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DEPRECIATION Reasons for Recording Depreciation

Depreciation is the allocation of cost of non-current asset over its useful life. 1. Matching Concept. A portion of the cost of the non-current asset is
It is recorded as an expense in the income statement. matched against the income earned from using the non-current asset in
the same period to find the accurate profits. [to match the
Causes of depreciation depreciation with profit and to avoid overvalued/overstated net
profit in the accounts of business.]
Wear and tear (e.g. motor vehicle)
2. Prudence Concept. States profits and assets should not be
Obsolescence/Out-dated (e.g. computers) overstated. Depreciation is charged to Income Statement to avoid
overstating profits, while accumulated depreciation is recorded in the
Usage/Depletion of resources (e.g. minerals in a quarry) balance sheet to avoid overstating the value of non-current assets.

Legal limits (e.g. 60 year leasehold shop) Recording Depreciation

Passage of time (e.g. patents and copyrights) Depreciation is recorded at the end of the accounting period. The double
entry for depreciation is
Accumulated Depreciation
DR Depreciation (increase in expense)
Accumulated depreciation refers to the total depreciation to-date. It is a
contra-asset account in the Balance Sheet. CR Accumulated depreciation (increase in contra-assets*)

The are three methods to calculate the value of depreciation, straight-line and reducing balance methods.
Straight-Line Reducing-balance

Formula % x (cost - scrap value) or Cost - Scrap value* % x Net Book Value (NBV)
Useful life (in years)
*Scrap value = Residual value NBV = Cost - Accumulated depreciation
Effect on Profit Equal amount of depreciation is recorded for each financial period Higher depreciation amount is recorded in the earlier financial
over the useful life of the non-current asset. periods and a lower amount is recorded in the later financial
periods of the useful life of non-current assets.
Advantages ✪ Simple to apply ✪ More accurately reflect pattern of usage of assets if assets
✪ Calculation of depreciation easy to understand provide most benefits during the initial years.
Disadvantages Not suitable for assets like machinery where the benefits obtained May never fully depreciate asset
from using the assets in each period are not of fixed amounts.
Higher depreciation charge in the early years of assets’ life.
Suitable Fixtures and fittings Motor Vehicles, Office equipment

Take Note: When using the formula Cost - Scrap value* , there can be instances where scrap value is not provided. If this is the case, the formula
would be: Cost Useful life (in years)
Useful life
1
Suitability of depreciation method

Straight line method is suitable for assets which benefits the business at a uniform rate over its useful life.

Reducing balance method is suitable for assets which benefits the business more in the initial years compared to subsequent years.

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* Assets is debit nature. “Contra means opposite and therefore contra-assets is credit in nature.
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COMMON THEORY QUESTIONS

Why should a business use the same depreciation method?

Following the consistency concept, the business uses the same depreciation methods from period to period so that its financial performance can be
meaningfully compared across financial periods.

FORMATS OF DEPRECATION & PROVISION FOR (ACCUMULATED) DEPRECIATION LEDGERS

Depreciation on non-current assets


Date Particular $ Date Particular $
2015 2015
Mar 31 Provision for depreciation on Non-current 1,800 Mar 31 Income Statements (Profit and Loss) 1,800
assets
Provision on depreciation on non-current assets account
Date Particular $ Date Particular $
2015 2015
Mar 31 Balance c/d 1,800 Mar 31 Depreciation on non-current assets 1,800
1,800 1,800

Apr 1 Balance b/d 1,800

* Assuming year end is 31 March 2015

Take Note:
1. Depreciation expense account is transferred to the profit and loss account in the income statement on the balance day.
2. Accumulated depreciation is brought down to the first day of the next accounting period. 2