Accounting treatment of depreciation
In this section, we will focus on how depreciation is provided for (provision for depreciation) in the books of accounts. At this point the entrepreneur/ learner should note that the depreciation amount to be charged in the profit and loss account of the organization can be computed using either of the four key methods (ie straight line, reducing balance, revaluation and sum of the digit approaches) . The entrepreneur/learner should also note that the method used to compute the amount of depreciation does not determine the approach of providing for such an item in the books of accounts which are direct and indirect in nature. Therefore, for the sake of full understanding on how to account for such transactions in this accounting tutorial series, we will consider previous illustrations (1&2) that used the straight line and the reducing balance approaches but the entrepreneur is not limited from using the other two.
To achieve the objective of accounting for depreciation, this level two accounting tutorial series has divided the discussion into two cases of study. Case one-straight line method. Where under this perspective, we will consider both direct and indirect methods of providing or accounting for depreciation in the books of accounts and then, in case two, we will again consider both the same direct and indirect methods of providing or accounting for depreciation in the books of accounts using reducing balance method. Therefore, the accounting treatment of depreciation will be twofold
a) Direct Accounting Method
b) Indirect Accounting Method
NB: Before demonstrating how each approach works as per case one and two, it should be noted that the two approaches are the same for it is just a matter of how the entries are presented.
Case 1: Straight Line Method of Computing Depreciation
From prior knowledge, straight line method of computing depreciation translates in to a constant/fixed amount of depreciation to be charged to the profit and loss account. In this case we will first consider the direct approach and second the indirect method of providing for depreciation.
a) Direct Accounting Method for Depreciation
The direct method involves charging of depreciation amount directly to profit and loss account and to the specific fixed asset account at the end of the financial period. The accounting entries to be made using general journal is as follows;
Being depreciation for the year
NB1: Direct method discloses the Net Book Value (NBV) of the fixed asset at the end of every financial period
Illustration 1
In this illustration, we will consider a case of straight line depreciation method whereby we will re-visit a previous computation case of illustration (1) so as to track how you as an entrepreneur need to compute and make the accounting entries correctly. So you remember that on 1st/01/2018 Our Co. ltd bought a motor vehicle for $100,000 by check. Useful life was 5 years with zero salvage value.
Required;
i) From the above information, extract the profit & loss account, motor vehicle account and balance sheet for the five years, that is 2014, 2015, 2016, 2017 and 2018 using the direct method
Solution
Therefore, the amount to be charge uniformly each year will be $20,000, that is;
1st/01/2014 Our Co. ltd bought a motor vehicle for $100,000 by check. Useful life was 5 years with zero salvage value. Determine the depreciation value per annum.
Solution
Therefore, the amount to be charge uniformly each year will be $20,000, that is;
Accounting Entries;
b) Indirect Accounting Method for Depreciation
This method introduces provision for depreciation account and maintains the fixed asset values at COST all through. The approach considers that depreciation is cumulative and therefore need to be accounted for using provision for depreciation account. The indirect method involves charging of depreciation amount directly to profit and loss account and to the provision for depreciation account at the end of the financial period. The accounting entries to be made using general journal is as follows;
DR P & L A/C XXX
CR Provision for Depreciation-A/C XXX
Being depreciation for the year
NB2 Unlike the direct method, this approach advocates maintenance of fixed asset at cost value all through the accounting period and even the proceeding periods.
NB3 Provision for depreciation account is cumulative in nature and as other accounts are closed down at the end of the financial period, this account remains open to accommodate additional provisions made in the future.
Illustration 2
Assume the facts of the previous case of 5.1.3 illustration (1) so as to track how you as an entrepreneur need to compute and make the accounting entries correctly. So you remember again that on 1st/01/2018 Our Co. ltd bought a motor vehicle for $100,000 by check. Useful life was 5 years with zero salvage value.
Required;
From the above information, extract the profit & loss account, motor vehicle account and balance sheet for the five years, that is 2014, 2015, 2016, 2017 and 2018. Use the indirect method
Solution
Accounting Entries;
NB1: The indirect method allows accumulation of depreciation amounts for each financial period. But for every year end, the amount of depreciation cumulated is subtracted from the cost value of the fixed asset at that point to determine the net book value which is the same as the NBV reflected in the direct method. As cumulated depreciation (see provision for depreciation a/c) increases each year, more is subtracted from the cost value of the fixed asset which is maintained at the original cost value.
