Revise Changing asset values for Cambridge 9706 (1.3.2)

Depreciation is the systematic allocation of the depreciable amount of a non-current asset over its useful life. It is an application of the matching principle, ensuring that the cost of using an asset is matched against the revenue it helps to generate in a reporting period. It is not a process of valuation, but of cost allocation. The two primary methods required by the Cambridge syllabus are the straight-line method and the reducing (or diminishing) balance method. The choice of method should reflect the pattern in which the asset's future economic benefits are expected to be consumed by the entity. This choice must be applied consistently to ensure comparability of financial statements over time, but can be changed if the pattern of consumption changes.

When a non-current asset is sold or scrapped, its value must be removed from the financial statements and any resulting profit or loss must be calculated. This is achieved through a disposal account, which is a temporary ledger account used to collect the relevant figures. The process involves three steps: 1) Transfer the original cost of the asset from the non-current asset account to the disposal account. 2) Transfer the total accumulated depreciation of that specific asset from the provision for depreciation account to the disposal account. 3) Record the cash or trade-in value received. The balancing figure on the disposal account represents either a profit on disposal (credit balance) or a loss on disposal (debit balance), which is then transferred to the income statement.

Instead of the cost model, entities may choose the revaluation model under IAS 16 Property, Plant and Equipment. This involves revaluing an asset to its fair value. When an asset is revalued upwards, the increase in its carrying amount is credited to a 'Revaluation Surplus' account, which is a component of equity shown on the statement of financial position. Depreciation is then calculated on the new revalued amount. If a subsequent downward revaluation occurs, it is first debited against any existing revaluation surplus for that asset. Any excess decrease beyond the surplus is recognised as an expense in the income statement. A downward revaluation on an asset with no prior surplus is always treated as an expense. Furthermore, an entity may choose to make an annual transfer from the revaluation surplus to retained earnings. This transfer represents the 'excess depreciation' charged on the revalued amount compared to the depreciation that would have been charged on the historical cost. The amount transferred is the difference between the two depreciation calculations. This is permitted but not required by IAS 16.

Understanding the double entry is crucial for recording these transactions accurately. Here are the standard journal entries:

The straight-line method is calculated as (Cost – Residual Value) / Useful Life. This results in a constant annual depreciation charge. It is suitable for assets that provide a consistent level of benefit throughout their life, such as buildings. The reducing balance method is calculated as Net Book Value x Depreciation Rate (%). The Net Book Value (NBV) is the asset's cost minus its accumulated depreciation to date. This method results in a higher depreciation charge in the early years, which declines over time. It is appropriate for assets like vehicles or machinery that are more efficient and productive when new, and incur higher maintenance costs as they age. The declining depreciation charge is offset by rising repair costs, smoothing the total expense over time.

Straight-line depreciation = $\frac{\text{Cost} − \text{Residual value}}{\text{Useful life}}$

Reducing balance = Net book value × Depreciation rate %