Ch 12: Definition of Depreciation

Ch 12: Definition of Depreciation

Question: What is ‘depreciation’?

Answers: ‘Depreciation’ is an example of the ‘matching’ principle in action. It represents the diminution

in value of a fixed asset over a period of time. Since depreciation is a provision, it is important to

calculate this figure as accurately as possible. The Net Book Value is the reduced fixed asset value at any point in time after depreciation.

As a fixed asset has a life of over 1 year and is

expected to produce revenue over a number of years, it is important to spread the cost of the fixed asset over these years.

Ch 12: Definition of Depreciation

Question: Why do we have to include depreciation in the balance sheet and profit and loss account?

Answers: The depreciation charge in the profit and loss account represents a cost of expense and can be viewed as

the cost of using the fixed asset over the period that the profit and loss account covers. This follows the

matching concept which requires that revenues are matched with expenses in the year they are incurred.

Ch 12: Causes of Depreciation

Question: What are the causes of depreciation?Answers:

Fixed assets are those assets bought by the company for the intention to be used for a long period of time. Fixed assets are said to depreciate over a period of time due to the following factors:

1) Physical deteriorationi) Wear and tear – When a motor vehicle or

machinery or fixtures and fittings are used, they eventually wear out. Some last many years, others last only a few year.

ii) Erosion, rust, rot and decay – Land may be eroded or wasted away by the action of wind, rain, sun and other elements of nature. Similarly, the metals in motor vehicles or machinery will rust away.


2) Economic factorsi) Obsolescence – This is the process of becoming out of date. For instance, replacing a computer with old operating system with a new computer with XP system.

ii) Inadequacy – This arises when an asset is no longer used because of the growth and changes in the size of the firm. For instance, a small ferryboat that is operated by a firm at a

coastal resort will become entirely inadequate when the resort becomes

more popular, to be more efficient and economical, the firm may replace it with

a large ferryboat.


3) The time factor (the effluxion of time)Some assets might have a legal life fixed in terms of years. For example, the patents, and leasehold. You may agree to rent some buildings for 10 years. This is normally called a lease. When the years are finished, the lease is worth nothing to you, as it has finished. Whatever you paid for the lease is now of no value.

4) DepletionOther assets are of wasting character, perhaps due to the extraction of raw materials from them. These materials are then either used by the firm to make something else, or are sold in their raw state to other firms. Natural resources such as mines, quarries and oil wells come under this heading.

Ch 12: Factors that affect the calculation of Depreciation

Question: What are the factors that affect the calculation of depreciation?

Answers:1) Cost of asset (include expenses and capital expenditure incurred eg. The installation fees, the legal fees)

2) Estimated useful life of assetThis is the number of years that the asset is expected to be used)

3) Residual or scrap value of the assetThis is the value of the asset at the end of its life.

4) Method of calculating depreciation

Ch 12: Methods of Depreciation

a) Straight-line method (using equation)Straight-line method of depreciation is based on the cost of an asset that is then depreciated, by the same amount, over the estimated useful life of the asset.

Cost – Estimated Disposal ValueDepreciation per annum =

Expected useful lifeExample 1:ABC Ltd. Bought a machine at a cost of £80,000. The machine has an expected useful life of 5 years and at the end of the 5th year, it can be sold for £10,000.

Depreciation per annum =

Ch 12: Methods of Depreciation

a) Straight-line method (continues)

Depreciation for 5 years would be: Cost Annual

DepreciationProvision for Depreciation

NBV

Date of purchase 80,000 80,000

End of 1st year 80,000 14,000 14,000 66,000

End of 2cd year 80,000 14,000 28,000 52,000

End of 3rd year 80,000 14,000 42,000 38,000

End of 4th year 80,000 14,000 56,000 24,000

End of 5th year 80,000 14,000 70,000 10,000

Ch 12: Methods of DepreciationThe depreciation expense can also be calculated by writing off a fixed percentage of cost of the asset.

a) Straight-line method (using fixed percentage of cost of asset)

Example 2:ABC Ltd. Bought a machine at a cost of £80,000. The depreciation is to be charged at a 20% per annum on cost.

