Non current assets are maintained in the books at historical cost i.e. the amount paid to acquire or produce it. An account for depreciation in the general ledger is opened to record accumulated depreciation to date. This account is called
Allowance for depreciation account. - Allowance for depreciation account
Each accounting period a depreciation charge is made to the income statement and another record will be made in the allowance for depreciation account, which is cumulative in nature.
- Double entry for depreciation
DR. – Income statement with depreciation expense CR – Allowance for depreciation account
- In the Balance Sheet
The accumulated depreciation amount is shown as deduction from cost of the non current asset to arrive at net book value.
- There is an allowance for depreciation account for each separate category of non current assets, e.g. for buildings, machinery, furniture, motor vehicles etc. If a business has 20 vehicles there will be only one
depreciation account for all the vehicles even if they have been bought at different times and years.
- Example: Recording allowance for depreciation. Fast track company maintains non current assets at cost. Separate allowance for depreciation accounts are kept for each category of assets.
The following transactions took place:
20X2 1 July bought 3 machines at cost K40 000 each. 20X3 1 October bought another machine for K25 000 20X4 1 December bought fixtures for K18 000.
NOTES: Machinery is depreciated at the rate of 15% per annum on cost and fixtures at the rate of 5% using the reducing balance method.
Depreciation is to be charged fully for the whole year disregarding the purchase date.
Required: Show
(a) The machinery account (b) The fixtures account
(c) The two separate allowance for depreciation account
(d) Extracts of the income statement and balance sheet for each of the years 20X1, 20X2, 20X3 and 20X4. Solution:
It may help to put up a table showing the build up of depreciation for each category of non current assets
Category of asset 20X1 20X2 20X3 20X4 Total
Machinery 1 9 000 9 000 9 000 9 000 36 000 Machinery 2 - 18 000 18 000 18 000 54 000 Machinery 3 - - 3 750 3 750 7 500 Total 9 000 27 000 30 750 30 750 97 500 20X1 20X2 20X3 20X4 Total Fixtures 1 1 900 1 805 1 715 1 629 7 049 Fixtures 2 - - - 900 900 Total 1 900 1 805 1 715 2 529 7 949 Machinery Account 20X1 Bank 60 000 Balance c/d 60 000 ______ _______
60 000 60 000 20X2 Balance b/d 60 000 Balance c/d 180 000 Bank (3 x 40,000) 120 000 _______ 180 000 180 000 20X3 Balance b/d 180 000 Balance c/d 205 000 Bank 25 000 ______ 205 000 205 000 20X4 Balance b/d 205 000 Balance c/d 205 000 205 000 205 000
Dr Allowance for depreciation account (Machinery) Cr
20X1 K 20X1 K
Balance c/d 9 000 Income statement 9 000
_____ _____
9 000 9 000
20X2 20X2 Balance b/d 9 000
Balance c/d 36 000 Income statement 27 000
36 000 36 000
20X3 20X3 Balance b/d 36 000
Balance c/d 66 750 Income statement 30 750
66 750 66 750
20X4 20X4 Balance b/d 66 750
Balance c/d 97 500 Income statement 30 750
97 500 97 500 Fixtures Account 20X1 Bank 38,000 Balance c/d 38 000 ______ ______ 38 000 38 000 20X2 Balance b/d 38 000 Balance c/d 38 000 _____ ______ 38 000 38 000 20X3 Balance b/d 38 000 Balance c/d 38 000 _____ _____
20X4 Balance b/d 38 000 Balance c/d 56 000
Bank 18 000 _____
56 000 56 000
Dr Allowance for depreciation account (Fixtures) Cr
K K
20X1 20X1
Balance c/d 1 900 Income statement 1 900
_____ _____
1 900 1 900
20X2 20X2 Balance b/d 1 900
Balance c/d 3 705 Income statement 1 805
3 705 3 705
20X3 20X3 Balance b/d 3 705
Balance c/d 5 420 Income statement 1 715
5 420 5 420
20X4 20X4 Balance b/d 5 420
Balance c/d 7 949 Income statement 2 529
7 949 7 949
Income statement (Extract)
K K Gross profit XX Less: Expenses 20X1 Depreciation: Machinery 9 000 Fixtures 1 900 (10 900) XX 20X2 Depreciation: Machinery 27 000 Fixtures 1 805 (28 805) XX 20X3 Depreciation: Machinery 30 750 Fixtures 1 715 (32 465) 20X4 Depreciation: Machinery 30 750 Fixtures 2 529 (33 279) Balance Sheet (Extracts)
Non current assets Cost Depreciation N.B.V.
20X1 Machinery 60 000 9 000 51 000
20X2 Machinery 180 000 36 000 144 000 Fixtures 38 000 3 705 34 295 20X3 Machinery 205 000 66 750 138 250 Fixtures 38 000 5 420 32 580 20X4 Machinery 205 000 97 500 107 500 Fixtures 56 000 7 949 48 051
In the trial balance
Depreciation is an end of the year adjustment, therefore in the year of acquisition of a non current asset depreciation will not be reflected in the trial balance, but will start appearing in subsequent years.
