IGCSE Accounting 0452 - 4.2 Depreciation and Disposal of Non-Current Assets

This section covers the methods used to allocate the cost of non-current assets (also known as fixed assets) over their useful economic life. Depreciation is an accounting process that reflects the gradual decrease in the value of an asset due to wear and tear, obsolescence, or other factors.

Introduction to Depreciation

Non-current assets are crucial for business operations. They include items like buildings, machinery, vehicles, and furniture. Instead of expensing the entire cost of these assets in the year they are purchased, depreciation allows the cost to be spread out over the asset's useful life. This provides a more accurate picture of profitability.

Why is Depreciation Important?

• Matching Principle: Depreciation matches the expense of using an asset with the revenue it helps generate.
• Accurate Profitability: Depreciation reduces profit figures, providing a more realistic view of a company's financial performance.
• Asset Valuation: Depreciation helps determine the book value of an asset (Cost - Accumulated Depreciation).

Methods of Depreciation

There are three main methods of calculating depreciation: Straight-Line, Reducing Balance (also known as diminishing balance), and Revaluation.

1. Straight-Line Depreciation

This is the simplest and most commonly used method. It allocates an equal amount of depreciation expense each year.

Formula:

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

Where:

• Cost of Asset: The original purchase price of the asset.
• Salvage Value: The estimated value of the asset at the end of its useful life. This is often negligible.
• Useful Life: The estimated number of years the asset will be used.

Example: A machine costs £10,000, has a salvage value of £1,000, and a useful life of 5 years.

Annual Depreciation = $$\frac{10000 - 1000}{5} = \frac{9000}{5} = £1800$$

2. Reducing Balance (Diminishing Balance) Depreciation

This method results in a higher depreciation expense in the early years of an asset's life and a lower depreciation expense in later years. It's based on the principle that an asset depreciates more in its early years.

Formula:

$$ \text{Annual Depreciation} = \frac{\text{Book Value} \times \text{Depreciation Rate}}{100} $$

Where:

• Book Value: Cost of Asset - Accumulated Depreciation to date.
• Depreciation Rate: (1 / Useful Life) This is a fixed rate applied each year.

Example: A machine costs £10,000, has a salvage value of £1,000, and a useful life of 5 years.

Year	Beginning Book Value	Depreciation Rate	Depreciation Expense	Ending Book Value
1	£10,000	20%	£2,000	£8,000
2	£8,000	20%	£1,600	£6,400
3	£6,400	20%	£1,280	£5,120
4	£5,120	20%	£1,024	£4,096
5	£4,096	20%	£819.20	£3,276.80

3. Revaluation

Revaluation involves periodically revaluing assets to their current market value. This method is less common than the other two and is often used for property. The revaluation is recorded as an increase or decrease in the asset's carrying amount (book value).

Process:

1. The asset is revalued to its current market value.
2. The difference between the current market value and the previous carrying amount is recognized as a gain or loss.
3. The carrying amount of the asset is updated to reflect the revaluation.

Example: A building has a carrying amount of £50,000. A market valuation is performed and the building is now worth £70,000. The revaluation gain is £20,000 (£70,000 - £50,000). The carrying amount is updated to £70,000.

Disposal of Non-Current Assets

When a non-current asset is disposed of (sold, scrapped, or otherwise removed from the business), it's important to record the disposal correctly.

Steps:

1. Remove the asset from the balance sheet.
2. Calculate the gain or loss on disposal: Selling Price - Carrying Amount (Book Value).
3. If the selling price is less than the carrying amount, a loss is recognized. If the selling price is greater than the carrying amount, a gain is recognized.

Example: An asset with a carrying amount of £3,000 is sold for £2,000. The loss on disposal is £1,000 (£3,000 - £2,000).

Summary Table

Method	Description	Year 1 Depreciation	Year 2 Depreciation
Straight-Line	Equal depreciation each year.	$\frac{(Cost - Salvage Value)}{Useful Life}$	$\frac{(Cost - Salvage Value)}{Useful Life}$
Reducing Balance	Higher depreciation in early years, lower in later years.	$\frac{Book Value \times Depreciation Rate}{100}$	$\frac{Book Value \times Depreciation Rate}{100}$ (using the reduced book value)
Revaluation	Periodic revaluation to market value.	Gain or loss based on market value difference.	Revaluation gain/loss (market value change)