# The early part of the article explains in detail the nature and purpose of Depreciation as a book-keeping and accounting concept.

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2 The depreciable amount of a tangible fixed asset should be allocated on a systematic basis over its useful economic life. The depreciation method used should reflect as fairly as possible the pattern in which the asset s economic benefits are consumed by the entity and the depreciation charge should be recognised as an expense in the profit and loss account. The useful economic life of a tangible fixed asset is defined as "the period over which the entity expects to derive economic benefits from the asset". The following factors need to be considered in determining useful economic life: expected usage of the asset expected physical deterioration of the asset economic or technological obsolescence legal or similar limits on the use of the asset Whatever method a business uses to calculate its annual depreciation provision, three factors should be taken into account: the cost or revalued amount of the asset; the estimated economic life; and the estimated residual value of the asset. While cost is known or can be derived, the second and third factors can only be estimated. Straight Line Method Straight line depreciation is calculated by dividing the amount to be written off (cost less estimated residual value) by the asset s predicted number of years of useful economic life. The figure derived from this calculation then becomes a fixed charge written off each year. As an equal amount is charged each year, a graph plotting the upward accumulation of depreciation year by year would appear as a straight line. Example 1 Sandsend Ltd purchase a new commercial vehicle for 20,000 plus VAT, paid in cash. It is estimated to have an economic life of five years with a residual value after the five years of 3,000. Using the straight line method, the annual charge for depreciation would be: 20,000-3,000 = 17,000 / 5 = 3,400 per annum The profits would bear an annual charge of 3,400, while the balance sheet value of the vehicle would be reduced by the same amount each year. The book-keeping entries to deal with the purchase of the asset would be: Debit the motor vehicles (Fixed Asset) account with 20,000. Debit the VAT (input tax) account 3,500. Credit the Cash Book 23,500 cash / cheque payment. At the year end the Depreciation account is debited with 3,400, in respect of the vehicle and the Depreciation provision is credited with the same amount.

3 Taking this one vehicle, as an example, the year end accounts would include net fixed assets on the Balance Sheet of 16,600 (disclosed as vehicles at cost - 20,000, less accumulated depreciation to date 3,500). Journal entries would include: 1. Debit: Depreciation a/c 3,400. Credit: Depreciation provision a/c 3,400. (Being the depreciation provision for the year on the commercial vehicle.) 1. Debit: Profit and Loss a/c 3,400. Credit: Depreciation a/c 3,400. (Being the depreciation charge to the profit and loss a/c for the year.) Extract from the Profit and Loss Account For example: Depreciation 3400 Heat, light, power * Motor vehicle running costs * Balance Sheet Extract Fixed Assets Cost Depreciation NBV Motor Vehicle 20,000 3,400 16,600 Reducing Balance Method This example illustrates how the % is derived to apply the reducing balance method so that the asset is fully written off over its economic life. HOWEVER IN THE CASE OF THE ICB EXAMINATIONS YOU WILL ALWAYS BE GIVEN THE % TO APPLY TO THE REDUCING BALANCE METHOD. There are many who share the view that assets depreciate more in the earlier years than they do in the later years of their useful life. This method reflects this view by applying a constant percentage to the net depreciated value of the asset brought forward at the beginning of each year. This means that the percentage remains the same, but since it is applied to a reducing balance brought forward, the actual amount will be less each successive year. The actual percentage rate that will result in a lifetime write off equal to the original cost of the asset (less its residual value) can be derived from the formula:

4 Example 2 Blyth Chemical Ltd purchase a special machine attachment at a cost of 12,000. Based on previous experience it estimates it can sell the attachment after 4 years to a reconditioning specialist for 1,000. The company is in a high tech environment and it believes the most prudent approach is to write off plant and machinery mostly during the early years after purchase when an income stream is more certain. It therefore chooses to depreciate its plant using the reducing balance method. Using the formula: The double entry treatment is exactly the same as in the case of straight line depreciation with a depreciation and a depreciation provision account, in this case for plant and machinery. When the % calculated using the reducing balance formula is applied to the asset we find: Year 1 Cost 12,000 Depreciation 46% 5,520 6,480 Year 2 Depreciation 46% 2,981 3,499 Year 3 Depreciation 46% 1,610 1,889 Year 4 Depreciation 46% 869 1,020 Residual Value Estimate 1,000 Difference 20 The effect of applying 46% to the reducing balance is that around 70% of the asset is written off in the first two years of the asset s life. Disposal of a Fixed Asset When a Fixed Asset is either disposed of during or at the end of its useful economic life an adjustment needs to be made to the depreciation provision account; so that the account balance represents only the accumulated depreciation to date on fixed assets held at that point in time.

5 Example 3 Let us assume that Blyth Chemical Ltd, at 31 December 2005 had a balance on its Motor Vehicles a/c of 100,000. This balance represents the vehicles at cost. The balance on the depreciation provision account was 40,000. On 31 December 2006 the company sold one of its delivery vans for 1,500. It had been purchased five years earlier on 1 January 2001, for 15,000, at which time the company had estimated its useful economic life at five years and its residual value after that time of 1,000. The company policy is to write off such vehicles at 20% straight line. The vehicle had been subject to a depreciation charge of ( 15,000-1,000)/5 = 2,800 per annum. The company policy is also to depreciate assets in the year of purchase but not in the year of sale. There is a need to determine the profit or loss on disposal and the current year must reflect that. This is determined as: Purchase Cost (1 January 2001) 15,000 Depreciation 4 years x 2,800 11,200 Net Book Value 31 December ,800 Sale Proceeds 1,500 Loss on Disposal 2,300 To account for this disposal the company would make the following entries to the accounts: the original cost of the vehicle disposed is transferred from Motor Vehicles account to a Disposal of Motor Vehicles Account ; the cumulative depreciation on the vehicle to the end of the previous year is transferred from the Provision for Depreciation account to the Disposal account; the Disposal of the Asset account is credited with the proceeds and the resulting balance represents the profit or loss on disposal and is transferred at the year end to the Profit and Loss account. The entries for the full procedure would appear thus. NB: The depreciation charge for 2000 was agreed as 20% straight line on 85,000 ie 17,000.

6 Extract from Profit and Loss a/c for Year: Depreciation 17,000 Loss on disposal of vehicle 2,300 Extract from Balance Sheet Fixed Assets Cost Depreciation NBV Motor Vehicles 85,000 48,000* 39,200 *NB: the provision to previous year end 40,000 Additional Depreciation for current year 17,000 57,000 Less accumulated depreciation on dsposal of vehicle 11,200 45,800 It is hoped students now have a better understanding of depreciation.

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