Section A: Key terms and recall
Define the term 'depreciation' in your own words. [2 marks]
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Depreciation is the gradual decrease in the value of a non-current asset over its useful life. It represents the cost of using the asset in the business. [2 marks]
List two reasons why it is necessary to account for depreciation. [2 marks]
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Two reasons for accounting for depreciation are: 1. To accurately reflect the value of non-current assets in the financial statements. 2. To match the cost of using the asset with the revenue it helps to generate. [2 marks]
Name the three methods of calculating depreciation. [3 marks]
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The three methods of calculating depreciation are: 1. Straight-line method 2. Reducing balance method 3. Revaluation method [3 marks]
Which method of depreciation is most suitable for a non-current asset that provides more benefit in its early years, such as a new computer system? [1 mark]
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The reducing balance method is most suitable for a non-current asset that provides more benefit in its early years. [1 mark]
What is the journal entry to record the annual depreciation of a non-current asset using the straight-line method? [2 marks]
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The journal entry to record the annual depreciation of a non-current asset using the straight-line method is: Dr Depreciation expense account Cr Provision for depreciation account [2 marks]
Section B: Applying your knowledge
A business purchases a delivery van for £20,000. The van is expected to have a useful life of 5 years and a residual value of £5,000. Calculate the annual depreciation using the straight-line method. [2 marks]
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Annual depreciation = (Cost - Residual value) / Useful life = (£20,000 - £5,000) / 5 years = £3,000 per year [2 marks]
A business purchases a machine for £30,000. The machine is expected to have a useful life of 4 years and a residual value of £2,000. Calculate the annual depreciation using the reducing balance method, with a depreciation rate of 40%. [3 marks]
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Year 1 depreciation = Cost x Depreciation rate = £30,000 x 40% = £12,000 Year 1 net book value = Cost - Year 1 depreciation = £30,000 - £12,000 = £18,000 Year 2 depreciation = Year 1 net book value x Depreciation rate = £18,000 x 40% = £7,200 Year 2 net book value = Year 1 net book value - Year 2 depreciation = £18,000 - £7,200 = £10,800 Year 3 depreciation = Year 2 net book value x Depreciation rate = £10,800 x 40% = £4,320 Year 3 net book value = Year 2 net book value - Year 3 depreciation = £10,800 - £4,320 = £6,480 Year 4 depreciation = Year 3 net book value x Depreciation rate = £6,480 x 40% = £2,592 Year 4 net book value = Year 3 net book value - Year 4 depreciation = £6,480 - £2,592 = £3,888 The machine is then sold for £3,000, which is less than its net book value, resulting in a loss on disposal of £888. [3 marks]
A business purchases a non-current asset for £15,000. At the end of the first year, the asset is revalued to £12,000. Calculate the revaluation loss and the new carrying amount of the asset. [2 marks]
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Revaluation loss = Original cost - Revalued amount = £15,000 - £12,000 = £3,000 New carrying amount of the asset = Revalued amount = £12,000 [2 marks]
A business sells a non-current asset for £8,000. The asset originally cost £20,000 and had accumulated depreciation of £12,000 at the time of sale. Calculate the profit or loss on disposal. [2 marks]
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Net book value = Original cost - Accumulated depreciation = £20,000 - £12,000 = £8,000 Profit or loss on disposal = Sale price - Net book value = £8,000 - £8,000 = £0 The business neither makes a profit nor a loss on the disposal. [2 marks]
Section C: Explain and analyse
Explain why different methods of depreciation may be appropriate for different types of non-current assets. [4 marks]
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Different methods of depreciation may be appropriate for different types of non-current assets because: 1. The straight-line method is suitable for assets that provide equal benefits over their useful lives, such as buildings or furniture. 2. The reducing balance method is suitable for assets that provide more benefits in their early years, such as computer systems or machinery, as it allocates more depreciation in the early years of the asset's life. 3. The revaluation method is suitable for assets that can be easily revalued, such as investment properties, as it reflects the current market value of the asset. [4 marks]
