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3. Depreciation Lecture Notes 6

4. Depreciation Definition Depreciation is the measure of the: – wearing out, – consumption – or other reductions in the useful economic life of a fixed asset, whether arising from: – use, – passage of time or – obsolescence.

5. Depreciation Definition Depreciation is the term most often employed to indicate that tangible plant assets have declined in service potential. The term tangible refers to physical assets within the business. Where natural resources, such as timber, gravel, oil and coal, are involved, the term depletion is employed. The expiration of intangible assets, such as patents, or goodwill is called amortization [Keiso & Weygandt 1990:543]

6. Depreciation Depreciation in Accounting Depreciation is defined as: – the accounting process of allocating the cost of tangible assets to expense – in a systematic and rational manner – to those periods expected to benefit from the use of the asset. To accountants, depreciation is not a matter of valuation but a means of cost allocation. Assets are not depreciated on the basis of a decline in their fair market value, but on the basis of systemic charges to expense. [Keiso & Weygandt 1990:543]

7. Depreciation Depreciation in the Financial Statements Unless assets are depreciated their value may sometimes be overstated on the Balance Sheet. Assets must be depreciated so as to give a true and fair value of the assets in the Balance Sheet. [Whitehead 1974:215] Assets such as plant and machinery are held for the purpose of earning income. The loss arising on those assets through wear and tear is undoubtedly an expense against such income. [Garbutt 1976:0602]

8. Depreciation Service Life – vs. – Physical Life There is a basic difference between the service life of an asset and its physical life. A piece of machinery may be physically capable of producing a given product for many years beyond its service life, But the equipment is not used for all of those years because the cost of producing the product in later years may be too high. [Keiso & Weygandt 1990:544]

9. Depreciation How does an Asset Depreciate? Through wear and tear in use – as in the case of machinery, furniture and fittings, loose tools, motor vans and other vehicles. Through effluxion or passage of time – as in the case of leases of factories and other buildings and of patent rights. Through obsolescence where, – for example, a machine is rendered out of date through the invention of a more efficient machine. [Favell 1977:104]

10. Depreciation Depreciation Methods 1.Activity Method (units or use or production) 2.Straight Line Method (Equal Instalment Method) 3.Decreasing Charge Methods – a)Sum-of-the-years digits b)Declining-Balance method/Reducing Balance Method 4.Special Depreciation Methods – a)Inventory Method b)Retirement & Replacement Methods c)Group & Composite Methods d)Compound Interest Methods

11. Depreciation Activity Method This method assumes that the asset has a useful life in terms of production hours. Formula (Cost Less Salvage) x Production Measure this year = Depreciation Total Production Measure

12. Depreciation Straight Line Method Using this method it is assumed that the net cost of the asset should be allocated equally over the useful life of the asset. To determine depreciation for a period, the cost of the asset or value of the asset, its useful life and the estimated scrap value is required. Formula Depreciation Charge = Cost – Scrap Value Useful Life

13. Depreciation Straight Line Method Advantages It is easy to understand and the calculations are simple. The valuation of the asset appearing on the balance sheet each year is reasonably fair, Complies with the Income Tax Act in the vast majority of the cases. Disadvantage The charge to the Profit and Loss account increases over the years; – for in the first year or two repairs will be uncommon, but as the machine gets older it will require more frequent attention.

14. Depreciation Sum-of –the year’s Digits Method This method also assumes that more of the net cost should be allocated in the earlier years. Using this method, we must first find the sum of the total years, – For Example - If the useful life is 5 years then the sum would be 5+4+3+2+1 = 15. – If the life is 3 years it would be 3+2+1 = 6. The depreciation for year would be a fraction of the net cost.

15. Depreciation Sum-of –the year’s Digits Method The remaining years as the numerator and total as the denominator. Formula Depreciation Charge = Remaining Years x COST Sum of the Years

16. Depreciation Reducing Balance Method This method assumes that more of the cost of the asset should be allocated to the earlier years. Why? Maintenance would be low in earlier years and less in its later years when maintenance is higher. How to Calculate Depreciation Charge Using the reducing balance method multiply the rate by the balance at the beginning of the period and not the cost of the asset.

17. Depreciation Reducing Balance Method Formula Depreciation Charge = Reduce Balance for the Year X Rate of Depreciation Rate of Depreciation ROD = (1 – {n √s/c}) x 100% – n = expected useful/service life in years – s = salvage/residual/scrap value – c = the acquisition cost

18. Depreciation Reducing Balance Method Advantages No recalculation is necessary when additional assets are purchased. [Whitehead 1974:218] It tends to give a fairly even charge against revenue each year. – For while depreciation is heavy during the first few years, this counterbalanced by the repairs being light. – In the later years, when repairs are heavy, this is counterbalanced by the decreasing charge for depreciation.

19. Depreciation Reducing Balance Method Disadvantages The percentage figure to be calculated each year is difficult to calculate. For assets with a very short life, the percentage figure is so high that it becomes ridiculous. (Whitehead 1974:218).

20. Depreciation Depreciation and Disposal Policy In addition to the basis or method of depreciation, the Disposal Policy adopted by the organisation is important. Because determines how depreciation is charged against profits for assets acquired and disposed of during an accounting period.

