Lesson 4.2: Depreciation of Non-Current Assets

Introduction

Welcome to Lesson 4.2 of Foundation Accounting! In this lesson, we will explore the concept of depreciation of non-current assets. Our objectives for today include understanding why non-current assets are depreciated, distinguishing between capital and revenue expenditures, and learning the methods to calculate depreciation. By the end of this lesson, you should be able to apply these concepts in real-world situations. Let's dive in! 🚀

Why Non-Current Assets Are Depreciated

Non-current assets, which include machinery, buildings, and vehicles, are essential for businesses. However, these assets lose value over time due to wear and tear, technological advancements, and other factors. This decrease in value is what we call depreciation.

Matching Cost to the Periods That Benefit:

The primary reason for depreciation is to match the cost of the asset to the revenues it generates over its useful life. For instance, if a company buys a delivery truck for $20,000 and expects to use it for 5 years, the cost should be spread over those 5 years. This is done to accurately reflect the expense related to the income generated during those years.

$$\text{Annual Depreciation Expense} = \frac{\text{Cost of Asset}}{\text{Useful Life}}$$

In our example, the annual depreciation expense for the truck would be:

$$\text{Annual Depreciation Expense} = \frac{20000}{5} = 4000$$

So, each year, $4,000 will be recorded as an expense until its total cost is accounted for.

Capital Versus Revenue Expenditure

Understanding the difference between capital and revenue expenditures is crucial in accounting.

Capital Expenditure: This refers to the money spent to acquire or upgrade non-current assets. These costs are capitalized, meaning they are added to the asset’s value on the balance sheet instead of being immediately expensed. Examples include purchasing a new machine or renovating a building.

Revenue Expenditure: This is the money spent on day-to-day operations or maintenance of the assets. These costs are expensed immediately. For example, costs for repairs or routine maintenance of the delivery truck fall under this category.

What Can Be Capitalized?

In general, costs that enhance the asset's value, extend its useful life, or increase its production capacity may be capitalized. However, regular maintenance that merely maintains an asset's current condition should be expensed. 🏗️

Methods of Depreciation

There are mainly two methods to calculate depreciation: Straight-Line Method and Reducing-Balance Method. Choosing the right method depends on how the asset is expected to be used over time.

Straight-Line Method

The straight-line method distributes the cost of the asset evenly over its useful life. This method is simple and widely used.

Formula:

$$\text{Depreciation Expense} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}}$$

Where:

Cost is the purchase price of the asset.
Residual Value is estimated value at the end of its useful life.
Useful Life is how long the asset is expected to be used.

Example:

If our delivery truck has a residual value of $2,000, its annual depreciation expense would be:

$$\text{Depreciation Expense} = \frac{20000 - 2000}{5} = 3600$$

Reducing-Balance Method

The reducing-balance method calculates depreciation based on a fixed percentage of the asset's remaining book value (cost minus accumulated depreciation) each year. This method usually results in higher depreciation in earlier years.

Formula:

$$\text{Depreciation Expense} = \text{Book Value} \times \text{Depreciation Rate}$$

Example:

If our delivery truck has a depreciation rate of 20%, the first year’s depreciation expense would be:

$$\text{Depreciation Expense} = 20000 \times 0.20 = 4000$$

In subsequent years, the book value will decrease, causing the depreciation expense to also decrease over time.

Accounting Entries

Now that we understand how depreciation is calculated, let's discuss the accounting entries involved.

Depreciation Charge

Each year when the depreciation is recognized, you will make the following journal entry:

Debit Depreciation Expense (an expense account)
Credit Accumulated Depreciation (a contra-asset account)

Example for Straight-Line Method:

If we are recording $4,000 as depreciation expense:
Debit: Depreciation Expense $4,000
Credit: Accumulated Depreciation $4,000

Carrying Amount

The carrying amount (or book value) of an asset is its original purchase price minus the accumulated depreciation. After a few years, this figure becomes very important for financial statements.

$$\text{Carrying Amount} = \text{Cost} - \text{Accumulated Depreciation}$$

If after three years using the straight-line method the accumulated depreciation is $12,000:

$$\text{Carrying Amount} = 20000 - 12000 = 8000$$

Presentation of Cost, Accumulated Depreciation and Carrying Amount

In the financial statements, the cost, accumulated depreciation, and carrying amount of non-current assets are usually presented on the balance sheet. Non-current assets are listed at their cost, with accumulated depreciation shown underneath. The net amount represents the carrying amount.

Conclusion

In summary, understanding depreciation is crucial for both businesses and accounting practices. It ensures that the true value of an asset is reflected in financial statements and that expenses align with revenues generated from those assets.

Study Notes

Non-current assets lose value over time due to depreciation.
The importance of matching the cost to the revenue period.
Distinction between capital and revenue expenditure.
The two main methods of depreciation: Straight-Line and Reducing-Balance.
Importance of journal entries and understanding carrying amount for financial statements.