2 DefinitionHKSSAP defines depreciation as the ‘allocation of the depreciable amount of an asset over its estimated life’.
3 The Objective of Depreciation According to the matching concept, revenues should be matched with expenses in order to determine the accounting profit.The cost of the asset purchased should be spread over the periods in which the asset will benefit a company.
4 Depreciable AssetsThe assets are acquired or constructed with the intention of being used and not with the intention for resale.HKSSAP regards assets as depreciable when theyAre expected to be used in more than one accounting period.Have a finite useful life, andAre held for use in the production or supply of goods and services, for rental to others, or for administrative purposes.
5 Non-Depreciable Asset Freehold LandIt has an indefinite useful life, and it retains its value indefinitely.Leasehold Land (Long Lease)It has an unexpired lease period not less than 50 yearsInvestment PropertyWhich construction work and development have been completedWhich is held for its investment potential, any rental income being negotiated at arm’s length.
6 Depreciation Methods (A) Straight Line Method (B) Reducing Balance Method/Diminishing Balance Method(C) Revaluation Method(D) Sum of Digits Method/Sum of The Years’ Digits Method(E) Production Output Method/Units of Production Method
7 (A) Straight Line Method Depreciation is computed by dividing the depreciable amount of the asset by the expected number of accounting periods of its useful life.Depreciation = Cost of Asset – Estimated Residual ValueEstimated Useful Economic Life
8 Useful Economic LifeUseful economic life is not equal to physical lifeIt is the period over which the present owner intends to use the asset
9 Residual Value It is the amount received after disposal of the asset Cost of asset - Residual value = Total amount to be depreciated
10 Example Cost of asset $1200 Residual/scrap/salvage value $200 Estimated useful life 4 yearsAnnual charge for depreciation= $1200-$2004= $10004=$250
11 Additional capital expenditures are made to increase the value of a fixed asset Depreciation of those extra capital expenditures should be charged over the remaining useful life of the asset
12 Example A company bought a machine for $1,000 on 1 January 1996 Estimated life of 4 years, no scrap value1 January 1997, an additional motor of $90 was fitted into the machineExpected that the useful life of the machine would not be affected
13 Depreciation for 1996= $10004= $250Annual depreciation from 1997 onwards= $10004$903+= $280
14 (B) Reducing Balance Method / Diminishing Balance Method ReasonGreater benefit is to be obtained from the early years of using an assetAppropriate to use the reducing balance method which charges more in the earlier years.Annual Depreciation = Net Book Value x Depreciation Rate= (Cost – Accumulated Depreciation) x Depreciation Rate
15 Example Cost of assets $10,000 Residual value $256 Useful life 4 years Depreciation Rate= (1 – 0.4) x 100%= 60%
16 Annual Depreciation Year 1 10,000 x 60% = $6,000 = Net Book Value x Depreciation Rate= (Cost – Accumulated Depreciation) x Depreciation RateYear ,000 x 60% = $6,000Year 2 (10,000 – 6,000) x 60% = $2,400Year 3 (10,000 – 8,400) x 60% = $ 960Year 4 (10,000 – 9,360) x 60% =$ 384
17 (C) Revaluation Method For some small-value assets such as loose toolsDepreciation= Value at the beginning of the year (Openingbalance) + Purchases in the year – Value at theend of the year (Closing balance)
18 AssetBalance b/f openingBank purchasesXP & L – Depreciation XBalance c/f closingDepreciation for the year is the balancing figure.
