Annual Depreciation Formula – Lesson Six

This is the sixth lesson in my free bookkeeping course and I am introducing you to the annual depreciation formula, prepayments, accruals, bad debt provisions and the way we must value our stock of materials and goods available for sale. Depreciation is not allowable as a tax deduction, the revenue treat asset value deductions under a heading called capital allowances within our tax returns. Bad debts can only be deducted from tax when a number of requirements are met to satisfy the Revenue that the debt is irrecoverable. Our bad debt provisions cannot be included within our tax returns.

Annual Depreciation

Within our balance sheet accounts we introduced accounts for Depreciation and the Amortization of a lease. Our plant, machinery, motor vehicles, furniture, office equipment etc. will all wear out over time and need renovating or replacement. We use depreciation to reflect in our accounts the gradual reduction in the value of our assets over their assumed lifetime in the business. The two most popular methods for depreciating assets are Straight Line Depreciation and Diminishing Balance Depreciation.

Straight Line Depreciation

Once a business has decided upon the method of depreciation it is going to use – Straight Line or Diminishing Balance – it must keep to that same method every year. The choice of most small businesses is the Straight Line Depreciation method.

When deciding to purchase an asset there are four factors to take into account in justifying your purchase decision:

1. The cost of the asset
2. The length of time we expect the asset to be used within the business
3. The proceeds we might expect on disposal of the asset at the end of it’s useful life in the business
4. The value of any efficiency savings the asset may bring to the business.

From this justification statement we can calculate the loss in value of the asset over the expected lifetime within the business. In most cases the maximum lifetime we would use for our calculations would be 10 years but this will vary asset to asset. It could be anything from 3 years to 10 years (with exceptional items in excess of 10 years, sometimes additional buildings will be depreciated over 50 years). On the Straight Line method of depreciation we will want to make an equal charge for each year of the expected lifetime.

Example Calculation

We are purchasing a machine for £89,000 and the expected life is 7 years, after which time the scrap value should be £5,000. The machine will reduce in value by £84,000 (Cost £89,000 – Disposal Value £5,000). An equal amount of annual depreciation will be £84,000 divided by the 7 years expected life = £12,000 Depreciation Charge each year. If we are producing monthly accounts we will be making a depreciation charge of £1,000 every month. When a purchase is made part way into our financial year then the charge for the first year will apply from the date the machine became active within the business.

Diminishing Balance Depreciation

The Diminishing Balance Depreciation method involves writing off a fixed percentage of the reducing value of the asset. On this method to reduce the value of our machine from £89,000 to £5,000 over 7 years we would need to make a charge of 34% of the reducing balance each year.
Our first full year depreciation would be £89,000 x 34% = £30,260 and the net book value will be £89,000 – £30,260 = £58,740.
Year two will be £58,740 x 34% = £19,972 leaving the NBV at £38,768
Year three will be £38,768 x 34% = £13,181 and NBV = £25,587
Year four will be £25,587 x 34% = £8,700 and NBV = £16,887
Year five will be £16,887 x 34% = £5,743 and NBV = £11,145
Year six will be £11,145 x 34% = £3,789 and NBV = £7,356
Year seven will be £7,356 x 34% = £2,501 and NBV = £4,855

Very often businesses will use a set diminishing depreciation rate for each group of assets, for example they may decide to reduce all of their Plant & Machinery at 20% a year on a Diminishing Balance method. ( Our machine reduced by 20% over 7 years on the diminishing balance would still be valued at £18,665 at the end of it’s assumed lifetime).

The Diminishing Balance depreciation method can be more realistic with the value of an asset in the early years. As we all know a car loses a lot of it’s value the moment it leaves the showroom and it’s value drops significantly in the early years.

Another argument for using the Diminishing Balance method is that as an asset ages it costs more to maintain and parts may need replacing. These additional running costs of the asset are compensated by having lower depreciation charges in the latter years.

Entries In Our Nominal Ledger

If we are writing up our ledgers every month we will include an entry for the depreciation charges. These entries are made in our Journal. As we have seen in the previous lesson there are two depreciation accounts within our ledger, one in the balance sheet to show the reducing value of our assets and the other depreciation account is within our expense accounts, reducing the business profits.

