Depreciation and Revaluation of Fixed Assets Revision Notes for Leaving Cert Accounting

Depreciation and Revaluation of Fixed Assets

Understanding fixed assets

Fixed assets are valuable items that a business owns and uses for several years. These long-term assets help generate income for the business and include buildings, machinery, equipment, vehicles, and furniture. Unlike current assets such as stock or cash, fixed assets are not bought and sold regularly as part of normal business operations.

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The key distinction between fixed and current assets lies in their intended use and duration. While current assets like inventory and cash are converted to cash within a year, fixed assets provide economic benefits across multiple years.

The key characteristic of fixed assets is their useful life - they provide economic benefits to the business over multiple accounting periods. However, most fixed assets (except land) lose value over time due to wear and tear, age, and technological changes.

What is depreciation?

Depreciation represents the gradual decline in value of fixed assets over their useful life. It's a non-cash expense that businesses must account for to show the true cost of using these assets to generate profits.

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Practical Example: Understanding Depreciation

Think of depreciation like this: when a business buys a delivery van for €20,000, it doesn't make sense to charge the entire €20,000 as an expense in the first year. Instead, if the van is expected to last 5 years, the business spreads this cost over 5 years through depreciation.

Annual depreciation = €20,000 ÷ 5 years = €4,000 per year

Depreciation serves two important purposes:

It matches the cost of the asset with the revenue it helps generate (matching principle)
It ensures the balance sheet shows assets at their realistic current value

Methods of calculating depreciation

Straight-line method

The straight-line method is the simplest and most commonly used depreciation method. It charges exactly the same amount of depreciation each year throughout the asset's useful life.

How it works:

Calculate depreciation as a fixed percentage of the original cost
The same monetary amount is deducted each year
Best suited for assets that depreciate steadily over time, such as buildings and office equipment

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Worked Example: Straight-Line Depreciation

A machine costs €10,000 and is expected to last 10 years. Using straight-line depreciation at 10% per year:

Step 1: Calculate annual depreciation $\text{Annual depreciation} = €10,000 \times 10% = €1,000 \text{ each year}$

Step 2: Calculate accumulated depreciation after 5 years $\text{Accumulated depreciation} = €1,000 \times 5 = €5,000$

Step 3: Calculate net book value $\text{Net book value} = €10,000 - €5,000 = €5,000$

Reducing-balance method

The reducing-balance method charges higher depreciation in the early years and lower amounts in later years. This creates a curved depreciation pattern.

How it works:

Year 1: Apply the depreciation percentage to the original cost
Year 2 onwards: Apply the same percentage to the remaining book value (not the original cost)
This method front-loads the depreciation expense
Particularly suitable for assets that lose value quickly initially, such as computers and vehicles

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Worked Example: Reducing-Balance Method

The same €10,000 machine using 20% reducing-balance:

Year 1: $€10,000 \times 20% = €2,000$ Year 2: $(€10,000 - €2,000) \times 20% = €8,000 \times 20% = €1,600$
Year 3: $(€8,000 - €1,600) \times 20% = €6,400 \times 20% = €1,280$

Notice how the depreciation amount decreases each year as it's applied to the reducing book value.

Recording depreciation in the accounts

Businesses use a provision for depreciation account (also called accumulated depreciation) to track the total depreciation charged on an asset over time. This account appears on the credit side and represents the total amount of value that has been written off.

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Annual Depreciation Journal Entry:

Debit Profit and Loss Account (with the depreciation expense)
Credit Provision for Depreciation Account (building up the total depreciation)

This entry ensures the expense is recorded while maintaining a running total of all depreciation charged.

The net book value (NBV) of an asset is calculated as:

$\text{Cost of Asset} - \text{Accumulated Depreciation} = \text{Net Book Value}$

This NBV represents what the business believes the asset is currently worth based on its accounting records.

Disposal of fixed assets

When a business decides to sell, scrap, or trade in a fixed asset, it must remove the asset from its books and account for any profit or loss on disposal.

Basic disposal process

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Three Accounts Are Always Affected:

Fixed Asset Account (existing) - removed
Provision for Depreciation Account (existing) - closed out
Disposal Account (new) - created to calculate profit/loss

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Standard Disposal Journal Entries:

Step 1: Remove the asset

Debit Disposal Account with the original cost
Credit Fixed Asset Account with the original cost

Step 2: Clear accumulated depreciation

Debit Provision for Depreciation Account with total accumulated depreciation
Credit Disposal Account with total accumulated depreciation

Step 3: Record cash received

Debit Bank Account with cash received from sale
Credit Disposal Account with cash received

Determining profit or loss on disposal

After posting all entries, check the disposal account balance:

Credit balance larger than debit balance = Profit on disposal (asset sold for more than its book value)
Debit balance larger than credit balance = Loss on disposal (asset sold for less than its book value)

The profit or loss is then transferred to the Profit and Loss Account.

Trade-ins

When a business trades in an old asset for a new one:

Debit Fixed Asset Account with cost of new asset
Credit Disposal Account with trade-in allowance given
Credit Bank Account with additional cash paid

Revaluation of fixed assets

Some fixed assets, particularly land and buildings, may increase in value over time rather than depreciate. When this happens, businesses can choose to revalue these assets upwards to reflect their current market value.

When and why to revalue

Revaluation typically occurs when:

Property values in the area have risen significantly
The business wants to show a more accurate financial position
The business is seeking loans or investment (higher asset values improve the balance sheet)

Accounting for revaluations

When an asset is revalued upwards, a special account called the revaluation reserve account is created to record the increase in value.

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Revaluation Journal Entries:

For the increase in asset value:

Debit Fixed Asset Account with the increase in value
Credit Revaluation Reserve Account with the increase in value

If there's accumulated depreciation on the asset:

Debit Provision for Depreciation Account with total depreciation to date
Credit Revaluation Reserve Account with total depreciation to date

Important revaluation rules

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Key Revaluation Rules:

The revaluation reserve account shows the total increase in asset value and appears in the balance sheet with other reserves
Future depreciation must be calculated on the new revalued amount, not the original cost
When a revalued asset is eventually sold, any capital gain is transferred from the revaluation reserve to the revenue reserve account

Practical considerations

Key factors to consider when calculating depreciation

When determining the appropriate depreciation method and amounts, businesses must consider several critical factors:

Estimated useful life of the asset
Residual value (what the asset might be worth at the end of its useful life)
Method of depreciation that best reflects how the asset loses value
Consistency - once a method is chosen, it should be applied consistently

Common exam scenarios

Students should be prepared to handle:

Calculating annual depreciation using both methods
Preparing disposal accounts and determining profits/losses
Recording revaluation entries
Computing net book values at specific dates
Dealing with part-year calculations when assets are bought or sold mid-year

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When dealing with part-year calculations, always proportion the annual depreciation based on the number of months the asset was owned during the accounting period.

Summary

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Key Points to Remember:

Fixed assets lose value over time through use and age - this is recorded as depreciation expense
Straight-line depreciation charges the same amount each year; reducing-balance charges more in early years
Net book value = Original cost minus accumulated depreciation
When disposing assets, create a disposal account to calculate profit or loss on sale
Some assets like land and buildings can increase in value and may be revalued upwards using a revaluation reserve account
Consistency in depreciation methods is essential for accurate financial reporting

Depreciation and Revaluation of Fixed Assets (Leaving Cert Accounting): Revision Notes