19 Depreciation for the year = $1,500 ExampleThe value of the loose tools changes during 1996 as shown below:1996Jan 1Value of loose tools$2,000Dec 31Purchases in the year$ 500Dec 31Value of loose tools$1,000Loose Tools$Jan 1 Balance b/f ,000Dec 31 Bank-purchases2,500$Dec 31 P & L ,500Dec 31 Balance c/f ,000Depreciation for the year = $1,500
20 (D) Sum of Digits Method / Sum of The Years’ Digits Method It provides higher depreciation to be charged in the early years, and lower depreciation in the later periods.Sum of digits = n(n+1) / 2Where n = Useful economic life (number of years)
21 Depreciation should be charged as follows: Year 1 (Cost – Residual value) x n / Sum of digitsYear 2 (Cost – Residual value) x (n-1) / Sum of digitsYear 3 (Cost – Residual value) x (n-2) / Sum of digitsYear 4 (Cost – Residual value) x (n-3) / Sum of digitsYear n (Cost – Residual value) x 1 / Sum of digitsWith diminishing years of life to run
22 Example Cost of asset $9,000 Estimated useful life 5 years No scrap valueSum of digits = 5(5+1) / 2 = 15Depreciation charge:Year 1 $9,000 x 5/15 = $3,000Year 2 $9,000 x 4/15 = $2,400Year 3 $9,000 x 3/15 = $1,800Year 4 $9,000 x 2/15 = $1,200Year 5 $9,000 x 1/15 = $ 600
23 Production Output Method / Units of Production Method Depreciation is computed with reference to the use or output of the asset in that period.
24 ExampleA company bought a machine at $10,000 and expects that the machine would run for 2,000 hours during its life. It is expected to have no scrap value.
25 Depreciation charge:Year hoursYear hoursYear hoursYear hoursDepreciation charge:Year 1 $10,000 x 800/2,000 = $4,000Year 2 $10,000 x 600/2,000 = $3,000Year 3 $10,000 x 350/2,000 = $1,750Year 4 $10,000 x 250/2,000 = $1,250
26 Accounting for Depreciation Accounting TreatmentDr. Fixed AssetCr. Bank/VendorPurchase price and other capital expenditureDr. Profit and LossCr. Provision for Depreciation
27 ExampleIn a business with financial years ended 31 December. A machine is bought for $2,000 on 1 January Year 1. The estimated useful life is 5 years.You are to show:(a) Machinery account(b) Provision for depreciation(c) Profit and loss account for the year ended 31 Dec Year 1, 2, and 3.(d) Balance sheet as at those date(1) Using straight line method and reducing balance method, at the rate of 20%.
28 Straight Line Method Year 1 Machinery Year 1 $ Year 1 $ Jan 1 Bank ,000Dec 31 Bal c/d 2,000Provision for dep. – MachineryYear 1$Year 1$Dec 31 Bal. c/dDec 31 P/L(2000/5)
29 Balance Sheets as at 31 Dec Profit and Loss for the year ended 31 DecYear 1$Less: ExpensesDepreciation - Machinery400Balance Sheets as at 31 DecYear 1$Fixed AssetMachinery at costLess: Provision for Dep.2,0004001,600
31 Balance Sheets as at 31 Dec Profit and Loss for the year ended 31 DecYear 1$Year 2$Less: ExpensesDepreciation - Machinery400400Balance Sheets as at 31 DecYear 1$Year 2$Fixed AssetMachinery at costLess: Provision for Dep.2,0002,0004008001,6001,200
33 Profit and Loss for the year ended 31 Dec $Year 2$Year 3$Less: ExpensesDepreciation - Machinery400400400Balance Sheets as at 31 DecYear 1$Year 2$Year 3$Fixed AssetMachinery at costLess: Provision for Dep.2,0002,0002,0004008001,2001,6001,200800
34 Reducing Balance Method Year 1MachineryYear $Year $Jan 1 Bank ,000Dec 31 Bal c/d 2,000Provision for dep. – MachineryYear 1$Year 1$Dec 31 Bal. c/dDec 31 P/L(2000*20%)
35 Balance Sheets as at 31 Dec Profit and Loss for the year ended 31 DecYear 1$Less: ExpensesDepreciation - Machinery400Balance Sheets as at 31 DecYear 1$Fixed AssetMachinery at costLess: Provision for Dep.2,0004001,600
37 Balance Sheets as at 31 Dec Profit and Loss for the year ended 31 DecYear 1$Year 2$Less: ExpensesDepreciation - Machinery400320Balance Sheets as at 31 DecYear 1$Year 2$Fixed AssetMachinery at costLess: Provision for Dep.2,0002,0004007201,6001,280
39 Profit and Loss for the year ended 31 Dec $Year 2$Year 3$Less: ExpensesDepreciation - Machinery400320256Balance Sheets as at 31 DecYear 1$Year 2$Year 3$Fixed AssetMachinery at costLess: Provision for Dep.2,0002,0002,0004007209761,6001,2801,024
