INTRODUCTION TO

FINANCIAL ACCOUNTING
course

Chapter VII.
DEPRECIATION &
DISPOSALS

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Causes of Depreciation:
a) CAPITAL AND REVENUE EXPENDITURE

Capital Expenditure: This is the amount

spent on the acquisition of a non-current
asset or adding value to a non-current
asset.
Examples of expenses incurred in
acquisition:
 Purchase price/cost of the asset.

 Delivery/carriage inwards costs (e.g. shipping

charges or import taxes).

 Costs incurred to get the asset in use (e.g.

assembly, testing)
 Installation
 Demolition costs in order to construct a
new building.
 Architect fees for construction and
supervision
 Legal fees incurred in acquisition of a new
asset (e.g. lease agreement)
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Examples of expenses incurred in
adding value to an asset:

 Modify plant to increase its useful life.

 Upgrading plant to improve quality of
output.
 Adopting or upgrading the production
process to improve or reduce costs.
 Revenue Expenditure: There’s an amount
spent by the firm in the normal trading
process or to assist in earning revenues or
income.
Examples:
 Postage and stationery.
 Carriage outwards (sales).
 Repairs and maintenance.
b) DEPRECIATION

 It is the loss of value of a non-current

asset throughout its period of use by the
firm.
 Depreciation is the allocation of a
depreciable amount of a non-current asset
over its estimated useful life.
 Under the matching concept, all incomes
or revenues and expenses for a
particular period should be reported in
the financial statements and because
depreciation is an expense of the
business therefore, it will be charged in
the Income statement
1. Physical Factors
 a) Wear and tear: Some non-current
assets depreciate or lose value due to use
overtime. e.g. machinery and motor
vehicles.
 b) Rot/decay/rust: This happens on assets
that are not well maintained by the firm
e.g. Some machines.
2. Economic Factors
 a) Inadequacy: Some assets lose value
due to them becoming inadequate e.g. when
a business grows or expands then some
buildings may become inadequate due to
space.
Also some machines that are unable to
manufacture a large number of goods.

 b) Obsolescence (outdated):
Some assets become obsolete due to
change in technology or different
Methods of production
e.g. computers.
 3. Time Factors
Some assets have a legal fixed time e.g.
properties on lease.
 4. Depletion
This occurs when some assets have a wasting
character due to extraction of raw
materials, minerals or oil.
Such assets include mines, oil wells, and quarries.

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Methods of Calculating Depreciation

 These are the methods developed to assist

in estimating the amount of depreciation to
be charged in the P&L a/c as an expense.
 The methods chosen by a firm should be in
accordance with the agreed accounting
practice, accounting standards and suit the
firm’s non-current assets.
 There are 2 main methods of estimating
depreciation and 5 others that will apply in
a firm’s situation.
The main methods are: Straight-line
method and Reducing Balance method.
The other 5 methods include:
 1) Sum of the digits methods – uses a formula.
 2) Revaluation method – applies to a non-current
asset of low value.
 3) Machine-Hour method – depreciation is based
on number of hours a machine is expected to
operate (manufacturing process).
 4) Unit of output method – depreciation is based
on the number of units a machine is expected to
produce.
 5) Depletion of units – depreciation is based on
number of units extracted from the asset.

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I. Straight-Line Method
 This method ensures that a uniform
amount of depreciation is charged in the
P&L a/c for a particular asset and is based
on the following formula:
Depreciation=
Residual Value

 The amount the firm expects to

sell the asset after the period of
use in the firm, also called Sales
Value / Scrap Value.
Estimated Useful Life

 The period the asset is expected to

be used in the firm.
Example
 A firm buys a machine for FRw100,000
which it expects to use in the firm for eight
years.
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After the eight years the machine will
be sold for FRw20,000.

Under the straight-line method, the

depreciation amount will be computed
as follows:
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 This means for this asset FRw10,000 will be
charged in the P&L account as depreciation
expense on the machine.
The straight line method assumes that
benefits accruing on use of a non-current
asset are spread out evenly over the life of
the asset e.g. buildings use straight-line method.

