Accounting for depreciation and disposal of non-current assets Revision Notes

Depreciation is the systematic allocation of the cost of a non-current asset over its useful life. Non-current assets, such as machinery, vehicles, or buildings, lose value over time due to wear and tear, obsolescence, or usage. Depreciation recognises this loss in value as an expense in the accounting period, matching the cost of the asset with the revenue it helps generate.

This process is important because it ensures that financial statements present a realistic view of the asset’s value and the business’s profitability. Without depreciation, profits would be overstated in early years and understated later, and the balance sheet would show assets at outdated values. Depreciation also helps businesses plan for asset replacement by spreading the cost over time.

• Depreciation allocates the cost of an asset over its useful life.
• It matches expenses with revenues for accurate profit measurement.
• It reflects the reduction in asset value on the balance sheet.
• It assists in planning for asset replacement.

There are three main methods to calculate depreciation: straight-line, reducing balance, and revaluation. Each method suits different types of assets and business needs.

1. Straight-Line Method: This method spreads the cost evenly over the asset’s useful life. The annual depreciation expense is constant each year.

2. Reducing Balance Method: This method applies a fixed percentage to the asset’s book value at the start of each year, resulting in higher depreciation in earlier years and decreasing amounts later. It reflects assets that lose value faster initially, such as vehicles or technology equipment. This method does not subtract residual value before applying the rate; instead, depreciation continues until the book value approaches residual value or zero, depending on policy. 3. Revaluation Method: This involves adjusting the asset’s book value to its current market value. This method is less common for depreciation calculation but is used when assets are revalued to reflect fair value. The difference between the old and new value is recorded in the revaluation account, affecting equity rather than profit or loss directly.

• Straight-line: equal depreciation each year.
• Reducing balance: depreciation decreases over time.
• Revaluation: asset value adjusted to market value.

**Straight-Line Method:** Suppose a machine costs £12,000, has a residual value of £2,000, and a useful life of 5 years. The depreciable amount is £12,000 - £2,000 = £10,000. Annual depreciation = £10,000 ÷ 5 = £2,000 per year.

**Reducing Balance Method:** Using the same machine, assume a depreciation rate of 40%. Year 1 depreciation = 40% × £12,000 = £4,800. Book value at end of Year 1 = £12,000 - £4,800 = £7,200. Year 2 depreciation = 40% × £7,200 = £2,880, and so on.

These calculations ensure expenses reflect asset usage and value decline accurately.

• Straight-line depreciation = (Cost - Residual value) ÷ Useful life.
• Reducing balance depreciation = Depreciation rate × Book value at start of year.
• Depreciation reduces asset book value each year.

Depreciation is recorded by debiting the Depreciation Expense account and crediting the Accumulated Depreciation (Provision for Depreciation) account, which is a contra-asset account reducing the asset’s book value.

**Ledger accounts:** The asset account shows the original cost. The accumulated depreciation account shows total depreciation to date. The net book value is the asset cost minus accumulated depreciation.

**Journal entry example:** To record annual depreciation of £2,000: Debit Depreciation Expense £2,000 Credit Accumulated Depreciation £2,000 This entry recognises the expense and increases the provision for depreciation without reducing the asset account directly.

• Depreciation Expense debited to record cost allocation.
• Accumulated Depreciation credited as a contra-asset account.
• Asset account remains at original cost.
• Net book value = Cost - Accumulated Depreciation.

When a non-current asset is sold or disposed of, the accounting records must reflect the removal of the asset and any gain or loss on disposal.

**Steps:** 1. Remove the asset’s original cost from the Asset account (credit). 2. Remove the accumulated depreciation related to the asset (debit). 3. Record the proceeds from sale (debit cash/bank). 4. Calculate the difference between the net book value (cost minus accumulated depreciation) and sale proceeds. 5. Record any gain (credit) or loss (debit) on disposal in the Disposal account or Profit and Loss account.

**Example:** A machine costing £10,000 with accumulated depreciation of £7,000 is sold for £4,000. Net book value = £10,000 - £7,000 = £3,000. Sale proceeds £4,000 exceed net book value by £1,000, so there is a gain on disposal of £1,000. Journal entries would remove the asset and accumulated depreciation, record cash received, and credit the gain on disposal.

• Remove asset cost and accumulated depreciation from ledger.
• Record cash received from sale.
• Calculate gain or loss: Sale proceeds - Net book value.
• Record gain (credit) or loss (debit) on disposal.
• Use Disposal account to summarise disposal transactions.