Depreciation of Non-Current Assets

Depreciation of
Chapter 11
Part One
Assets & Expenses
Just like assets, expenses are necessary –
necessary to help in earning revenue. A
business that had no employees, no
premises, no advertising and no electricity
could simply not do its job. In this way,
assets and expenses have something in
common – they both assist in the earning of
revenue – and this is reflected in the fact
that the definitions of both items refer to the
economic benefit they bring to the business.
a resource controlled by the entity as a
result of past events from which future
economic benefits are expected to flow to
the entity
a consumption or outflow (or reduction in
an inflow) of an economic benefit, in the
form of an decrease in assets or increase
in liabilities, which results in a decrease in
owner’s equity (except drawings)
Expenses refer to economic benefits that
have already been consumed (in the current
Reporting period), whereas assets refer to
economic benefits that are yet to be
consumed (and will be consumed in future
Reporting periods).
Depreciable Assets
Items like vehicles, office equipment and shop
fittings (which are controlled by the business)
will provide a future economic benefit (for more
than 12 months), and so should be recorded
as non-current assets when they are
At the same time, just because assets like
these will last for more than 12 months does
not mean they will last forever; as they age,
they wear out, and as their life expires, so too
does their ability to earn revenue. This means
they are depreciable assets – they have a
finite life, and will be useful for a fixed period of
time, but at some point in the future will be no
longer able to earn revenue.
Every year, part of the value of the asset is
consumed, until – at the end of its life – the
asset’s revenue earning capacity is wholly
consumed, and it is unable to earn revenue
any longer. As we already know, a
consumption of an economic benefit is an
expense, meaning that each year part of
the asset’s value is consumed, so part of its
value becomes an expense. This process of
calculating how much value has been
consumed in each period is called
Lane Cove Furniture
The vehicle is a depreciable asset with a finite
life: slowly but surely, the productive capacity
of the vehicle will be consumed. This will not
happen in one Reporting period, but rather
over a number of Reporting periods, so only
part of the asset’s value should be reported as
an expense for the year ended 31 December
2010. The remainder – the part yet to be
consumed – should be reported as a noncurrent asset (i.e. $32 000 less the amount
consumed so far). In order to calculate the part
of the cost of the vehicle consumed in the
current Reporting period (the year ended 31
December 2010), it is necessary to depreciate
the asset.
Review Questions 11.1.
Q’s 3, 5 & 6.
Depreciation of Non-Current
Although the term depreciation is frequently used to
describe the expense, it actually refers to the process
– the accounting procedure – that creates
Depreciation expense.
Because a non-current asset is not consumed
entirely within one Reporting period, depreciation is
an attempt to work how much of the asset’s value has
been consumed in the current Reporting period. It
therefore spreads out or allocates the cost of the
asset over the years in which it is useful for earning
revenue, rather than treating all of the cost as an
expense in any one year.
As a result of this process, depreciation expense is
created, representing that part of the cost of a noncurrent asset that has been consumed in the current
Reporting period.
Depreciation of Non-Current
Depreciation is a balance day adjustment. It
is made to ensure that an accurate profit is
calculated, by comparing revenues earned
against expenses incurred in the current
Reporting period.
Depreciation does not involve any payment
of cash. The cash payment relating to each
non-current asset will be recorded only at
the time when the asset is purchased.
Depreciation affects only the Income
Statement and the Balance Sheet.
Review Questions 11.2.
Q’s 3 & 4.
There are a number of different ways of
calculating depreciation expense, each of
which makes different assumptions about
the way assets are consumed. Note this
course only covers the straight-line
This method of calculating depreciation
assumes that non-current assets contribute
evenly to revenue, doing the same job in the
last year of their life as they did in their first.
As a result, it assumes that the value of a
non-current asset is consumed evenly over
its life, and that the depreciation expense will
be the same every year.
HC = Historical cost: the original purchase price of
the non-current asset.