40 Disposal Account Should be opened when The asset is sold, or The asset is disposed of due to an accident.
41 Accounting Treatment Cost price of the asset sold Dr. Disposal Cr. Fixed AssetCost price of the asset soldDr. Provision for DepreciationCr. DisposalDepreciation already charged on the assets concernedDr. Cash / VendeeProceeds received / receivable on the disposalIn case of loss on the disposal (Debit side greater than credit side)Dr. Profit and LossWith any loss on the disposalIn case of profit on the disposal (Credit side greater than debit side)Cr. Profit and LossWith any profit on the disposal
42 ExampleIn a business with financial years ended 31 December. A machine is bought for $2,000 on 1 January Year 1. The estimated useful life is 5 years. In Year 4, the machinery has been sold for $1,070. Show the accounting entries:You are to show:(a) Machinery account(b) Provision for depreciation(c) Disposal account(d) Profit and loss account and Balance sheet as at 31 Dec Year 4
44 Profit and Loss for the year ended 31 Dec $$Gross profit XLess: ExpensesAdd: Gains on disposalLoss on disposal XE.g. if the machinery was sold for $ 900.DisposalYear 4$Year 4$Dec 31 Machinery 2,000Dec 31 Pro. For DepDec 31 BankDec 31 P/L- loss ondisposal2,0002,000
45 Depreciation on monthly/full-year basis Fixed assets can be purchased and sold at any time during the accounting year.Depreciation on a monthly basis:Based on the fraction of the year in which the asset is held.Depreciation on a full-year basis:Full year’s depreciation in the year of purchase and none in the year of disposal irrespective of the period in which the asset is held.In an examination, it is necessary for the students to follow the approach required by the question. Where no indication is given, the monthly basis approach is recommended.
46 ExampleA company bought two motor vehicles for $2,400 each on 1 July One of the vehicles was sold for $1,500 on 1 April 1998.Depreciation is to be charged:At 20% on the straight line basis (monthly basis)At 20%, using the straight line method,and bases on assets in existence at the end of each year, ignoring items sold during the yearPrepare the following accounts:Motor vehicle accountProvision for depreciation,Disposal account for the year ended 31 Dec 1996,1997 and 1998.
47 Provision for dep. – Motor Vehicles (1.)Motor Vehicles1996$1996$July 1 Bank ,800Dec 31 Bal. c/d ,800Provision for dep. – Motor Vehicles1996$1996$Dec 31 Bal. c/dDec 31 P/L($4,800 x 20% x 6/12)
48 Provision for dep. – Motor Vehicles 1996$1996$July 1 Bank ,800Dec 31 Bal. c/d ,80019971997Jan 1 Bal. b/d ,800Dec 31 Bal. c/d ,800Provision for dep. – Motor Vehicles1996$1996$Dec 31 Bal. c/dDec 31 P/L($4,800 x 20% x 6/12)19971997Dec 31 Bal. c/d ,440Jan Bal. b/dDec 31 P/L($4,800 x 20%)1,4401,440
55 Provision for dep. – Motor Vehicles 1996$1996$Dec 31 Bal. c/dDec 31 P/L ($4,800 x 20%)19971997Dec 31 Bal. c/d ,920Jan Bal. b/dDec 31 P/L ($4,800 x 20%)1,9201,92019981998Apr 1 Disposal ($2,400x 20% x 2)]Jan Bal. b/d ,920Dec 31 P/L ($2,400 x 20%)Dec 31 Bal. c/f ,4402,4002,400
56 Disposal of Motor Vehicle 1998$1998$Dec 31 Machinery ,400Apr 1 Pro. For Dep.($2,400x 20% x 2)Dec 31 P/L – gainApr 1 Bank ,5002,4602,460
57 Trade-in-allowance The assets being trade in for a new assets Accounting entries:Dr Fixed AssetsCr DisposalWith the trade-in value of disposed asset
58 Example A company purchased machine for $2,500 each on 1 Jan. Year 1. It is the company’s policy to provide for depreciation on its machinery at a rate of 20%, with a full year’s depreciation made in the year in which a machine is purchased, but none in the year of sale.One machine was traded in and a new machine for $4,000 was purchased on 1 Feb. Year 2.The trade-in value of the old machine was $1,000.
