What it means
Fixed assets do not last forever, and businesses dispose of them for many reasons: they wear out, become obsolete, are replaced with better equipment, are surplus after a reorganisation, or are sold because the business needs cash or is leaving an activity. Whatever the reason, the accounting treatment is the same.
The asset is derecognised: its original cost is removed from the asset account and the depreciation accumulated on it is removed from the accumulated depreciation account, so that nothing relating to the asset remains on the balance sheet. The proceeds, if any, are recorded, and the difference between the proceeds and the carrying amount that was removed is the gain or loss on disposal.
The gain or loss is, in substance, a correction of the depreciation charged over the asset's life. Depreciation was based on estimates of useful life and salvage value made when the asset was acquired; the disposal reveals what the asset was actually worth at the end.
A gain means the asset was depreciated too fast or held its value better than expected; a loss means the opposite, or that the asset was damaged, obsolete or sold in a hurry. Because of this, gains and losses on disposal are usually presented within operating profit, often on the same line as depreciation or as a separate line, and analysts treat them as non-recurring when they are large, since they reflect past estimates rather than current trading.
Disposal takes several forms, each with its own detail. A straight sale for cash is the simplest.
A part-exchange, in which an old asset is traded in against a new one, is treated as a sale of the old asset at the trade-in allowance and a purchase of the new asset at its full price, so that the gain or loss on the old asset is recognised and the new asset is not understated. Scrapping an asset with no proceeds produces a loss equal to its carrying amount, plus any cost of removal.
An asset destroyed or stolen is derecognised with a loss, and any insurance recovery is recorded separately as income when it becomes receivable. An asset that the business has decided to sell but has not yet sold is reclassified as held for sale, measured at the lower of carrying amount and fair value less costs to sell, and depreciation stops.
Tax follows its own rules. Most tax systems calculate their own written-down value for each asset or pool of assets, using their own depreciation rates, and on disposal compare the proceeds with that figure.
Proceeds above the tax written-down value produce a balancing charge, taxable income that claws back depreciation allowances previously given; proceeds below produce a balancing allowance, a deduction. For land, buildings and some other assets, capital gains rules may apply instead, with different rates and reliefs.
The accounting gain and the tax result are often different, and the difference is part of deferred tax. Controls around disposals are important because assets that leave the business without being recorded produce a fixed asset register that overstates what the business owns, depreciation charged on assets that no longer exist, and the opportunity for theft.
Good practice requires an authorised disposal form for every asset leaving the business, evidence of the proceeds, prompt updating of the register, and periodic physical verification of the assets on the register against those in the building. For significant disposals, such as property or a whole business, the board's approval, an independent valuation and attention to the tax consequences are standard.
In practice
Real-world examples.
Example
A haulage company sells ten four-year-old trucks with a total carrying amount of $400,000 for $520,000, recording a gain of $120,000 that shows its depreciation policy was more conservative than the second-hand market.
Example
A retailer closing a store scraps fittings with a carrying amount of $85,000 for no proceeds and pays $12,000 to strip them out, recording a loss of $97,000 as part of its closure costs.
Example
A company's annual asset verification finds 40 laptops on the register that cannot be located, and writes off their carrying amount of $18,000 as a loss on disposal while tightening its equipment controls.
Think of it
“Disposal is getting rid of assets-what you get minus book value equals your gain or loss.
Formula
Calculation
Carrying amount at disposal = Cost minus Accumulated depreciation to the date of disposal
Gain (loss) on disposal = Net proceeds minus Carrying amount (minus Costs of disposal)
Part-exchange: proceeds for the old asset = Trade-in allowance; cost of the new asset = Full purchase price (cash paid + trade-in allowance)
Tax balancing charge (allowance) = Proceeds minus Tax written-down value, positive is taxable, negative is deductible
Worked example: sale. A machine cost $500,000 and has accumulated depreciation of $270,000, so its carrying amount is $230,000.