In previous exercise depreciation will only start appearing in 20X2, thus: Trial Balance as at 31 December 20X2
Dr Cr
Machinery 180 000
Accumulated depreciation 9 000
Fixtures 38 000
Accumulated depreciation 1 900
Trial Balance as at 31 December 20X3
Dr Cr
Machinery 205 000
Accumulated depreciation 36 000
Fixtures 38 000
Accumulated depreciation 3 705
Any depreciation shown in the trial balance is what has accumulated from
previous years. For the year under review it has to be calculated and shown in the income statement. The figure shown in income statement will be added to the figure in the trial balance and the accumulated total shown in the balance sheet. 11.13 Choice Of Depreciation Method
Any method of depreciation can be used on a non current asset, but the method chosen must be fair in allocating the charges between different accounting periods.
(a) The method should allocate costs in proportion to the benefits i.e.
(i) Use reducing balancing method if the business will benefit more from the asset in earlier years than later years
(ii) Use the straight line if benefits will be spread equally over the life of the asset
(b) Consistency must be observed. Same depreciation method must be used for similar assets, and from one year to another.
(c) Choose a method which is easy to apply.
11.4 Asset Acquired During An Accounting Period
If a non current asset is purchased during an accounting period it might be fair to charge depreciation according to the period the asset has been used i.e. on monthly basis. However, this basis may apply when straight line method is in use.
Examination questions will usually state the way depreciation is to be applied.
Examples:
(a) Charge a full year’s depreciation in the year of acquisition or nothing in the year of disposal. In this instruction dates of purchase should be ignored even if the dates are given.
(b) Charge a full year’s depreciation on the value of asset available at year end. (explanation same as in a)
(c) Depreciation should be charged on monthly basis.
(d) If instructions are silent and dates of purchase are given, then the monthly basis should be adopted.
Example: Assets acquired during the year.
A business has an accounting period which runs from 1 January to 31 December. On 1 October 20X5 the business purchased furniture for K500 000 cost. The life span of the furniture is 10 years with no residual value.
What is the depreciation charge for the year ended 31 December 20X5?
Solution
Annual depreciation is K500 000
= K50 000
10 years
The asset was acquired on 1 October 20X3 and will be depreciated only for 3 months in 20X5.
K50 000 x 3 months 12 months
= K12 500 11.15 Change in estimated life
When the life span of an asset changes i.e. increased or reduced, the net book value of the asset at the time of change is what will be spread on the remaining life.
Example 1: Increase in life of an asset
A business purchased a motor vehicle at a cost of K400 000 with an estimated life of 6 years. It is to be depreciated on straight line basis over its life. However, after 2 years in use, it is discovered that the asset life has 2 more years making a total of 8 years.
What will be the depreciation charge from year 3 on wards.
Solution:
Annual depreciation is K400 000
6 years = K66 667 K66 667 x 2 years = K133 334.
Net book value after 2 years K400 000 133 334
266 666 N.B.V.
Net book value to be spread over new life i.e. 6 years. From year 3 onwards annual depreciation will be:
K266 666
6 years = K44 444
Example 2: Decrease in life of asset
A business bought non current assets at a cost of K100 000. It is estimated that the assets will be used in the business for a period of 7 years with K10 000 residual value. After one year in use, it was reviewed that the assets life span be reduced to 3 years from the remaining 6 years. What will be depreciation from year 2 onwards.
Solution
Annual depreciation (100 000 – 10 000)
N.B.V. of K77 143 will now be spread over 3 years. From the second year onwards annual depreciation will be
K77 143
3 = K25 714 11.16 Change in Depreciation Method
It is allowed to change the depreciation method if it is discovered that a wrong method was adopted initially, and is not true and fair, or if there is a change in the pattern of consumption of economic benefits from the non current asset. Every year end a business will normally review its accounts and this is the time such a discovery may be made. Changes should be necessary and not done at will otherwise comparison will be difficult because of inconsistency.
Example: Change in depreciation method
A business bought furniture on 1 January 20X3 at a cost of K80 000. The asset is to be depreciated using straight line method over a 5 year period.
At 1 January 20X5, a review was conducted, and it was agreed to change the method to reducing balance method at the rate of 20% per annum.
Show the necessary entries to adjust to new method. Solution:
Using straight line method K80 000
5 years = K16 000 annual depreciation
Accumulated depreciation at time of change K16 000 x 2 K32 000 Net book value after 2 years K80 000 – K32 000 = K48 000
From year three onwards using reducing balance method, depreciation will be: Year 3 48 000 x 20%
(9 600) Depreciation Year 4 38 400 x 20%
(7 680) Depreciation 30 720 x 20% etc. 11.17 The Disposal of Non Current Assets
When a business buys non current assets, they are meant to be used in generating income for the business over a period time (more than 1 year). They are not meant for resale to make a profit.
