4.2 Accounting for depreciation and disposal of non-current assets (3)
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1.
The depreciation on a plant is calculated using the straight-line method. A plant cost £15,000 and has a residual value of £2,000. Calculate the annual depreciation expense and prepare the journal entry to record it.
Annual Depreciation Expense Calculation:
Depreciable Amount = Cost - Residual Value
Depreciable Amount = £15,000 - £2,000 = £13,000
Annual Depreciation = Depreciable Amount / Useful Life
Since the useful life is not provided, we assume it is 5 years. Therefore:
Annual Depreciation = £13,000 / 5 = £2,600
Journal Entry:
Debit: Depreciation Expense £2,600
Credit: Accumulated Depreciation £2,600
2.
ABC Company uses the reducing balance method to depreciate a machine costing £20,000. At the beginning of Year 1, the book value is £12,000. At the end of Year 1, the depreciation expense is £4,000. Prepare the ledger account for Depreciation Expense and the corresponding journal entry.
Ledger Account: Depreciation Expense
| Depreciation Expense |
| Date | Description | Debit (£) | Credit (£) |
| 1 January 2023 | Opening Balance | 12,000 | |
| 31 December 2023 | Depreciation Expense | 4,000 | |
| Closing Balance | | 8,000 | |
Journal Entry:
Debit: Depreciation Expense £4,000
Credit: Accumulated Depreciation £4,000
3.
Explain the reasons for accounting for depreciation of assets in a business. Your answer should consider both the matching principle and the realistic valuation of assets.
Depreciation is the systematic allocation of the cost of a tangible asset over its useful economic life. There are several key reasons why businesses must account for depreciation:
- Matching Principle: This is a fundamental accounting principle. It states that expenses should be recognized in the same period as the revenues they helped to generate. Assets, such as machinery or vehicles, are used to earn revenue. Depreciation reflects the cost of using these assets to generate that revenue. By matching the expense (depreciation) with the revenue generated during the asset's useful life, a more accurate picture of profitability is presented in the income statement.
- Realistic Valuation of Assets: Assets lose value over time due to wear and tear, obsolescence, or simply because they are no longer as efficient. Ignoring this decline in value would result in an overstatement of the asset's worth on the balance sheet. Depreciation provides a more realistic representation of the asset's value.
- Accurate Profitability Measurement: Without accounting for depreciation, profits would be artificially inflated. This would mislead stakeholders (investors, creditors, management) about the true financial performance of the business. Depreciation ensures that profits reflect the actual cost of using the assets.
- Tax Implications: Depreciation is often tax-deductible, meaning it reduces taxable profits. Accurate depreciation accounting is essential for calculating tax liabilities.
In summary, accounting for depreciation provides a more accurate and reliable financial picture, adhering to accounting principles and reflecting the economic reality of asset usage.