RV = Residual Value: the estimated value of the noncurrent asset at the end of its useful life.
Life = Useful Life: the estimated period of time for
which the non-current asset will be used (by the
current entity) to earn revenue. (This is usually
measured in years.)
The basic premise is to divide the cost of the asset by
the number of years for which it is used, thus
determining how much of that cost is consumed per
Big Cycles
See example p. 243.
In this example, depreciation calculates that
the business is consuming $1400 worth of
the furniture’s value each year. This amount
would be recorded as an expense, and
would also decrease the value at which the
furniture is valued in the Balance Sheet.
Note: Because each non-current
depreciable asset is different in terms of its
useful life and residual value, each must be
depreciated individually.
Residual Value
‘Residual value’ is an estimate of the value
of the asset at the end of its useful life. If we
plan to use the asset until it is utterly
worthless, then the residual value will simply
be zero. However, we may dispose of the
asset while it still has some value. This
amount will then not be consumed by our
business, but by another entity.
Thus, the residual value must be deducted
from the Historical cost, because this is the
amount that will not be consumed by our
Depreciable Value
The amount calculated by deducting residual
value from Historical cost (in the top line of
the equation) is known as the depreciable
value; it is the total value of the asset to be
consumed by the current owner/entity, and
so must be allocated over its useful life.
Do Review Questions 11.3.
Q’s 4 & 5.
Recording Depreciation
As was noted earlier, depreciation is a
balance day adjustment. As a result, it is
recorded in the General Journal on balance
day – at the end of the Reporting period –
just like a stock loss, prepaid rent or accrued
Mixwell Paints
See Figure 11.1 on p. 245.
Remember, depreciation calculates that part of the
cost of a non-current asset that has been consumed
in the current Reporting period. This amount would
be recorded as an expense, by debiting a new
account called ‘Depreciation of van’. At the same
time, depreciation also decreases the value at which
the asset is valued in the Balance Sheet. (After all,
the non-current asset is a future economic benefit,
but by depreciating the asset we are recognising that
some of this benefit has now been consumed.) This
reduction in the value of an asset would normally be
recorded as a credit entry, but rather than credit the
asset account directly, the credit entry is made to a
new account called ‘Accumulated depreciation of
van’. This account is a negative asset account.
General Ledger
Note it is imperative to identify precisely
which asset is being depreciated.
I know generally I have been advising you
against abbreviations. However,
Depreciation is an area where intelligent
abbreviations can make your life much
easier! Use ‘Dep.’ for Depreciation, and
‘Acc. Dep.’ for Accumulated depreciation.
See Figure 11.2.
Depreciation vs. Accumulated
The key to understanding Accumulated
depreciation lies in the title. Whereas
Depreciation expense refers to the amount
consumed in the current Reporting period,
Accumulated depreciation refers to
depreciation that has accumulated (or built
up) over the life of the asset so far. That is,
Accumulated depreciation will grow every
year as the depreciation expense for each
Reporting period is added to it.
Depreciation vs. Accumulated
As an expense, the Depreciation of van
account must be closed to the Profit and
Loss Summary account at the end of each
Reporting period. In fact, it will open and
close on the very same day, leaving it with a
zero balance at the end of the period.
Accumulated depreciation of van on the
other hand is an ongoing account – it will be
balanced at the end of the period, with its
balance carried forward to the next.
Review ledger accounts on p. 246.
Depreciation vs. Accumulated
Note that the entry to close the Depreciation
of van account is made in the General
Journal at the same time that all the
expense accounts – including expenses
such as Cost of sales, Wages and
Advertising – are closed.
That is, all the expense accounts are
credited individually (to transfer the amount
so that profit or loss can be calculated, and
reset them to zero for the next Reporting
period), but only one debit entry is made to
Profit and Loss Summary. The depreciation
expense account would never be closed on
its own.
Part Two
Subsequent Periods
See example on pp. 246-247.
