## Depreciation – Disposal Account

Disposal is generally simple to do, I have not seen students facing much difficulty in a straight forward question. Disposal account is opened upon the sale of an asset, because we have to delete the item from our accounts.

Some important points to take note in this topic:

1) The asset values at its original cost or historical cost.

2) Accumulated depreciation of the asset will have to be disposed of.

3) There is a cash transaction involved for the disposal of the asset (i.e. you sold your asset for cash or trade-in.)

4) There will be a profit or loss arising from such disposal. (No gain no loss could also be possible but rarely occurs.)

5) (*Optional) You will need to charge the profit or loss from disposal to the Profit & Loss Account.

The T-accounts and explanation are shown below:

As an example, if a motor vehicle was purchased at the start of the year at \$50,000, and then disposed off at the end of the second year at a disposal value of \$35,000. In this case, let’s assume that the depreciation was accumulated to \$10,000 (straight line method, \$5,000 per year).

 Motor Vehicle A/C 1-Jan Cash 50,000 31-Dec Motor Vehicle disposals 50,000 You are disposing of an asset worth \$50,000

Here, students often confused why credit a \$ 50,000 motor vehicle account. The reason was obvious, the vehicle that you will throw away is originally worth \$50,000. Most students tend to write down the disposal value of \$35,000… which is wrong –> Imagine that your motor vehicle was gone and that your motor vehicle account still has a balance carried down of \$15,000 (\$50,000-\$35,000), this is unexplainable (a gone vehicle with a worthiness of \$15,000?). Therefore, any assets sold  should be reduced with its original cost.

 Provision of Depreciation: Motor Vehicle 31-Dec Motor Vehicle disposals 10,000 31-Dec Balance c/d 10,000

Because we are supposed to close of all accounts related to the motor vehicle that we brought, all relevant accounts should be closed. If you note that the words Motor Vehicle disposals appear in the accounts of Motor Vehicle and Provision for depreciation. This signals another account that will be used to close all relevant accounts. (Take note that the account for provision of depreciation is kinda simplified, it only shows accumulated depreciation for second year.)

Important Information: In this example, the asset was purchased at 1st January and sold at the end of the year of the second year – 31st December, so it has to be fully depreciated for two years. For A Level students, most often, you will need to pay attention to the date and the month of the purchase and accounts for the depreciation accordingly to the months used during the financial year. However, you should also note if there is any additional information given on the company’s depreciation policy. The depreciation policy is to be given highest priority.

 Motor Vehicle Disposals A/C 31-Dec Motor Vehicle 50,000 31-Dec Provision for depreciation 10,000 Cash 35,000 Loss on disposal 5,000

Motor Vehicle Disposals account will be the final account. Those that I have embolded means it were transferred from the first two accounts that we closed. The cash will be amount that we received or the amount that the motor vehicle was disposed off. Since every account has to be balanced, there will be shortage of amount in the credit side of the disposal account by \$ 5,000. This is a loss on disposal. Can’t picture why? Here, the motor vehicle is worth \$50k originally and at the end of the second year, the motor vehicle should worth \$40k (after depreciation). And because you sold it for \$35k, you are losing the \$5,000.

You will also need to note that the reverse of loss on disposal will be on the debit side (profit on disposal).

If the question requires you to open up profit and loss account, then you should! If you are unsure, just note that Loss is an expense, it falls at debit entry in the profit and loss account. Profit is a gain, it falls at credit entry in the profit and loss account. Or you could use double entry rule, the loss on disposal is credit side, so it will falls on the debit side of profit and loss account, and vice versa.

## Depreciation – Accounts Based

For depreciation, started opening accounts are the weakness for most students. I see through them! And I can’t emphasize enough how you will need a good basic (if you want to improve, read the first few topics of any accounting textbook) to be really able to grasp opening accounts easily! So the double entry rule is the most basic skill (for the fact that the trial balance and balance sheet will have to be balanced were all thanks to double entry rule!)

I will start explaining from the start (you can skip if you want to), I hope this explanation will implant a seed into your memory!

Example:

On 1 January 2012, a business brought a motor vehicle for \$ 40,000. The motor vehicle was depreciated at \$5,000 per annum using the Straight Line Method.

