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BA5 - can't get my head around depreciation!

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  • # 111970

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

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  • # 111973

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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