Our monthly journal entry for the month of June for our machine using the straight line depreciation method will be:

June 30  DR Depreciation A/c. (Expenses)                                  L(x)       £1,000.00
June 30          CR Plant & Machinery Depn. A/c. (Bal Sheet)    L(y)                          £1,000.00
Being Depreciation of machine ref. 1234 for June 2017

Our folio References L(x) and L(y) would be the account numbers in our nominal ledger.

Prepayments

Some of our expenses will be charged in advance. Examples being the annual road tax for vehicles and the annual insurance charges the business incurs.

Example

Say, during May we receive an invoice for our business insurances covering the year commencing 1st June. The insurances include £6,000 for our vehicles and a further £12,000 general business insurances. In May we have analysed the invoice in our Purchases Day Book as £6,000 to Motor Vehicle Expenses A/c. and £12,000 to Insurances A/c.

As the insurance charges commence in June we will reverse the charges from our May accounts with the following Journal entry:

May 31   DR  Prepayments A/c.                                                L(a)        £18,000.00
May 31              CR Motor Vehicle Expenses A/c.                  L(b)                               £6,000.00
May 31              CR Insurances A/c.                                          L(c)                              £12,000.00
Being insurance charges for the year commencing 1st June

We will now need to process a monthly journal entry from June through to the following May for one twelth of the annual charges each month. The following journal entry will be made each month:

(Month)    DR Motor Vehicle Expenses A/c.                  £500.00
(Month)    DR Insurances A/c.                                      £1,000.00
(Month)              CR Prepayments A/c.                                                 £1,500.00
Being Insurance charges for the month.

Accruals

At the end of a month there might be charges we have incurred which have not yet been invoiced to us. An example may be the gas and electricity we have used during the month. By taking meter readings on the last day of the month we can calculate the gas and electricity charges to come and add these amounts to the month’s expenses. We accrue outstanding expenses. Our journal entry will read:

June 30    DR  Heat & Light A/c. (Gas)                 £700.00
June 30    DR  Heat & Light A/c. (Elec.)               £400.00
June 30             Cr Accruals A/c.                                                   £1,100.00
Being gas and electricity usage for the month

When the actual bill arrives in July we will need to reverse the above journal entries.

Bad Debts Provision

Each month we will review our Aged Debt Analysis to see if we have any customers with overdue debts that we are concerned we might not recover. We make a provision for this possibility by a journal entry debiting the Bad Debts Provision A/c. (Expenses) and crediting the Bad Debt Provision A/c. (Balance Sheet). Each month we consider whether the provision we have already made should be increased or reduced and would journal for any required adjustment.

Lease Amortisation

If we have purchased a long lease on our property we will need to write-off the amount paid for the lease over the lease period. If we have a 10 year lease costing us £40,000 then we will write-off £4,000 each year. Similar to depreciation charges we will debit Lease Amortisation A/c. (Expenses) and credit the Lease Amortisation A/c. (Balance Sheet).

Stock Valuation

Stock must be valued at the lower of it’s cost price or realisable value. When completing a stock check we look out for any deterioration or old stock lines which are no longer selling. The value of deteriorated and old stocks should be reduced to acknowledge that these items may have to be reduced in price in order to sell them.

The cost price of stock items is the price we paid for the items plus any carriage costs and unrecoverable taxes we may have incurred on the purchases.

F.I.F.O. Stock Valuation Example

It is usual to value stock on a First In First Out basis (F.I.F.O.). At our stock-take on 31st March we counted a stock of 32 10-inch picture frames. During March we had received a consignment of 20 10-inch frames which cost us £2.70 each. Our most recent consignment before the March delivery was 30 10-inch frames during December costing £2.45 each.

We value our stock as having the 20 received in March and 12 remaining from the December delivery. Our valuation of 32 10-inch picture frames is 20 at £2.70 each plus 12 at £2.45 each.

To proceed to Lesson Seven click here

If you have any comments or questions on this subject, please leave them in the area below and I will be very pleased to help you out.

Colin