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## BA5 - can't get my head around depreciation!

• Member
• 8 posts

Hi, does anybody have any notes about depreciation? I just can't get my head around it and I'm now overthinking it, which is making it impossible! If we have the trial balance figures for the assets, and are using the straight line method, how do we calculate cost and the next years depreciation. i know it should be the same depreciation figure using the straight line method but it just doesn't seem to make sense. I've always struggled with this topic and now am confusing myself!

TIA X

• 56 posts

Hi Tia

Some notes are below.

Kind regards

Brian

Depreciation can be defined as the writing off (to Profit and Loss Account) of the cost of a fixed asset (or cost less estimated residual value) over its estimated useful life.

Virtually every business has fixed assets and therefore depreciation applies to almost every set of accounts produced.

The most common method of depreciation is the straight line method. By this method the cost of a fixed asset (less any estimated residual sales value to be received at the end of its useful life) is written off to the profit and loss account in equal annual installments as follows:­

£
COST OF FIXED ASSET                                100,000
ESTIMATED RES1DUAL SALES VALUE     20,000

AMOUNT TO BE WRITTEN OFF                    80,000

ESTIMATED EXPECTED USEFUL LIFE

OF THE FIXED ASSET                                      4 YEARS

ANNUAL DEPRECIATION

(UNDER THE STRAIGHT LINE METHOD)          20,000

At the end of the four years the asset would appear in the balance sheet with a net book value of £20,000 as follows:­

£
FIXED ASSET AT COST                                100,000
DEPRECIATION PROVISION (4 X 20,000)    80,000

NET BOOK VALUE                                          20,000

If the asset is sold for £20,000 the fixed asset would disappear from the balance sheet and the current asset of cash would increase by £20,000.

The accounting entries for depreciation are as follows:­

(i)    debit a depreciation (expense) account with the annual depreciation - close off this depreciation (expense) account at the end of the financial period and transfer the charge to the profit and loss account.

(ii)   credit a depreciation (provision) account with each years depreciation.

Notes:

(i) the provision for depreciation account holds (as a credit balance) the total cumulative depreciation charged on the asset since its acquisition.

(ii)  The fixed asset account remains at cost.

The bookkeeping entries for the above would appear as follows:-

Debit

FIXED ASSET ACCOUNT

Year I    Cash at bank       100,000

## DEPRECIATION (EXPENSE) ACCOUNT

Debit                                                   Credit

Year l      Depreciation    provision     20,000      Year l          P&L A/C             20,000
Year 2     Depreciation     provision     20,000     Year 2         P&L A/C            20,000
Year 3     Depreciation      provision   20,000     Year 3         P&L A/C            20,000
Year 4     Depreciation      provision    20,000     Year 4         P&L A/C            20,000

Credit

DEPRECIATION (PROVISION) ACCOUNT

Year I                 Depreciation expense 20,000

Year 2                 Depreciation expense 20,000

Year 3                 Depreciation expense 20,000

Year   4                Depreciation expense 20,000

Debit

PROFIT AND LOSS ACCOUNT

Year I      Depreciation   charge for year      20,000
Year 2     Depredation      charge for year     20,000
Year 3     Depreciation      charge for year    20,000
Year 4     Depreciation      charge for year    20,000

BALANCE SHEETS (EXTRACTS):-

Year l             Year 2               Year 3              Year 4
£                 £                   £                  £

FIXED ASSET                            100,000       100,000        100,000       100,000

DEPRECIATION

PROVISION                             (20,000)       (40,000)       (60,000)       (80,000)

NET BOOK VALUE                 80,000          60,000          40,000         20,000

Note:

Net Book Value (NBV) is sometimes called Written Down Value (WDV).

REDUCING BALANCE METHOD

Under the straight line method the amount to be written off  (£80,000) was charged to profit and loss account in equal annual sums of £20,000. In other words a depreciation rate of 25% per annum was used.

Under the reducing balance method a fixed percentage is applied to the net book value (amount still to be written off).

Applying a fixed percentage of 60% (as an example) to the above example gives the following:-

£

Amount to be written off       80,000

Year 1 deprecation at 60%       48,000       (60% x 80,000)
NET BOOK VALUE       32,000

Year 2 depreciation at 60%      19,200       (60%x 32,000)
NET BOOK VALUE       12,800

Year 3 depreciation at 60%        7,680      (60%x 12,800)
NET BOOK VALUE         5,120

Year 4 depreciation at 60%       3,072     (60%x 5,120)
NET BOOK VALUE         2,048

Year 5 depreciation at 60%       1,229       (60% x 2,048)
NET BOOK VALUE
819

Year 6 depreciation at 60%          492       (60%x 819)
NET BOOK VALUE            327

The differences between the two methods are as follows:­

(i)    Under the reducing balance method the majority of the depreciation has been charged in the earlier years of the life of the asset

(ii)   Under the reducing balance method the depreciation period carries on for more than 6 years.

The reducing balance can be more prudent than the straight line method as the depreciation is weighted in favour of the earlier years.

The main advantages of the straight line method are its simplicity and its consistency in charging fixed annual amounts of depreciation.

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