59 MachineryYear 1$Year 1$Jan 1 Bank ,500Dec 31 Bal. c/d ,500Provision for dep.-MachineryYear 1$Year 1$Dec 31 Bal. c/dDec 31 P/L(2500*20%)
62 The Carrying Amount of Assets CostPurchase priceProduction costRevalued Value
63 Purchases Price Acquisition cost of a fixed asset: Invoice price (after deducting any trade discounts)Expenditures incurred in bringing the asset to a location and condition suitable for its intended use.E.g. Import duty, freight charges, insurance, etc.Expenditures incurred in improving the asset. They increase the expected future benefit from the existing fixed asset.E.g. Additional motor for machinery, the extension of a factory, etc.
64 Example A company purchased a machine for $50,000. In addition, an import duty of $5,000, landing charges of $2,000 and installation costs of $1,000 were paid.A service contract was entered into for the life of the machine at a cost of $800 per annum.The depreciation is charged at 10% of the cost per annum.
65 Expenditure itemsCapital expenditureRevenue expenditure$Invoice price50,000Import duty5,000Landing charges2,000Installation cost1,000Service charges80058,000Cost of the machine = $58,000Annual depreciation charge = $58,000 x 10% = $5,800
66 Example The supplier’s invoice for a machine was as follows: $ List price200,000Less Trade discount10,000Trade-in value50,00060,000140,000Delivery charges2,000Adaptation and testing3,000Maintenance1,500Spare components1,0007,500147,500**The depreciation is charged at 10% of cost per annum.
67 Expenditure itemsCapital expenditureRevenue expenditure$Invoice price($200,000 - $10,000)190,000Delivery charges2,000Adaptation and testing3,000Maintenance1,500Service charges1,000195,0002,500Cost of the machine = $195,000Annual depreciation =$195,000*10% = $1,950
68 Production costAn asset is produced by the firm itself, the following expenditures should be included in the cost of the asset:Cost of raw materialsDirect cost of production, e.g. direct labour, royalties, etc.A Reasonable proportion of factory overhead expenses / indirect production costs, e.g. indirect raw materials, indirect labour, indirect expenses and interest on borrowed capital to finance the production of the asset.
69 ExampleA company constructed a machine. The related costs are as follows:$Drafting and design8,000Construction:Materials and components120,000Assembling wages5,000Other expenses2,000Testing and Adaptation3,000** Depreciation is charged at 10% of cost per annumCost of the machine = $8,000 + $12,000 + $5,000 + $2,000 + $3,000= $30,000Annual depreciation = $30,000*10% = $3,000
70 Revalued valueWhere assets are revalued in the financial statements, the provision for depreciation should be based on the revalued amount and the current estimate of the remaining useful life.
