Financial Accounting · Lesson 7

Depreciation methods, provisions and disposal of non-current assets

JAMBWAECNECO

What the syllabus asks

JAMB: Topic 6 depreciation of fixed assets (straight line, reducing balance), provision for depreciation and disposal

WAEC: Depreciation: causes, methods (straight line, reducing balance, sum-of-the-years’ digits, revaluation), provision for depreciation account, disposal account; capital and revenue reserves (brief)

NECO: Depreciation: causes, methods (straight line, reducing balance, sum-of-the-years’ digits, revaluation), provision for depreciation account, disposal account; capital and revenue reserves (brief)

What you will learn

Explain the meaning, causes and purpose of depreciation.
Calculate depreciation by straight-line, reducing balance, sum-of-the-years’ digits, revaluation and units of production.
Apply part-year conventions.
Record depreciation in the asset, provision for depreciation and income statement.
Prepare a disposal account, including trade-in.
Distinguish capital and revenue reserves; record a revaluation surplus.

Key points

Depreciation allocates (cost − residual value) over useful life.
Causes: wear and tear, time, obsolescence, depletion.
Straight-line: equal charges. Reducing balance: % of NBV, falling charges.
SYD: fractions n/sum, (n−1)/sum …; sum = n(n+1)/2.
Revaluation method: opening + additions − closing.
Follow the stated part-year policy.
Dr income statement, Cr provision for depreciation each year.
Disposal: cost in, accumulated depreciation and proceeds out; balance is profit or loss.
Trade-in: allowance = proceeds; new asset at full cost.
Revaluation surplus goes to a capital reserve, not profit.

Start here: Meaning and causes of depreciation

Tunde Bakare runs a printing press in Ibadan. He buys a large diesel generator for ₦2 400 000 (illustrative) and expects to use it for five years. If he charged the whole ₦2 400 000 as an expense in year 1, that year would show a huge loss and the next four years would look unrealistically profitable, though the generator helped earn revenue every year. Depreciation solves this: it spreads the cost over the years that benefit.

IAS 16 defines depreciation as the systematic allocation of the depreciable amount (cost less residual value) of an asset over its useful life.

Causes of depreciation

Wear and tear from use: a delivery van’s engine and tyres on Nigerian roads.
Passage of time: a 10-year lease loses value as it runs out, even if unused.
Obsolescence: a working machine replaced by newer technology (analogue printers, old POS terminals).
Depletion: exhaustion of natural resources such as a granite quarry in Abeokuta or a tin mine on the Jos Plateau.
Inadequate maintenance and accidents.
Change in market demand that makes the asset’s output unwanted.

What depreciation is NOT

It is not a method of valuing the asset at market price. NBV is simply unexpired cost.
It does not set aside cash. It is a book entry (Dr expense, Cr provision); no money leaves the business. To have cash for replacement, the owner must invest or save separately (a sinking fund).

Estimates, not certainties

Useful life and residual value are estimates made by management when the asset is bought. A transport company in Aba may expect a bus to last five years on good roads, but potholes, flooding in the rainy season and overloading may shorten that. Because they are estimates, depreciation is an approximation; what matters is that the method is reasonable, applied consistently and reviewed at least at each year end, as IAS 16 requires.

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Practice questions

1. Depreciation is best defined as

the allocation of the cost of a non-current asset over its useful life
the fall in market value of all assets
money set aside to buy a new asset
the cost of repairing assets

Show answer

A: the allocation of the cost of a non-current asset over its useful life
It spreads cost, less residual value, over useful life.

2. An asset costs ₦1 200 000, residual value ₦200 000, useful life 5 years. Annual straight-line depreciation:

₦240 000
₦280 000
₦1 000 000
₦200 000

Show answer

D: ₦200 000
(₦1 200 000 − ₦200 000) ÷ 5 = ₦200 000.

3. A machine costs ₦800 000, depreciated at 20% reducing balance. Depreciation in year 2:

₦320 000
₦512 000
₦128 000
₦160 000

Show answer

C: ₦128 000
Year 1 ₦160 000; NBV ₦640 000; year 2 = 20% × ₦640 000 = ₦128 000.

4. Using the data above, the NBV at the end of year 2 is:

₦288 000
₦512 000
₦480 000
₦640 000

Show answer

B: ₦512 000
₦800 000 − ₦160 000 − ₦128 000 = ₦512 000.

5. The reducing balance method charges

higher depreciation in early years
equal depreciation each year
no depreciation in the first year
higher depreciation in later years

Show answer

A: higher depreciation in early years
A fixed rate on a falling NBV.

Key words

Depreciation: The systematic allocation of the depreciable amount of an asset over its useful life.
Depreciable amount: Cost less residual value.
Residual (scrap) value: Estimated amount obtainable at the end of an asset’s useful life.
Useful life: The period over which an asset is expected to be used by the business.
Net book value (carrying amount): Cost less accumulated depreciation.
Accumulated depreciation: Total depreciation charged on an asset to date; also provision for depreciation.
Straight-line method: Equal depreciation each year.
Reducing balance method: A fixed percentage of the opening NBV each year.
Sum-of-the-years’ digits: An accelerated method using fractions based on remaining life.
Revaluation method: Depreciation found by comparing opening and closing valuations.
Obsolescence: Loss of usefulness because of new technology or changed demand.
Depletion: Exhaustion of a wasting asset such as a quarry or oil well.

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