4.2 Accounting for Depreciation and Disposal of Non-Current Assets

Objective: Define Depreciation

What is Depreciation?

Depreciation is the systematic allocation of the cost of a tangible non-current asset over its useful economic life. It reflects the gradual decline in the asset's value due to wear and tear, obsolescence, or other factors.

Why is Depreciation Important?

Depreciation is an important accounting concept because it provides a more realistic representation of a company's financial position. Instead of expensing the entire cost of an asset in the year it's purchased, depreciation spreads the cost over the period the asset is used to generate revenue. This matching principle ensures that expenses are recognized in the same period as the revenues they helped generate.

Key Concepts Related to Depreciation

• Cost: The original purchase price of the asset, including any costs to get it ready for use.
• Useful Economic Life: The period over which the asset is expected to be used by the business.
• Salvage Value (Residual Value): The estimated value of the asset at the end of its useful economic life.
• Depreciable Amount: The cost of the asset less its salvage value. This is the amount that will be depreciated over the asset's life.

Methods of Calculating Depreciation

There are several methods for calculating depreciation. The most common are:

1. Straight-Line Method: Depreciation is spread evenly over the asset's useful life.
2. Reducing Balance Method (Diminishing Balance Method): Depreciation is calculated as a fixed percentage of the asset's carrying value (book value) each year.
3. Units of Production Method: Depreciation is based on the actual usage of the asset.

Formula for Straight-Line Depreciation

The formula for calculating depreciation using the straight-line method is:

$$ \text{Annual Depreciation} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Economic Life}} $$

Example Calculation (Straight-Line Method)

A machine was purchased for $10,000. Its estimated useful economic life is 5 years, and its salvage value is $1,000. Calculate the annual depreciation using the straight-line method.

Item	Value
Cost	$10,000
Salvage Value	$1,000
Depreciable Amount	$10,000 - $1,000 = $9,000
Useful Economic Life	5 years
Annual Depreciation	$\frac{9,000}{5} = $1,800$

Disposal of Non-Current Assets

When a non-current asset is disposed of (sold, scrapped, or otherwise removed from the business), the following steps are taken:

1. The asset is removed from the accounting records.
2. The carrying amount (original cost less accumulated depreciation) is calculated.
3. Any gain or loss on disposal is calculated. This is the difference between the disposal proceeds (the amount received from the disposal) and the carrying amount.
4. The gain or loss is recognised in the profit and loss account.

Formula for Gain or Loss on Disposal

The formula for calculating the gain or loss on disposal is:

$$ \text{Gain or Loss} = \text{Disposal Proceeds} - \text{Carrying Amount} $$