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Reducing Balance Method

 Reducing balance method – result in a

reducing or diminishing
charge/amount over the useful life
of the asset.

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 The firm determines a fixed percentage
rate that is applied on the cost of the asset
during the first period of use.
The same rate is applied in the subsequent
financial periods but the rate is applied on the
reduced value of the asset:
(Cost of asset – total depreciation provided
to date).
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 This method ensures that higher
amount of depreciation are charged in
the P&L account in the earlier periods
of use and lower amounts in the
latter periods of use as shown in the
following example:

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 Example
 Assume a firm buys machinery for
FRw100,000 and provides depreciation on
machines at 20% p.a. on reducing balance
method.
The depreciation charged to the Income
statement will be as follows for the next
3 years.

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 Year 1
Description Frw

Cost 100,000
Depreciation 20% of 100,000
(20,000) P&L Year 1

Balance to year 2 80,000

Year2 Cost 80,000

Depreciation 20% of 80,000 (16,000)
P&L Year2

Balance to Year 3 64,000

Year3 Cost 64,000

Depreciation 20 % of 64,000 Labor for the future
P&L Year 3
(12,800)
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 Reducing balance method (diminishing balance
method) assumes that benefits accruing from the
use of an asset are higher in the first periods of
use and lower in the latter periods

Examples:

Fixtures, furniture and fitting.

Plant and machinery.

Motor vehicles.

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 Unit of production method
 – It results in a charge based on the

number of production units in the

period compared to the expected
total units of an asset.

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Sum of digits:
 –It results to decreasing charge over the
useful life of an asset, but the depreciation
is calculated as follows.

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 Revaluation method
 –The method is used for a business with
small items like in a kitchen and garage.
The depreciation is determined as follows:
FRw
Valuation at the start xx
Acquisitions xx
Disposal (xx)
Expected value xx
Valuation at the end (xx)
Depreciation xx

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Recall:

 Depreciation is the systematic allocation

of the depreciable amount of an asset
over its estimated useful life.
 Depreciation for the accounting period is
charged to net profit or loss for the
period either directly or indirectly.

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 It is accumulated to be reduced from the
cost of the asset to get the carrying
amount (cost less accumulated
depreciation).
 Depreciable assets are tangible non-current
assets as defined and do have a limited useful
life (so land is not included here) that is held
for use in the business.

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Useful life is either:

 The period over which a depreciable asset

is expected to be used by the enterprise
or
 The number of production or similar units
expected to be obtained from the asset by
the enterprise.

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 Depreciable amount is the historical
cost or other amount substituted for
historical cost in the financial
statements, less the estimated residual
value.

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 Residual value/salvage value is the net
amount, which the enterprise expects
to obtain for an asset at the end of its
useful life after deducting the expected
costs of disposal.

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Accounting Treatment of Depreciation
1.The Asset account:
This account is always kept at cost until the
asset is disposed.
Purchase of asset:
Debit: Asset a/c
Credit: Cash/ Bank a/c

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2. Recording annual Depreciation
 When non-current assets are
depreciated, a new account for
each type of asset is opened; this
account is called a provision for
depreciation whereby the following
entries will be made:

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 Debit – Income statement
(Deprecation)
 Credit – Provision depreciation a/c

With the amount of depreciation

charged for the period.
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 Example on straight-line method

The entries will be as follows:

 Debit – P&L a/c with FRw10,000
 Credit – Provision for depreciation.

Machines a/c with FRw10,000 being

depreciation provided for the machine.

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The ledger accounts will be as follows:
Dr Machinery Cr

FRw FRw

Cash Book 100,000 31/12 Bal. c/d 100,000

Dr Provision for Depreciation Machinery Cr

FRw FRw
31/12 Bal c/d 10,000 P&L 10,000

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 The balance in account is accumulated and
carried down (c/d) to next period.