21. Depreciation Depreciation and Disposal Policy Some of the policies that be adopted are:- 1.Full depreciation in the year of acquisition and none in the year of disposal. 2.Full depreciation in the year of disposal and none in the year of acquisition. 3.Half depreciation in the year of acquisition and half in the year of disposal 4.Prorated depreciation.

22. Depreciation Double Entry For Depreciation The double entry for depreciation: – Credit the Accumulated Depreciation Account and – Debit the Profit and Loss Account With the Depreciation Charged for the period

23. Depreciation Comparison of Methods Lecture Notes 6

24. Depreciation Comparison of Straight Line to Reducing Balance Method Exercise – A firm has just bought a Machine for $8,000. It will be kept in use for four years and then it will be disposed of for an estimated amount of $500. The firm asks for a comparison of the amounts charged as depreciation using both methods. For the straight line method, a figure of ($8,000 - $500) ÷ 4 = $1,875 per annum is to be used. For the reducing balance method, a percentage figure of 50% will be used.

25. Depreciation Comparison of Straight Line to Reducing Balance Method Straight Line MethodReducing Balance Method Cost Price8,000 Depreciation Y11,875 Net Book Value6,125 Depreciation Y2 1,875 Net Book Value 4,250 Depreciation Y3 1,875 Net Book Value 2,375 Depreciation Y4 1,875 500 Cost Price8,000 Dep. Y1 – 50%4,000 Net Book Value 4,000 Dep. Y2 – 50% 2,000 Net Book Value 2,000 Dep. Y3 – 50% 1,000 Net Book Value 1,000 Dep. Y4 – 50% 500 Net Book Value 500

26. Depreciation Double Entry and Posting Lecture Notes 6

27. Depreciation Double Entry For Depreciation The double entry for depreciation: – Credit the Accumulated Depreciation Account and – Debit the Profit and Loss Account With the Depreciation Charged for the period Accumulated Depreciation – Total depreciation provided on asset from date of purchase to date on current balance sheet

28. Depreciation Posting Depreciation Exercise – In a business belonging to L Heywood with the financial years ending December 31 a machine is bought for $20,000 on January 1, 2011. It is to be depreciated at the rate of 20% using the Reducing balance method. Step 1 – Calculate Depreciation Cost Price20,000 Dep. Y1 – 20% 4,000 Net Book Value 16,000 Dep. Y2 – 20% 3,200 Net Book Value 12,800 Dep. Y3 – 20% 2,560 Net Book Value 10,240

29. Depreciation Posting Depreciation Step 2 – Post Accumulated Depreciation Account 2011 2012 2013 2014 2011 2012 2013 2014 Accumulated Depreciation Account Dec 31 Balance c/d4,000Dec 31 Profit and Loss A/c 4,000 Balance b/d 4,000Jan 1 Dec 31 Profit and Loss A/c 3,200 Dec 31 Balance c/d 7,200 Balance b/d 7,200Jan 1 Dec 31 Profit and Loss A/c 2,560 Dec 31 Balance c/d 9,760 Balance b/d 9,760Jan 1

30. Depreciation Posting Depreciation Step 2 – Post to Profit and Loss Account Extract L Hart Profit and Loss Account Extract 2011 2012 Depreciation4,000 Depreciation3,200 2013 Depreciation2,560

31. Depreciation Posting Depreciation Step 3 – Charge Accumulated Depreciation against Assets in Balance Sheet L Hart Balance Sheet (Extracts). As at December 31, 2011 Machinery at Cost20,000 Less Depreciation to date 4,000 Net Book Value 16,000 As at December 31, 2012 Machinery at Cost20,000 Less Depreciation to date 7,200 Net Book Value 12,800 As at December 31, 2013 Machinery at Cost20,000 Less Depreciation to date 9,760 Net Book Value 10,240

32. Depreciation & Disposals Lecture Notes 6

33. Depreciation Disposal of an Asset When an asset has reached the end of its useful life the company will either dispose of the asset or donate it. The asset may have reached the end of its useful life but may still have service life. As such it will be sold at its fair market value The sale or disposal may result in a: – Gain on Sale – Sale Price > Net Book Value – Loss on Sale – Sale Price < Net Book Value The gain or loss should be accounted for along with the removal of the assets and depreciation from the books of accounts.

34. Depreciation Disposal of an Asset – Accounting Entries 1.Transfer the cost of the Asset sold to Disposal Account – Debit Assets Disposal Account – Credit Asset Account 2.Transfer total depreciation of asset to Disposal A/c – Debit Accumulated Depreciation Account – Credit Assets Disposal Account 3.Record Receipt of money for asset sold – Debit Cash Account – Credit Assets Disposal Account

35. Depreciation Disposal of an Asset – Accounting Entries 4.Determine if there is a gain or loss on Sale of Asset (Difference or balance on Disposal Account) If the account shows a credit balance, it is a gain on sale: – Debit Assets Disposal Account – Credit Profit and Loss Account If the account shows a debit balance, it is a Loss on sale: – Debit Profit and Loss Account – Credit Assets Disposal Account