third Year Depreciation ( 20% of $ 6,400) 1,280 NET BOOK VALUE 5,120

Comparison of Methods Example: A firm has just bought a machine for $ 8,000. It will be kept in use for four years, then it will be disposed of for an estimated amount of $ 500. Calculate and compare the depreciation charge for each of the method. Assume 20% depreciation on reducing balance Method.

Solution Straight Line Method Reducing Balance Method

Double Entry for Depreciation Debit : Profit or Loss Account Credit :Provision for Depreciation Account Notes: –Depreciation of assets is treated as expenses, therefore it should be disclosed in the debit side of the Profit & loss account. –In the Balance sheet, remember to present the Cost of Fixed Assets ( in categories like motor vehicles, plant and machinery, furniture & fitting, etc ) less Provision for depreciation ( accumulated depreciation ) which is equal the book value of the fixed

Example In a business with financial years ended 31 Dec a machine is bought for $ 2,000 on 1 st January It is to be depreciated at the rate of 20% using the reducing balance Method. Show the records of this transaction in the First Three years

Example In a business with financial years ended 31 Dec a machine is bought for $ 12,000 on 1 st January It is to be depreciated at the rate of 20% using the Straight line Method. Show the records of this transaction in the first four years

Disposal of Assets Delete it from the Books – Dr Machinery Disposal a/c – Cr Machinery Account The deletion here is the cost of the asset Take out the Depreciation of the sold assets from the Books from the depreciation provision – Dr Provision for Depreciation –Cr Machinery Disposal Account - All depreciations provided for the assets during its life time need to be written off Recognize the Sale on the Books – Dr Bank or Cash Account –Cr Machinery Disposal Account The actual money received from the sales of the assets

Using the previous example except that the company decided to sell the asset at a price of $ 1,500 determine what will be the profit or loss on sale of the machine and show the Machinery Disposal Account.