Provisions for the depreciation of non-current assets (AS Level) Financial accounting

 


Depreciation is defined as the part of the cost of a non-current asset that is consumed during the period it is used by a business. It is an accounting adjustment that reflects the fact that an asset's value diminishes due to use (e.g., a $10,000 motor vehicle being worth $8,000 after one year, showing $2,000 in depreciation).

 Purpose and Governing Concepts

Depreciation is necessary because spending on non-current assets is classified as capital expenditure. Since these assets are intended for use over many years to generate revenue, recording the full cost as an expense when bought would be incorrect.

Depreciation is provided to comply with two primary accounting concepts:

  1. Matching (Accruals Concept): The cost of the asset used up in the accounting period is charged as an expense in the Income Statement, thereby matching this cost against the revenue the asset helped generate in that same period.
  2. Prudence (Concept of Conservation): Charging depreciation ensures that profit is not overstated in the Income Statement.

 Accounting Treatment and Double Entry

The bookkeeping entries for depreciation separate the asset's original cost from the accumulation of its consumption over time:

  1. Non-Current Asset Account (Cost): This ledger account continues to show the asset at its original cost each year of its life. These accounts sometimes include the words 'at cost' in their titles.
  2. Annual Charge (Expense): The annual depreciation amount is charged as an expense by debiting the Income Statement (often listed as an overhead).
  3. Accumulation (Provision): The amount charged is recorded in the separate Provision for Depreciation account. This account accumulates (or increases) the total depreciation charged since the asset was acquired.
  4. Requirement: A separate provision for depreciation account must be opened for each class of non-current asset (e.g., motor vehicles, plant and machinery).

 Presentation in the Statement of Financial Position (SFP)

In the Statement of Financial Position (SFP), the Provision for Depreciation account balance (known as Accumulated Depreciation) is used to determine the asset's remaining value:

The following three headings are typically shown for non-current assets:

  • Non-current assets at cost.
  • Accumulated depreciation (the total balance of the provision account).
  • Net Book Value (NBV) or Written-Down Value (WDV): This is calculated by deducting the accumulated depreciation from the original cost. This figure is also known as the Carrying Amount. The NBV represents the amount of the asset's cost that has not yet been charged as an expense against profit.

 Methods of Calculating Depreciation

The sources outline three main methods used to calculate the annual depreciation charge:

Method

Calculation Basis

Key Feature

Suitability

Straight-Line

Estimated total depreciation (Cost minus Residual Value) is spread evenly over the useful life.

Charges the same amount annually (or monthly).

Assets generating consistent revenue or declining gradually, like office furniture. Also used to amortise assets with fixed lives, such as leases.

Reducing-Balance

A fixed percentage rate is applied to the written-down value (or net book value) each year.

The charge for depreciation reduces each year.

Assets whose earning power diminishes as they age, or those losing most value early in their life, such as motor vehicles.

Revaluation

Used for assets that are numerous and difficult to track individually (e.g., loose tools).

Depreciation is calculated as: (Opening Valuation + Purchases) - Closing Valuation. The resulting charge is debited to the Income Statement.

Small, non-current assets, like loose tools.

 

Specific Rules for Timing

Businesses have different policies regarding when depreciation is charged in the years of acquisition and disposal:

  • Full Year Policy: A full year's depreciation is taken in the year of acquisition, but none in the year of disposal.
  • Month-by-Month Policy: Depreciation is calculated from the date of acquisition; in the year of disposal, it is calculated only up to the date of disposal. The recommendation is generally to calculate depreciation on a monthly basis for the years of acquisition and disposal if those dates are available.

 Accounting for Disposal of Non-Current Assets

When a non-current asset is sold, a Disposal Account is opened to calculate the profit or loss on the sale. This process removes the disposed asset and its related depreciation from the books:

  1. Remove Cost: Debit the Disposal Account and Credit the Non-Current Asset Account (at cost) to remove the original cost.
  2. Remove Accumulated Depreciation: Debit the Provision for Depreciation Account and Credit the Disposal Account with the total accumulated depreciation provided to date.
  3. Record Proceeds: Debit the Bank Account (or the asset account for a part-exchange value) and Credit the Disposal Account with the sale proceeds.
  4. Determine Profit/Loss: A remaining debit balance on the Disposal Account indicates a loss on disposal (transferred to the Income Statement as an expense). A credit balance indicates a profit on disposal (transferred to the Income Statement as income/added to gross profit).

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