NB2: Therefore, the approaches are the same for the only difference is the manner in which the entries have been made. Otherwise the rule of double entry principle has applied in both cases.
c) Trial Balance and End of Year Depreciation Adjustments
In level one and two, we concluded that a trial balance is a summary of account balances at the end of the financial period. Hence, this statement represents all accounts with closing debit and credit balances brought down (ie b/d) as it is at the end of the financial period. Contrariwise, for fixed assets subjected to depreciation process, they are presented in the trial balance at their opening balance brought down. That is, at their Net Book Value (NBV) in the beginning of the current financial period. Such that as the balance brought down for the other accounts are being recorded for example as at 31/12/XX, the balances brought down for fixed assets are usually recorded in the trial balance as at 01/01/XX. So, to update the fixed asset NBV to reflect the closing balance brought down at the end of the year, the entrepreneur has to charge depreciation for the current year as guided in the additional information appended to the trial balance. The entrepreneur/ learner need to note that format of presenting fixed asset NBV in the trial balance is guided by either direct or indirect methodology used as explained.
i) If Direct Method is Adopted;
If direct method is adopted, the trial balance expressly discloses the NBV opening balance brought forward for that specific fixed asset. To substantiate this concept, let us still use illustration 1 discussed earlier in this tutorial and go straight in the presentation of the trial balance whereby we will consider any one of the years, let say accounting entries as at 31/12/2016
The trial balance will appear as follows;
In this case, the asset net book value (NBV) is expressly debited in the trial balance as indicated in the trial balance. Sometimes, authors in accountancy may even indicate the abbreviations-NBV against the fixed asset item in the trial balance. Remember that, the $60,000 is the NBV of the fixed asset in the beginning of the financial period.
ii) If Indirect Method is Adopted;
In this circumstance, the trial balance will disclose both opening historical cost value and the accumulated depreciation amount of the fixed asset of the fixed asset up to the beginning of the current financial period under investigation. To substantiate this concept, let us still use illustration 1 discussed earlier in this tutorial and go straight in the presentation of the trial balance whereby we will consider any one of the years, let say accounting entries as at 31/12/2016
The trial balance will appear as follows;
In this case, the asset cost and accumulated depreciation values are expressly debited and credited in the trial balance as indicated. Sometimes, authors in accountancy may even indicate the abbreviations-COST against the fixed asset item in the trial balance. Remember that, in this approach, the fixed asset is always recorded at cost. In this illustration, the $100,000 is the initial cost that was incurred or paid for its acquisition and that is what is recorded in the trial balance all through if the indirect method is used.
Although the indirect method apparently appears different from the direct one, the two approaches of recording fixed assets in the trial balance are the same. This is because, the debit entry of fixed asset at cost with the corresponding credit entry of the accumulated depreciation (ie provision for depreciation) implies a net value of $60,000 (ie 100,000-40,000) as it is in the case of the direct method. So in conclusion, the entrepreneur/learner need to note that fixed asset is always recorded in the trial balance at the net book value as portrayed by the two approaches.
Case 2: Reducing Balance Method of Computing Depreciation
In case 2, we will focus our discussion on the two methods of providing for depreciation bearing in our mind that the computation of the depreciation amount is based on reducing balance approach. For the reducing balance method, the amount of depreciation computed from one financial year to the next and so on varies unlike the straight line method. Whichever way the direct and indirect approaches are similar to our previous discussion. So in this session, we will go straight to the illustrations to avoid repeating ourselves.
a) Direct Method of Computing Depreciation
General journal is as follows;
DR P & L A/C XXX
CR FIXED ASSET A/C XXX
Being depreciation for the year
NB1: Direct method discloses the Net Book Value (NBV) of the fixed asset at the end of every financial period
Illustration 1
In this illustration, we will consider a case of reducing balance depreciation method whereby we will re-visit a previous case of illustration (2) where by on 1st/01/2014 Our Co. ltd bought a motor vehicle for $100,000 by check. Useful life was 5 years and the depreciation rate was 20% per annum and other computational details are as provided
Required;
From the above information, extract the profit & loss account, motor vehicle account and balance sheet for the five years, that is 2014, 2015, 2016, 2017 and 2018 using the direct method.
