Provision for depreciation is an account that can be used to handle depreciation of fixed assets. Fixed assets are the machinery and furniture a company needs to carry out its business. Office furniture, desks, lathes, tractors, ovens are all examples of fixed assets. The cost of those assets should not be assigned to the year in which they are bought. That would mean that the company would be using the equipment for free in subsequent years, and that would not correctly reflect the company’s expenses in each year. Instead, although the company had to pay the entire cost of an asset when it bought it, it allocates that cost to every year of the equipment’s useful life. This is depreciation.
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A company buys a van at the beginning of the financial year and expects it to last ten years. It pays £20,000 for it and so by straight line depreciation it will charge £2,000 to each year of its use. This £2,000 is the depreciation. The accountant writes £20,000 in the Fixed Assets account as a credit and £2,000 in the depreciation account as a debit. At the end of the year, the depreciation account is cleared out and the Fixed Asset account is carried forward as the net amount so the opening FA account in the next year will contain a credit of £18,000 for the van and there will be another debit of £2,000 in the depreciation account.
The alternative methods of accounting for depreciation is to use a provision of depreciation account. The asset retains its purchase price. So in year 1, £20,000 goes into the asset register. The Profit and Loss account receives a debit for £2,000 and the provision for depreciation receives a credit for £2,000. At the end of year 1, the depreciation in the P&L is a debit of £2,000 and the provision of depreciation account contains a credit of £2,000. At the end of year 2, the Van is still recorded at its purchase price of £20,000, the P&L contains a debit of £2,000, the same as year 1 and the provision of depreciation account contains a credit of £4,000. The provision of depreciation account increases each year.
Profit and Loss
The Profit and Loss statement that gets submitted to Companies House will not be different in wither method of recording depreciation. This is because the P&L only records the transactions that occurred during the year. It is not concerned with the residual value of assets. So in both instances, depreciation will show up as an expense under “Other Expenses” and, in the example, whether the provision of depreciation account is used or not, the depreciation expense will show as £2,000 for each of the ten years the van is being written off.
The Balance Sheet does change depending on the method of depreciation used, although the difference is one of presentation and the overall total asset value is the same. Under the standard method, the Balance Sheet would show the Van as “Fixed Assets £18,000” and in the second year: “Fixed Assets £16,000.” When using the provision for depreciation method the reporting of Fixed Assets takes three lines: “Fixed Assets (cost) £20,000 less Provision for Depreciation (£2,000) Fixed Assets (Net Book Value) £18,000.” In the second year, that will be: “Fixed Assets (cost) £20,000 less Provision for Depreciation (£4,000) Fixed Assets (Net Book Value) £16,000.”
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