Accounting Adjustments The effect on net profit of changing method of depreciation

© Hodder Education 2008 Changing method of depreciation A business may wish to change the method used to calculate depreciation. This is acceptable provided that they have a good reason for changing the method.

© Hodder Education 2008 Changing method of depreciation For example the method used may no longer be appropriate for the type of asset. If they wish to do this they have to show how this change in method has affected the net profit of the business.

© Hodder Education 2008 Changing method of depreciation Questions will often provide the net profit using the original method of depreciation. You will then be required to calculate the revised net profit using the new method.

© Hodder Education 2008 Example Gary Kent commenced business on 1 January The following net profits were reported for the first two years of business: £ , ,000 Fixed asset transactions during this period were: Machinery £44,000 bought on 1 January 2005 £60,000 bought on 1 July 2006 There were no disposals Depreciation policy in 2005 and 2006 was: 15% on cost straight line method, with rates being applied for each proportion of the year the asset is owned. Early in 2007 consideration was given to changing to the reducing balance method of depreciation on machinery. A rate of 20% would be applied, with the rate being charged for each proportion of the year the machinery is owned.

© Hodder Education 2008 Required a)Calculate the depreciation for machinery in 2005 and 2006, using the original method and rate selected by Gary Kent. b)Calculate the depreciation for machinery in 2005 and 2006, using the alternative method of depreciation. c)Prepare a statement to show the net profit which would have been reported in 2005 and 2006 if the reducing balance method had been used.

© Hodder Education 2008 First calculate the depreciation using the original method: 2005 Machinery cost £44,000 on 1 January 2005 Depreciation 15% straight line method Depreciation = £44,000 x 15% = £6,600

© Hodder Education Machine 1 £44,000 x 15%= £6,600 Machine 2 £60,000 x 15% x 6/12= £4,500 Total depreciation= £6,600 + £4,500 = £11,100

© Hodder Education 2008 Next calculate the depreciation using the new method: 2005 Machinery cost £44,000 on 1 January 2005 Depreciation 20% reducing balance method Depreciation = £44,000 x 20% = £8,800

© Hodder Education Machine 1 Net book value of machinery £44,000 – £8,800= £35,200 Depreciation= £35,200 x 20% = £7,040 Machine 2 £60,000 x 20% x 6/12 = £6,000 Total depreciation= £7,040 + £6,000 = £13,040

© Hodder Education 2008  Add back the depreciation using the original method.  Deduct the depreciation using the new method.  We have now calculated the net profit using the new method of depreciation. Method

© Hodder Education £ Original net profit 65,000 Add back old method 6,600 71,600 Deduct new method 8,800 Revised net profit 62,800

© Hodder Education £ Original net profit72,000 Add back old method 11,100 83,100 Deduct new method 13,040 Revised net profit 70,060

© Hodder Education 2008 Summary  Calculate depreciation using the original method.  Calculate depreciation using the new method.  Add back the depreciation using the old method to the net profit, deduct the depreciation using the new method.  We have now calculated the revised net profit.

© Hodder Education 2008 Tips Always show your workings.

© Hodder Education 2008 Tasks Complete the task sheet.