 The balance is the Accumulated

Depreciation (Acc. Depr) to be shown in the
Statement of Financial Position(SFP).

 This is deducted from the cost of the asset to

arrive at the net Book Value of that Asset.

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Assets brought during the year
 Depreciation is charged on prorate basis.
That is proportionately for the period
it is used in that year.

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 Example1:
A motor van was bought on 2nd July 2015 for
Frw 2,000,000. It was being depreciated at
20% p.a. on straight line basis.
The policy is to charge depreciation for per
period the asset is used in the year of
purchase.
Required: Show the amount of depreciation to be
charged as at 31st December 2015
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Example2
A Motor Van was bought on the 1st January
2014 for Frw1,000,000. The Policy is to
depreciate the motor van at 20% on
straight line method.
Required:
i) Calculate the annual depreciation for the
year end 31st December 2014, 2015 &

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ii) Show the following accounts for the
three years:
 A) Motor Vehicle a/c
 B) Provision for Depreciation a/c
 C) S P&L Extract
 D) SFP Extract

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Disposal of Assets

A firm may dispose off its non current

assets in the following ways:
 Selling the asset;
 Asset being written off from damage /
accident / theft

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 Accounting Entries to record
disposal of asset
 Cost of the asset being disposed:
Debit:Asset Disposal a/c
Credit :Asset Account
 Total Depreciation provided to date on
the asset:
Debit: Provision for Depreciation of Asset
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 Credit: Asset Disposal a/c

Cash received on disposal of an asset:

Debit : Cash or Bank a/c
Credit : Asset Disposal a/c

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When an asset is written off as a
result of damage/accident/ theft and
the insurance of the company has
accepted the responsibility:
Debit : Insurance receivable a/c
Credit : Asset Disposal a/c
With the amount expected from the
insurance

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 If the insurance pays before the end of
the financial period, it will not be
necessary to create an insurance debtor
so the following entries will be made
Debit : Cash or Bank a/c
Credit :Asset Disposal a/c

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 The balance in the disposal account
after the above entries will either
be a debit balance (loss on
disposal) or a credit balance (gain
on disposal).
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 Debit balance:
Dr: P&L a/c
Cr : Disposal a/c
 Credit balance:
Dr : Disposal a/c
Cr : P&L a/c

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Illustration

 A machine was bought on 3rd October

2010 for Frw 15,000,000. It was sold for
cash Frw 8,000,000 on 2nd January 2015.
The machine had been depreciated at 12%
on cost.

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Depreciation is charged proportionately for
the period the asset is used during the
year of purchase with no depreciation
charge during the year of disposal.
Required:
Necessary accounts to record the above
disposal.

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Trade in of a non current asset:

 This happens when the firm gives out

an old asset to a supplier in exchange
of a new one, with the firm paying
some cash as a top up on the agreed
net book value of the old asset to
make the selling price.
 In this case:
Cost of the asset being disposed:
 Dr Asset disposal a/c
 Cr Asset a/c
Total depreciation provided to date
on the asset.
Dr: Provision for depreciation of asset a/c
Cr: asset disposal a/c
 Cash paid for the new asset:
Dr: Asset a/c
Cr: Cash a/c
Balance ( Price of new asset – Cash paid):
Dr :Asset a/c
Cr : Disposal a/c

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 The balance in the disposal account
after the above entries will either be
a debit balance (loss on disposal)
or a credit balance (gain on
disposal).

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Illustration:
A motor van was purchased on 2nd January
2011 for Frw 8,000,000. it was traded in for
new one whose price was Frw 10,000,000
on 2nd March 2014.
The policy of the company is to charge the
depreciation for its motor van at 10% on
cost per annum. Depreciation is charged in
full during the year of purchase, but no
depreciation is charged in the year of
disposal.

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Required
Prepare the following account for the year
ended 2014 :
 1) Motor van account
 2) Provision for Depreciation account
 3) Motor van disposal account
 5) Profit & Loss Extract
 6) SFP Extract
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