The Depreciation of van account had been
closed at the end of 2015, so the
depreciation expense for 2016 will be the
only entry in that account until it is closed
again on 31 December 2016.
Review Questions 11.4 (all q’s).
Reporting Depreciation
The Income Statement.
Remember that it is only the depreciation
expense – the amount consumed in the
current Reporting period – which is
reported in the Income Statement.
Accumulated depreciation is a negative
asset, not an expense, and so must not be
reported in the Income Statement at all.
Reporting Depreciation
The Balance Sheet
The first effect of depreciation on the
Balance Sheet is via Owner’s equity. As we
have already seen, depreciation expense
decreases Net profit. In terms of the Balance
Sheet, this decreases owner’s equity. The
second effect occurs on the asset side.
Accumulated depreciation reports the value
of the asset that has been consumed over
its life so far. It is reported directly under the
asset itself.
Reporting Depreciation
Mixwell Paints Balance Sheet (extract).
Note historical cost, acc. dep. & carrying
value (p. 250).
The Rate of Depreciation
Depreciation can also be expressed as a
rate – a percentage of the cost.
Rate of Depreciation
Using the figures from the earlier example
regarding the office furniture, the
depreciation rate would be calculated as:
Note there is residual value of $800.00 (28%
X 3 = 84%).
Calculating using the rate
In some cases, it may be the rate of
depreciation that is given rather than the
Historical cost, residual value and useful life.
In these cases, the depreciation expense (in
dollar terms) can be calculated by simply
multiplying the rate by the Historical cost.
See Carlton Clothing example p. 251.
The cost of a non-current
it is quite common for a business to modify
an asset, or incur costs for its installation,
that must also be included in this definition
of cost. After all, if these other costs will
provide a future economic benefit over the
life of the asset, then they should be
classified as non-current assets, and
depreciated. The cost of an asset is thus
defined as:
All costs incurred in order to bring the
asset into a location and condition ready
for use, that will provide a benefit for the
life of the asset.
The cost of a non-current
The cost of a non-current asset may
therefore include:
the purchase price/supplier’s price
Note GST is not part of the cost of an
delivery costs
modification costs
installation costs.
Maintenance Fee
Note also the maintenance fee ($1000) may
also be a necessary cost, but it is a yearly
fee; its benefit will be consumed within a
year. This means it is not part of the value
of a non-current asset, but rather a current
asset – Prepaid maintenance fee.
It has its own separate ledger account. (It
would then be subject to a balance day
adjustment at the end of the Reporting period
to calculate the maintenance incurred.)
Basically, any costs where the benefit does not
extend for the life of the asset are not included
in the cost of the asset, but rather treated
separately as expenses or prepaid expenses.
Recording the cash purchase
of a non-current asset
Remember that the payment would be
recorded in the CPJ on the date it occurred
(1 March 2015), but not posted to the
General Ledger until totals are calculated at
the end of the period (31 March 2015).
See also General Ledger p. 253.
Depreciating for less that a
if by the end of the Reporting period the firm
has had control of the asset for less than a
year, the depreciation figure will need to be
applied on a pro-rata basis; if the business
has had the asset for only one month, then
only one month’s worth of depreciation (1/12
of a year) should be charged as an expense.
Pay very careful attention to the date on
which the asset is acquired – this will
determine how many months worth of
depreciation need to be applied.
Depreciating for less that a
If the asset has been under control of the
business for only three months, only three
months of depreciation should be calculated.
Use of estimates
Because the residual value and useful life are
estimates, using them in the calculation of
depreciation means that the reports will not be
free from bias and to some extent this will
undermine the Reliability of the accounting
However, depreciation ensures that the Profit
and Loss Statement includes all information
that is useful for decision-making about profit,
by showing the consumption of non-current
assets in the current Reporting period
(relevance). Similarly, by showing accumulated
depreciation in the Balance Sheet, it ensures
that assets are shown at their carrying value,
which is vital for decision-making about their
Read Summary.
Do exercises.