Cash or Bank account Fixed Assets account

Deciding the journal entries for Depreciation and Provision for Depreciation can be somewhat tricky.

If you could memorize the journal entries real hard, this will be it

 Date Particulars Debit Credit 1-Jan Depreciation of Motor Vehicle 5,000 Provision for Depreciation of Motor Vehicle 5,000

But if you think you can’t memorize, I will explain it more thoroughly.

First, if you remember that all expenses will falls in the debit side. Check the trial balance to confirm.

Second, the word depreciation means expense, and therefore, it lies in the debit entry. See the journal entry above and refer to the definition previously posted on depreciation.

Third, the double entry account. If you refer to the motor vehicle account earlier, you will know that depreciation will reduce the amount of your fixed assets, and this is opened in another account named Provision for Depreciation. The Motor Vehicle account is not to be reduced because you will need to show the original cost of the asset at the Balance Sheet, and a separate amount to show the total amount of depreciation charged towards the assets.

So the general format for depreciation account,

 Depreciation A/C Provision for Depreciation XXX Profit and Loss XXX

and provision for depreciation account,

 Provision for Depreciation A/C First year depreciation. Balance c/d XXX Depreciation XXX Second year depreciation. Balance c/d XXX Balance b/d XXX Depreciation XXX XXX XXX

Whilst in the final account,  profit and loss account

 Profit and Loss Account for the year ended … (vertical format) Expenses: Depreciation of fixed assets (FROM DEPRECIATION A/C) XXX

and balance sheet,

 Balance Sheet as at … (vertical format) Fixed Assets: Cost Agg Depr NBV Motor Vehicle (FROM PROV of DEPRECIATION A/C) XXX (XXX) XXX XXX

Next post will be on disposal account.

## Depreciation – Calculation Based

Updated on 18th July 2012 on the meaning of depreciation and provision for depreciation.

This topic requires students to memorize the formula to calculate with each method of depreciation. It should be noted that depreciation only applies to assets (for business purposes only and not for resale)  and anything purchased for resale should never be included for depreciation (most often used to trick A level students.)

1) Straight line method (also called fixed installment method)

(Cost – Estimated Disposal Value) / Number of Expected Years of Use

Example:

If a motor vehicle was purchased for \$25,000 and the estimated disposal value is \$5,000, and the number of useful life is 4 years, then,

Depreciation = (25,000 – 5,000) / 4 = \$ 5,000 per year.

Therefore, this assets will have to be depreciated for 4 years at \$ 5,000 per year (fixed) before this asset will be disposed off.

2) Reducing Balance Method (also called diminishing balance method)

The general formula is presumed to be = Net Book Value x Fixed Percentage Given

*Important terms have to be remembered, failure to understand this usually caused students proceeding to A level having the same difficulty.

Cost means Original Price of an Asset.

Provision for depreciation is the total depreciation used to reduce the amount of fixed assets in the balance sheet.

Depreciation is a one year expense which is brought forward to the profit and loss account.

Net Book Value means value after depreciation.

Example:

Assume the same motor vehicle at \$25,000. The depreciation is to be charged at 10%.

1st year depreciation will be = \$ 25,000 x 0.10 = \$2,500

2nd year depreciation will be = \$ (25,000 – 2,500) x 0.10 = \$2,250

3rd year depreciation will be = \$ (25,000 – 2,500 – 2,250) x 0.10 = \$2,025

and so on… The first year uses Cost x Percentage only, while the second year and consecutive years use NBV x Percentage.

3) For A level student, Revaluation method (often used in manufacturing account to depreciate loose tools*)

Revaluation = Opening balance + Purchases – Closing balance

The most easiest depreciation method, but most students failed to recall the formula or are unknown of this method.

Example:

If the opening balance of a loose tools account amounted to \$2,000 and during the year, the business purchased \$500 worth of loose tools and at the end of the year, the loose tools accounted to \$1,500.

Depreciation = OB + P – CB = \$2,000 + \$ 500 – \$1,500 = \$ 1,000.

*Loose tools are a part of machinery (spare parts) which can include things such as nails, tools and etc that is easily lost. There are considered to be a part of the fixed assets and so depreciation applies (to account for loose tools lost or stolen).