Accounting Entries;
b) Indirect Method of Computing Depreciation
This method incorporates provision for depreciation and maintains the fixed asset values at cost all through. The approach considers that depreciation is cumulative and therefore need to be accounted for using provision for depreciation account. The indirect method involves charging of depreciation amount directly to profit and loss account and to the provision for depreciation account at the end of the financial period. The accounting entries to be made using general journal is as follows;
DR P & L A/C XXX
CR Provision for Depreciation-m/v A/C XXX
Being depreciation for the year
NB2 Unlike the direct method, this approach advocates maintenance of fixed asset at cost value all through the accounting period and even the proceeding periods.
NB3 Provision for depreciation account is a cumulative in nature and as other accounts are closed down at the end of the financial period, this account remains opened to accommodate additional provisions made in the future.
Illustration 2
In this illustration, we will consider a case of reducing balance depreciation method whereby we will re-visit a previous case of illustration (2) where by on 1st/01/2014 Our Co. ltd bought a motor vehicle for $100,000 by cheque. Useful life was 5 years and the depreciation rate was 20% per annum and other computational details are as provided;
Required;
From the above information, extract the profit & loss account, motor vehicle account and balance sheet for the five years, that is 2014, 2015, 2016, 2017 and 2018. Use the indirect method
Solution
Accounting Entries;
NB1: The indirect method allows accumulation of depreciation amounts for each financial period. But for every year end, the amount of depreciation cumulated is subtracted from the cost value of the fixed asset at that point to determine the net book value which is the same as the NBV reflected in the direct method. As cumulated depreciation (see provision for depreciation a/c) increases each year, more is subtracted from the cost value of the fixed asset which is maintained at the original cost value.
NB2: Therefore, the approaches are the same for the only difference is the manner in which the entries have been made. Otherwise the rule of double entry principle has applied in both cases.
c) Trial Balance and End of Year Depreciation Adjustments
In this session, we will not give detailed explanation for it is similar to case (c) of the straight line approach we have already discussed. Instead, we will interrogate the recording of the fixed asset and depreciation transactions in the trial balance as per direct and indirect approaches. Again note that the explanation is the same except that we will adjust the figures given. Otherwise all the facts remain the same.
i) If Direct Method is Adopted;
If direct method is adopted, the trial balance expressly discloses the NBV opening balance brought forward for that specific fixed asset. To substantiate this concept, let us still use illustration 2 in discussed earlier in this tutorial and go straight in the presentation of the trial balance whereby we will consider any one of the years, let say accounting entries as at 31/12/2016
The trial balance will appear as follows;
In this case, the asset net book value (NBV) is expressly debited in the trial balance as indicated in the trial balance. Sometimes, authors in accountancy may even indicate the abbreviations-NBV against the fixed asset item in the trial balance. Remember that, the $64,000 is the NBV of the fixed asset in the beginning of the financial period.
ii) If Indirect Method was Adopted;
In this circumstance, the trial balance will disclose both opening historical cost value and the accumulated depreciation amount of the fixed asset of the fixed asset up to the beginning of the current financial period under investigation. To substantiate this concept, let us still use illustration 2 in discussed earlier in this tutorial and go straight in the presentation of the trial balance whereby we will consider any one of the years, let say accounting entries as at 31/12/2016
The trial balance will appear as follows;
In this case, the asset cost and accumulated depreciation values are expressly debited and credited in the trial balance as indicated. Sometimes, authors in accountancy may even indicate the abbreviations-COST against the fixed asset item in the trial balance. Remember that, in this approach, the fixed asset is always recorded at cost. In this illustration, the $100,000 is the initial cost that was incurred or paid for its acquisition and that is what is recorded in the trial balance all through if the indirect method is used. Although the indirect method apparently appears different from the direct one, the two approaches of recording fixed assets in the trial balance are the same. This is because, the debit entry of fixed asset at cost with the corresponding credit entry of the accumulated depreciation (ie provision for depreciation) implies a net value of $64,000 (ie 100,000-36,000) as it is in the case of the direct method. So in conclusion, the entrepreneur/learner need to note that fixed asset is always recorded in the trial balance at the net book value as portrayed by the two approaches.
