Depreciation of NCA and Disposal (IAS 16)

IAS 16: Property, Plant and Equipment

The objective of this Standard is to prescribe the accounting treatment for property, plant and equipment so that users of the financial statements can recognize information about an entity’s investment in its non current assets and the changes in such investment.

Property, plant and equipment are tangible items that

• are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and
• are expected to be used during more than one period.

For example:

• Plant and Machinery
• Land and Building
• Fixtures and Fittings

The cost of an item of property, plant and equipment shall be recognised as an asset only if:

• it is probable that future economic benefits associated with the item will flow to the entity; and
• the cost of the item can be measured reliably.

The cost of an item of property, plant and equipment comprises:

• its purchase price, including import duties and taxes, after deducting trade discounts
• any costs directly attributable in bringing the asset to its present location and condition

According to IAS 16, an entity shall choose either the cost model or the revaluation model as its accounting policy and shall apply that policy to an entire class of property, plant and equipment. Under the cost model, an item of property, plant and equipment shall be valued at its cost less any accumulated depreciation.

Depreciation

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life (number of years it will be used). Depreciation is an expense to the business for using non-current asset to generate economic benefits. It is provided to spread the cost of using non-current asset over its useful life. Depreciation is not the fall of value of a non-current asset.

Factors affecting the useful life of non-current asset

• wear and tear
• obsolescence (outdated/old fashion)
• damage by accident
• technological improvement

Reasons for providing depreciation

• Prudence concept: Profit will be overstated if depreciation is not charged against income during an accounting period.
• Matching concept: Depreciation is an expense and must be properly matched against income generated during a financial year.

Methods of calculating depreciation

Straight line method

According to this method depreciation is calculated as a fixed percentage on cost. It is mostly used for non-current assets such as fixtures & fittings which is consistently used over its useful life. Under this method depreciation can also be calculated using the following formula.

Depreciation               = (Cost - Residual Value) / Useful life

The residual value of a non-current asset is the estimated amount that an entity would obtain from the disposal of the asset.

Reducing balance method

According to this method depreciation is a fixed percentage on its net book value each year. It is mostly used for machinery since it produces more during its first years of trading.

Revaluation method

According to this method, depreciation is the difference between the value at start and the value at end. This method is appropriate for businesses that have many small items of non-current assets (example loose tools).

Depreciation                     =          Balance at start + acquisition – disposal – Balance at end

A non-current asset may also be revalued upwards. For example land does not depreciate but it may be revalued upwards. In this case a revaluation reserved must be created and recorded as part of the equity of the business. Revaluation reserve may be calculated as follows:

Revaluation reserve             

=          revalued amount – (cost – accumulated depreciation)

=          revalued amount– NBV

Each time a non-current asset is revalued upwards, its provision for depreciation must be eliminated (debited) and the amount of revaluation reserve must be credited to the reserve account.

Accounting entries

Acquisition/purchase of non-current assets

Debit               Non current asset

Credit              Cash / bank / trade payables

Depreciation charge for the year

Debit               Income statement

Credit              Provision for depreciation

Disposal of non-current assets

Cost of asset                                 

 Debit               Disposal Account

Credit              Non current asset

Proceeds from disposal                

Debit               Cash/bank

Credit             Disposal

If there is a part exchange           

Debit               Non Current Asset

Credit              Disposal Account

Accumulated depreciation           

Debit               Provision for depreciation

Credit              Disposal