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

This section covers the accounting treatment of depreciation, which is the allocation of the cost of a non-current asset over its useful life. It also explains the journal entries required for the disposal of non-current assets.

What is Depreciation?

Non-current assets (also known as fixed assets) are assets that a business uses for more than one accounting period. Examples include buildings, machinery, and vehicles. These assets lose value over time due to wear and tear, obsolescence, or usage. Depreciation reflects this gradual decline in value.

Depreciation is an expense that is recognised in the income statement each year. It does not involve a cash outflow.

Methods of Calculating Depreciation

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

• Straight-Line Method: This method allocates an equal amount of depreciation each year.
• Reducing Balance Method (Diminishing Balance): This method applies a fixed percentage to the book value of the asset each year.
• Units of Production Method: This method calculates depreciation based on the actual usage of the asset.

For the IGCSE syllabus, the Straight-Line Method is typically the most commonly used.

Straight-Line Depreciation Formula

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

$$ \text{Depreciation per year} = \frac{\text{Cost of asset} - \text{Salvage Value}}{\text{Useful Life}} $$

Where:

• Cost of asset: The original cost of acquiring the asset.
• Salvage Value: The estimated value of the asset at the end of its useful life.
• Useful Life: The estimated period for which the asset will be used.

Journal Entries for Depreciation

The journal entry for depreciation involves two accounts:

• Depreciation Expense: This is an income statement account that increases the profit figure.
• Accumulated Depreciation: This is a balance sheet account that represents the total depreciation charged on an asset up to a certain date. It is a contra-asset account, meaning it reduces the book value of the asset.

The journal entry is as follows:

Date	Account	Debit	Credit
(At the end of the accounting period)	Depreciation Expense	$XXX
	Accumulated Depreciation		$XXX
(To record depreciation for the period)			$XXX

Example:

A machine cost $10,000, has a salvage value of $1,000, and a useful life of 5 years. Using the straight-line method, the annual depreciation is:

$$ \text{Depreciation per year} = \frac{\$10,000 - \$1,000}{5} = \$1,800 $$

The journal entry at the end of the year would be:

Date	Account	Debit	Credit
31 December	Depreciation Expense	$1,800
	Accumulated Depreciation		$1,800
(To record depreciation for the year)			$1,800

Disposal of Non-Current Assets

When a non-current asset is disposed of (sold, scrapped, or traded in), the following steps are taken:

1. Remove the asset from the balance sheet: The asset and its accumulated depreciation are removed from the balance sheet.
2. Calculate the gain or loss on disposal: This is the difference between the disposal proceeds (the amount received) and the carrying amount of the asset (cost less accumulated depreciation).
3. Journal Entry: A journal entry is made to record the disposal.

Journal Entry for Disposal of a Non-Current Asset

The journal entry for the disposal of a non-current asset depends on whether a gain or a loss is made.

Case 1: Disposal at a Gain

If the asset is sold for more than its carrying amount, a gain is made.

Date	Account	Debit	Credit
(Date of disposal)	Cash/Bank	$XXX
	Depreciation Expense		$XXX
	Gain on Disposal		$XXX
(To record disposal at a gain)			$XXX

Case 2: Disposal at a Loss

If the asset is sold for less than its carrying amount, a loss is made.

Date	Account	Debit	Credit
(Date of disposal)	Depreciation Expense	$XXX
	Loss on Disposal	$XXX
	Cash/Bank	$XXX
(To record disposal at a loss)			$XXX

Example:

A machine with a cost of $10,000 and accumulated depreciation of $6,000 is sold for $7,000.

Carrying amount = $10,000 - $6,000 = $4,000

Loss on disposal = $4,000 - $7,000 = $3,000

The journal entry would be:

Date	Account	Debit	Credit
(Date of disposal)	Depreciation Expense	$6,000
	Loss on Disposal	$3,000
	Cash/Bank	$7,000
(To record disposal at a loss)			$7,000

Summary

Understanding depreciation and its accounting treatment is crucial for accurately reflecting a business's financial performance and position. Properly recording depreciation and the disposal of non-current assets ensures that financial statements are fair and provide a true picture of the company's assets and profitability.