Depreciation of Assets

Depreciation – The systematic allocation of the cost of an asset over its useful life is called depreciation.

For example, the cost of an asset is $1000 and its estimated useful life is 10 years. Here we shall take $100 as depreciation expense every year into our profit and loss account.

Basically depreciation is an estimate of how an asset is used during its productive life.

There are different methods of calculating depreciation expense. The business has to make sure that once a method is used, it should continue to use this method every year.

Book value of the asset is the amount appearing in the asset-account on any date.

For example, if asset is purchase at $1000. Its book-value is $1000 in the first year.

If we charge a depreciation expense of $100 in first year then the book-value of the asset in the accounts of the company is $900 (= cost of asset – total depreciation expense charged).

Book-value is also called the net-book value of an asset.

Methods to calculation Depreciation –

1. Straight line depreciation method –

Depreciation expense per year :

= Cost of asset - Residual valueLife of asset (in years)

Residual value means any amount of money received when the business sells the asset after using it.

So if cost of asset is $1000 , residual value is $0 and life of asset is 10 years. The depreciation expense will be $100 per year.

Methods to calculation Depreciation – (continued)

2. Declining-balance method –

Depreciation expense per year :

Net book value of asset x depreciation rate

For example, cost of asset = $1000 and we use the depreciation rate of 10%.

Depreciation expense in 1st year = 1000 x 10% = 100Depreciation expense in 2nd year = 900 x 10% = 90Depreciation expense in 3rd year = 810 x 10% = 81Depreciation expense in 4th year = 729 x 10% = 73

Methods to calculation Depreciation – (continued)

So the declining balance method charges more depreciation in early years of the life of the asset.

3. Double-Declining-balance method –

Depreciation expense per year : 2 x (Net book value of asset x depreciation rate)

For example, cost of asset = $1000 and we use the depreciation rate of 10%.Depreciation expense in 1st year = 2(1000 x 10%) = 200Depreciation expense in 2nd year = 2(800 x 10%) = 160Depreciation expense in 3rd year = 2(640 x 10%) = 120Depreciation expense in 4th year = 2(520 x 10%) = 104

Depreciation accounting for assets –

Depreciation is an estimate of the expense of productive life of an asset due to its use in business.

When we account for depreciation:1. we reduce the value of asset in our books by the amount of depreciation expense each year. The journal entry is:

Depreciation expense a/c Dr. To asset a/c

Depreciation accounting for assets – (continued)

2. At the end of the year, the depreciation expense account is closed to the profit and loss account:

Profit and Loss a/c Dr.To Depreciation expense a/c

As depreciation is an expense it shall lower the profit of the business.

Gain or loss on sale of an asset:

When a business sells an asset before its useful life ends it can make a gain on the sale or it can make a loss.

The business shall make a gain when, the price at which it sells the asset is more than the book-value of the asset at the time of the sale.

For example, today the book-value of a machine is $400 and the business sells it for $500. So the gain on the sale of the machine is $100.

It is important to note that when we measure the gain on sale of an asset we compare its book-value (not cost) with the sale-price of the asset.

The business shall make a loss when, the price at which it sells the asset is less than the book-value of the asset at the time of the sale.

For example, today the book-value of a machine is $400 and the business sells it for $300. So the loss on the sale of the machine is $100.

Journal entries for a gain on sale of asset:

We have to make 2 entries to record the transaction of sale of the asset. One entry to record the receipt of cash and selling of machine. Second entry to record the gain on this sale of machine.

1. Debit cash account with the amount of sale-price and credit asset account with the same amount.Cash a/c Dr. 500 Machine a/c 500

2. Debit asset account with the amount of gain and credit the profit and loss account. Machine a/c Dr. 100

Profit & Loss a/c 100

Below is the machine account after it the machine has been sold and the account is closed by the company.

Date Particulars Amount $ Date Particulars Amount $

To balance b/d

To Profit & loss a/c

400

100

500

By cash a/c 500

500

Dr. machine account Cr.

Journal entries for a loss on sale of asset:

We have to make 2 entries to record the transaction of sale of the asset. One entry to record the receipt of cash and selling of machine. Second entry to record the loss on this sale of machine.

1. Debit cash account with the amount of sale-price and credit asset account with the same amount.Cash a/c Dr. 300 Machine a/c 300

2. Debit profit and loss account with the amount of loss and credit the asset account. Profit & Loss a/c Dr. 100

Machine a/c 100

Below is the machine account after it the machine has been sold and the account is closed by the company.

Date Particulars Amount $ Date Particulars Amount $

To balance b/d 400

400

By cash a/c

By Profit & loss a/c

300

100

400

Dr. machine account Cr.