- Sold for $200,000: loss on disposal = $200,000 minus $230,000 = $30,000. Entries: debit cash $200,000; debit accumulated depreciation $270,000; debit loss on disposal $30,000; credit machinery (cost) $500,000
- Sold for $260,000: gain on disposal = $30,000. Entries: debit cash $260,000; debit accumulated depreciation $270,000; credit machinery $500,000; credit gain on disposal $30,000
Worked example: part-exchange. The same machine is traded in against a new one with a list price of $600,000; the dealer allows $250,000 for the old machine and the company pays $350,000 in cash.
- Proceeds for the old machine = $250,000; gain on disposal = $250,000 minus $230,000 = $20,000
- New machine recorded at $600,000, not at the $350,000 cash paid
- Entries: debit new machinery $600,000; debit accumulated depreciation $270,000; credit old machinery $500,000; credit cash $350,000; credit gain on disposal $20,000
Worked example: scrapping. Equipment with a carrying amount of $12,000 is scrapped, and removal costs $1,500. Loss on disposal = $12,000 + $1,500 = $13,500.
Worked example: tax. The machine sold for $200,000 had a tax written-down value of $180,000 (tax depreciation had been faster than book). Balancing charge = $200,000 minus $180,000 = $20,000, taxable at 25%: $5,000 of tax, even though the accounts show a loss of $30,000. The $50,000 difference between the book carrying amount and the tax written-down value had been recognised as a deferred tax liability of $12,500, which reverses on the disposal.Case study
Seen in the real world.
A distribution company owned its head office building, bought fifteen years earlier for $8,000,000 and depreciated to a carrying amount of $5,000,000. The area had been redeveloped, and a property developer offered $14,000,000 for the site.
The board accepted, moved the head office to leased premises, and recorded a gain on disposal of $9,000,000, which took the year's reported profit from $3,000,000 to $12,000,000. The chief executive's statement described a record year.
The company's shareholders and its bank read the result more carefully. The $9,000,000 gain was the recognition of fifteen years of property appreciation that had never been in the accounts, plus the reversal of depreciation charged on a building that had in fact gained value; it said nothing about the company's trading, which had produced the same $3,000,000 as the year before.
Analysts stripped the gain out of their earnings figures. The tax computation treated the sale under capital gains rules, with the gain calculated on the original cost rather than the depreciated value and with indexation relief, producing a tax charge of about $1,400,000, which the board had not modelled when it approved the sale and which reduced the cash available for the special dividend it had announced.
The company's rent on the new premises was $900,000 a year, so the disposal converted an asset that cost nothing to occupy into a recurring cost, and the following year's operating profit fell to $2,100,000. The finance director's review for the board separated the three things the transaction had done: realised a real gain of $9,000,000 in cash terms, less tax; removed a one-off from the trading results that should be reported separately; and changed the company's cost base permanently. All three had been sound decisions on their merits, the review concluded, but presenting the gain as a record year had cost the board credibility with investors who understood the difference between selling a building and running a business.
Watch out
Common mistakes.
- Removing only the carrying amount from the books rather than both the cost and the accumulated depreciation, which leaves the gross figures overstated.
- Recording a part-exchanged asset at the cash paid rather than its full price, which understates the new asset and hides the gain or loss on the old one.
- Presenting a large gain on disposal as if it were trading profit, and forgetting that the tax on the disposal is calculated separately and may bear no relation to the accounting gain.
Questions
People also ask.
What is the difference between a gain on disposal and revenue?
Revenue is income from the business's ordinary activities, selling its goods and services. A gain on disposal is the excess of proceeds over carrying amount on the sale of an asset the business used, not one it traded. It is presented separately and is generally non-recurring.
What happens to depreciation in the year of disposal?
Depreciation is charged up to the date of disposal, on the company's usual policy (some charge a full year, some none, some pro rata in the year of disposal). The carrying amount used for the gain or loss is after that final charge.
Why does the tax result differ from the accounting gain or loss?
Because tax uses its own written-down value, calculated at tax depreciation rates, and for some assets applies capital gains rules with their own base cost and reliefs. The accounting and tax figures are reconciled through deferred tax.
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