Depreciation

We all think we have an intuitive understanding of what depreciation is – things are worth less over time. They either wear out or become obsolescent. Yet our intuitive understanding is not the correct accounting understanding. If we follow our intuition will be trying to follow the market value of our asset, yet the reason for depreciation in bookkeeping is more to do with the accruals concept than market values.

Misleading accounts

Suppose a company buys a new piece of factory plant for £1m and they decided to expense the whole cost in that year (ie charge £1m to profit and loss and have no fixed asset in the balance sheet). The financial accounts would show a huge dip in profit, possibly a loss for that year. But in subsequent years, there would be a huge bounce in profits as the company benefits from the extra productivity of the plant.

The accounts would be seriously misleading and not reflect the reality of the company at all. The accruals concept comes to the rescue here, and tells us that the revenue earned by the new plant should be matched against the cost. Since the revenue is being earned over the useful lifetime of the asset, then we have to spread the cost over that period as well.

Book Value

Over time, the asset as held in the books, become less and less. This book value is obtained by keeping a running tally of each year’s depreciation. The book value (or net book value, or carrying value) will always be the original cost less total accumulated depreciation. The only exception is Land, which is never depreciated, and impaired assets which have to be written down to less than the value of that the depreciation would indicate.

Calculating depreciation

Most commonly used are the straight line and the reducing balance methods.

Straight Line Method
The original cost is spread over the number of years that the asset will be used in the business. If it is reckoned it will then be sold – known as residual value – this will be deducted from the cost.
So, annual depreciation charge = (Original cost – residual value) 
  Number of years use

Reducing balance method
This method more closely tracks market value, since it makes higher depreciation charges in earlier years than later years. First, an annual percentage charge, say x% is decided on. At the end of the first year the depreciation charge is calculated : x% of original cost.

The following year, we apply the charge x% to the net book value not to the original cost. As the nbv grows smaller each year, the annual depreciation charge also gets less each year. This kind of depreciation is commonly used with motor vehicles, with 25% being a common rate of charge.

Accounting for depreciation

So, when we bought the asset we debited the asset at cost account and credited the bank (or a creditor’s account if we bought on credit). At the end of the year we calculate the annual depreciation charge using one of the above methods and make the following entries:

    Debit Depreciation charge account (a profit and loss account)
  Credit Motor vehicles accumulated depreciation (a balance sheet account)

As all the accounts in the profit and loss heading are cleared out at the year end, but the balance sheet accounts remain in place, the result is that each year the depreciation charge is deducted from income while the accumulated depreciation ... accumulates.

The book value of the asset – its carrying value – becomes less and less each year. But we will always keep two accounts – one showing the original cost, and one showing depreciation. This is important for when we dispose of the asset.

Disposal of the Asset

There comes a time when the assets useful life is over, and it is disposed of. When this happens, both the original cost and accumulated depreciation are written out of the books, which is done by transferring these amounts from their original accounts into a disposal account.

Suppose we have a piece of machinery which cost the business £10,000 and has been depreciated on a straight line basis of 10% pa for 6 years. After that time we sell the machinery and receive £3,700. Here's what the disposal account looks like.

Disposal 1

This is what we did to get there.

1) Take the asset at cost out of the books:
Debit Asset disposal account £10,000
  Credit Asset at cost account £10,000

2) Take the assets accumulated depreciation out of the books:
Debit Asset accumulated depreciation account £6,000
  Credit Asset disposal account £6,000

3) Account for the proceeds from the sale:
Debit Bank account £3,700
  Credit Asset disposal account £3,7000

4) Finally, we have to account for the loss. This arises because we have received less than the book value. This appears as the balancing figure of £300. The more we would receive, the smaller this balancing figure would be, until after the breakeven point, it would be a balancing figure on the debit side. In that case, we would have a gain on disposal instead of a loss. The other side of this double entry is to debit the profit and loss account with £300.
Debit Profit and Loss account £300
  Credit Asset disposal account £300

The £300 in the profit and loss account would be an expense to the business. It is basically an adjustment to the depreciation made in order to keep the accounting equation in balance.

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