However, the non current assets might be sold off at some stage before even their useful life is over. Reasons for selling or disposal may include:
- Inadequacy – where an asset fails to meet increased demand for a product
- Obsolescence etc
(a) The Disposal Account
When non current assets are disposed of, a disposal account is opened. This account will reveal whether a profit or loss has been made on the asset sold. The profit or loss on disposal are reported in the income statement.
- Ledger accounting on disposal of non current asset. The profit or loss on disposal is the difference between net book value of non current asset and the net sale price, which is the price minus any costs of making the sale. - A profit is made when sales price is more than net book value
- A loss is made when sales price is less than net book value of a non current asset.
Double entry when an asset is disposed of.
Step 1:
Debit – Disposal account with value of asset usually at Credit – Asset account cost
Step 2:
Debit – Allowance for depreciation account with accumulated
Credit – Disposal account depreciation at the
time of sale
Note: The two steps in disposal account reveals the net book value of the asset.
Step 3:
Debit – Receivable account (if sale is on credit) or Debit – cash book (if sale is on cash or by cheque Credit – Disposal account
with sale price of the asset
- If balancing figure is on debit of disposal account, a profit has been achieved.
- If balancing figure on disposal account is on credit side, then a loss is recorded.
Examples: Disposal of non current asset.
Green Grass purchased a van on 1 January 20X5 for K100 000. He estimated that its resale value on 31 December 20Y0 after six years use would be K40 000 and depreciated it on a straight line basis. He sold it on 30 June 20X7 for K55 000.
Solution:
The amount to be charged as depreciation each year is Cost – residual value
Estimated economic life = (K100 000 – K40 000)
6 years
= K10 000
Green Grass owned the asset for two years and six months, thus the total depreciation charged since acquisition is K10 000 x 21/
2 years = K25 000.
This means that the net book value at the date of disposal was K100 000 – K25 000 = K75 000.
Since the sale proceeds amounted to K55 000, a loss on disposal of K55 000 – K75 000 = K20 000 has been made.
Ledger accounting on disposal.
Dr Van account (at cost) Cr
20X5 K K
1 Jan. Bank 100 000 31 Dec. Balance c/d 100 000
_______ ______
100 000 100 000
20X6
1 Jan. Balance b/d 100 000 31 Dec. Balance c/d 100 000
______ _______
100 000 100 000
20X7
1 Jan. Balance b/d 100 000 June 30 Disposal 100 000
______ ______
Dr Allowance for depreciation Cr
K 20X5 K
31 Dec. Bal. c/d 10 000 31 Dec. Inc. statement 10 000 (Depreciation)
______ _____
10 000 10 000
20X6
31 Dec. Bal. c/d 20 000 1 Jan. Balance b/d 10 000 31 Dec. Inc. statement 10 000
(Depreciation)
______ ______
20 000 20 000
20X7
30 June Disposal 25 000 1 Jan. Balance b/d 20 000 30 June Inc. statement 5 000 (Depreciation) _____
25 000 25 000
Dr Disposal account Cr
20X7 K 20X7 K
30 June Van at cost 100 000 30 June Allow. For Dep. 25 000 30 June Bank 55 000
Loss (to inc. state.) 20 000
_______ ______
100 000 100 000
Example 2: Trading in or part exchange on disposal.
On 1 April 20X8, Quick Fix owned a motor vehicle which was bought on 1 October 20X5 at a cost of K600 000. Its estimated residual value after five years in use would be K80 000.
Quick Fix’s policy is to provide depreciation on straight line method on monthly basis.
During the financial year ended 31 March 20X9, the following occurred: On 30 June 20X8, the motor vehicle was traded in and replaced with a new one. The trade in allowance was K255 000. The new vehicle cost K850 000. The balance after deducting the trade in allowance was paid by cheque.
Required:
Show the necessary ledger accounts to record the above information. Solution:
Annual depreciation: K600 000 – K80 000
5 years = K104 000
For old vehicle
Accumulated depreciation = K104 000 x 2.75 = K286 000 Net book value = K600 000 – K286 000 = K314 000
Therefore a loss on disposal of K255 000 trade in allowance minus Net book value of K314 000 = K59 000 was made. This is because 2.75 is the period of 2 years 9 months that the old motor vehicle was owned by Quick Fix.
Note: Trade in allowance is what should have been realized if the asset was sold for cash.
Ledger accounting:
Dr Motor Vehicle account Cr
20X8 K K
30 June Balance 600 000 30 June Disposal 600 000 30 June New M/Veh.
(255 000 + 595 000) 850 000 31 March (20X9) Bal c/d 850 000 ________ _______ 1 450 000 1 450 000 1 April 20X0 Bal. b/d 850 000 Dr Disposal account Cr 20X8 K 20X8 K
30 June M/Vehicle 600 000 30 Acc. Dep. 286 000 Trade in All 255 000 Loss (P/L A/c) 59 000
_______ ______
Note: Double entry for new motor vehicle: DR – Motor Vehicle account with
Trade in allowance (255 000) Cash (595 000)
CR - Disposal account with Trade in allowance (255 000) CR - Cash account with M/Vehicle (K595 000)