71 Example A company purchased a machine for $1,000 on 1 January 1996. It is assumed that the useful economic life of the machine is 4 years.Depreciation has been provided at 25% per annum on cost.Balance Sheet as at 31 December 1996 (Extract)$Machinery, at cost ,000Less Provision for Dep($1,000 x 25%)1,250
72 Balance Sheet as at 31 December 1997 (Extract) E.g. The machine was revalued on 1 January 1997 at $1,500. There is no change in its estimated remaining useful life.Value of the machinery = $1,500The remaining useful economic life = 4-1 = 3 yearsDepreciation for 1997 = $1,500 ÷ 3 = $500Balance Sheet as at 31 December 1997 (Extract)$Machinery, at valuation 1,500Less Provision for Dep1,000
74 ExpenditureIt is the amount of economic resources given up in obtaining goods and services.
75 Capital Expenditure It is an expenditure to: Get a long-term benefit, Buy fixed assets, orAdd to the value of an existing fixed asset.
76 ExampleAcquiring fixed asset, such as premises, equipment, fixtures and furniture, etc.Expenditure which is spent to prepare the asset for its intended use, such as freight charges, legal cost, installation cost, landing charge, import duty of buying the asset.
77 Revenue Expenditure It is an expenditure for: The acquisition of assets for resale, orFor the purpose of earning revenue income.
78 Example Buying trading stock Administrative expenses, selling expenses, or financial expenses
79 Accounting Treatment Capital Expenditure On acquiring assets,Dr. Asset accountsCr. Bank / Cash / CreditorsAt the year end, the balances go to the Balance SheetRevenue ExpenditureWhen there are expenses,Dr. Expenses accountsAt the year end, the balances will be debited to the Profit and Loss Account, or Trading Account.
80 ExampleOn acquiring premises, how do we distinguish between capital and revenue expenditures?
81 Expenditure Benefit Nature of Accounting Treatment (a) Buying a houseLong-term benefitfixed asset acquiredCapitalDr. PremisesCr. Bank/Cash/Creditor(b) Legal cost of buying a houseextending beyond current accounting period
82 Expenditure Benefit Nature of Accounting Treatment (c) Installation of partition walls and lighting system in preparing the flat for use as an officeLong-term benefitto prepare the asset for intended useCapitalDr. PremisesCr. Bank/Cash/Creditor
83 Expenditure Benefit Nature of Accounting Treatment (d) Renting a houseShort-term benefitconsumed within current accounting periodRevenueDr. RentCr. Bank/Cash/Creditor(e) Management feeDr. Management feeCr.Bank/Cash/
84 Capital IncomeIt is the income from the sale of a fixed asset or asset which was not acquired for resale.ExampleProfit on disposal of machineryRealization of goodwill
85 Revenue IncomeIt is the income form the sale of trading stock or goods acquired for resale.ExampleSale of trading goodsRental income of a property company
86 Accounting Treatment Revenue Income This is normal trading income, and will be credited to Trading Account.Trading Account$Sales X
87 Profit and Loss Account Capital IncomeThis is non-trading income, and will be credited to Profit and Loss Account.Profit and Loss Account$Gross Profit b/fXProfit on Disposal X
88 RevaluationA fixed asset should be recorded at cost less depreciation.The value of an asset in reality is increasing as a result of inflation, which may be significantly greater than its historical cost stated in the balance sheet.Revaluation of assets is not common in Hong Kong, because he market value of an asset is very subjective.
89 Revaluation ProfitWhen the market value of an asset is greater than its historical cost, the increase in value should be:Dr. Fixed AssetCr. Revaluation ReserveWith the rise in valueIt is NOT to be treated as an income in the Profit and Loss Account
90 With the decrease in value Revaluation LossWhen the market value is smaller than the historical cost, the decrease in value can be treated in two ways:If the asset had been revalued before, and a revaluation reserve has been established:Dr. Revaluation ReserveCr. Fixed AssetWith the decrease in value
91 With the decrease in value If the loss cannot be covered by any reserve arising from the previous revaluation of the same asset:Dr. Profit and Loss AccountCr. Fixed AssetWith the decrease in value