Analyse the impact of under-providing for depreciation on the financial statements of a business. [5 marks]
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Under-providing for depreciation can have the following impacts on the financial statements of a business: 1. Overstating the value of non-current assets in the statement of financial position, as the accumulated depreciation will be lower than it should be. 2. Overstating the profit for the year in the statement of profit or loss, as the depreciation expense will be lower than it should be. 3. Overstating the assets of the business, which can lead to an overstatement of the business's profitability and financial health. 4. Understating the liabilities of the business, as the provision for depreciation is a liability. 5. Potentially leading to incorrect decision-making by stakeholders, such as investors or lenders, who rely on the financial statements to assess the business's performance and financial position. [5 marks]
A business purchases a non-current asset for £25,000. The asset has a useful life of 5 years and a residual value of £5,000. The business uses the straight-line method of depreciation. At the end of the third year, the business sells the asset for £10,000. Prepare the necessary journal entries and ledger accounts to record the purchase, depreciation, and sale of the asset. Calculate the profit or loss on disposal. [6 marks]
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Journal entries: 1. Purchase of the asset: Dr Non-current asset account £25,000 Cr Bank account £25,000 2. Annual depreciation: Dr Depreciation expense account £4,000 (£25,000 - £5,000 / 5 years) Cr Provision for depreciation account £4,000 3. Sale of the asset: Dr Bank account £10,000 Dr Provision for depreciation account £12,000 (£4,000 x 3 years) Cr Non-current asset account £25,000 Cr Loss on disposal account £7,000 Ledger accounts: Non-current asset account: Date Details £ 2023 Jan 1 Balance b/d 25,000 2025 Dec 31 Disposal 25,000 Provision for depreciation account: Date Details £ 2023 Dec 31 Depreciation 4,000 2024 Dec 31 Depreciation 4,000 2025 Dec 31 Depreciation 4,000 2025 Dec 31 Disposal 12,000 Profit or loss on disposal: Net book value = Original cost - Accumulated depreciation = £25,000 - £12,000 = £13,000 Profit or loss on disposal = Sale price - Net book value = £10,000 - £13,000 = £3,000 loss on disposal [6 marks]
Section D: Challenge
A business purchases a non-current asset for £50,000. The asset has a useful life of 10 years and a residual value of £10,000. The business uses the reducing balance method of depreciation, with a depreciation rate of 20%. At the end of the fifth year, the business revalues the asset to £35,000. Prepare the necessary journal entries and ledger accounts to record the purchase, depreciation, revaluation, and disposal of the asset. Calculate the profit or loss on disposal. [6 marks]
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Journal entries: 1. Purchase of the asset: Dr Non-current asset account £50,000 Cr Bank account £50,000 2. Annual depreciation: Year 1: Dr Depreciation expense account £10,000 (£50,000 x 20%) Cr Provision for depreciation account £10,000 Year 2: Dr Depreciation expense account £8,000 (£40,000 x 20%) Cr Provision for depreciation account £8,000 Year 3: Dr Depreciation expense account £6,400 (£32,000 x 20%) Cr Provision for depreciation account £6,400 Year 4: Dr Depreciation expense account £5,120 (£25,600 x 20%) Cr Provision for depreciation account £5,120 Year 5: Dr Depreciation expense account £4,096 (£20,480 x 20%) Cr Provision for depreciation account £4,096 3. Revaluation of the asset: Dr Non-current asset account £14,596 (£35,000 - £20,480) Cr Revaluation surplus account £14,596 4. Sale of the asset: Dr Bank account £35,000 Dr Provision for depreciation account £23,616 (£10,000 + £8,000 + £6,400 + £5,120 + £4,096) Cr Non-current asset account £50,000 Cr Revaluation surplus account £14,596 Cr Profit on disposal account £7,104 Ledger accounts: Non-current asset account: Date Details £ 2023 Jan 1 Balance b/d 50,000 2027 Dec 31 Revaluation 14,596 2027 Dec 31 Disposal 50,000 Provision for depreciation account: Date Details £ 2023 Dec 31 Depreciation 10,000 2024 Dec 31 Depreciation 8,000 2025 Dec 31 Depreciation 6,400 2026 Dec 31 Depreciation 5,120 2027 Dec 31 Depreciation 4,096 2027 Dec 31 Disposal 23,616 Revaluation surplus account: Date Details £ 2027 Dec 31 Revaluation 14,596 2027 Dec 31 Disposal 14,596 Profit or loss on disposal: Net book value = Revalued amount - Accumulated depreciation = £35,000 - £23,616 = £11,384 Profit or loss on disposal = Sale price - Net book value = £35,000 - £11,384 = £23,616 profit on disposal [6 marks]