Depreciation per annum = £80,000 x 20% = £16,000 per year

Ch 12: Methods of Depreciationb) Reducing balance method

Depreciation is calculated on a fixed percentage on the Diminishing Balance of the Asset (the NBV). This results in a higher depreciation charge in the earlier years of the asset’s estimated useful life. Example 3: A machine costs £50,000 is to be depreciated at

15% on Reducing Balance Method. Cost Annual Depreciation Provision

for Depreciatio

n

NBV

Date of purchase

50,000 0 - 50,000

End of 1st year 50,000 50,000 x 15% = 7,500 7,500 42,500

End of 2cd year

50,000 42,500 x 15% = 6,375 13,875 36,125

End of 3rd year 50,000 36,125 x 15% = 5,419 19,294 30,706

End of 4th year 50,000 30,706 x 15% = 4,606 23,900 26,100

End of 5th year 50,000 26,100 x 15% = 3,915 27,815 22,185

Ch 12: Methods of Depreciationb) Reducing balance method

Advantages of using reducing balance method:1) Appropriate for assets which lose value quickly in the

early year.2) Appropriate for assets which become outdated/obsolete

Disadvantages:1) Asset is never completed written off2) For assets which have a short life, the percentage used

to calculate depreciation is very large.

Ch 12: Double entry records for depreciation and the disposal of fixed

assetsThe ledger accounting entries for depreciation:

Dr Profit & Loss (Profit and Loss) Cr Provision for Depreciation (Balance

Sheet)

Ch 12: Double entry records for depreciation and the disposal of fixed assets

Using the answers in Example 3, write up the depreciation expenses and provision for depreciation accounts for 2001, 2002, 2003, 2004, and 2005. Also, records the provision for depreciation in the Balance Sheet.


The Disposal of an Asset

Reason for accounting entries:Upon the sale of an asset, we will want to delete it from our accounts. This means that the cost of that asset needs to be taken out of the asset account. In addition, the depreciation of the asset which has been sold will have to be taken out from the provision for depreciation. Finally, the profit and loss on sale, if any, will have to be calculated.


The Disposal of an Asset: The accounting entries neededOn the sale of a fixed asset, for instance machinery, the following entries are needed:

A) Transfer the cost price of the asset sold to an assets disposal account:

Dr Machinery disposals A/CCr Machinery A/C

B) Transfer the depreciation already charged to the assets disposals account:Dr Provision for Depreciation A/C

Cr Machinery disposals A/C


C) For remittance received on disposal:Dr Cash A/C

Cr Machinery disposals A/C

D) Transfer difference to the profit and loss account. If the machinery disposals account shows a credit balance, it is a profit on sale:

Dr Machinery disposals A/CCr Profit and loss A/C

If the machinery disposals account shows a debit balance, it is a loss on sale:

Dr Profit and loss A/CCr Machinery disposals A/C


Example 4:In a business with financial years ended 31 December, a machine is bought for £2,000 on 1 January 1995. It is to be depreciated at the rate of 20% using the reducing balance method.The company has decided to sell the machine for £1,070 on 2 January 1998.

Required:Show the following ledger accounts for the year ended 31 December 1998:i) Machinery A/C ii) Cash A/Ciii) Provision for Machinery A/Civ) Disposals on Machinery A/C


Example 5:In a business with financial years ended 31 December, a machine is bought for £2,000 on 1 January 1995. It is to be depreciated at the rate of 20% using the reducing balance method.The company has decided to sell the machine for £950 on 2 January 1998.

Required:Show the following ledger accounts for the year ended 31 December 1998:i) Machinery A/C ii) Cash A/Ciii) Provision for Machinery A/Civ) Disposals on Machinery A/C

Exercise 1

The financial year of Lu Ltd. ends on 31 December. On 1 January 2002, the following balances are in its Ledger Accounts that relate to fixed assets:

Fixed Assets at cost £Machinery 650,000Equipments 320,000 Provision for depreciation £Machinery 140,000Equipments 72,000 The company adopts the following policies for the depreciation of its assets:i) The reducing balance method of depreciation is used to depreciate the machinery. A rate of 10% per annum is used.ii) The straight-line method of depreciation is used to depreciation the equipments at a rate of 10% per annum.iii) When fixed assets are purchased in the first half of a financial year, a full year’s depreciation is charged. When fixed assets are purchased

in the second half of a financial year, a half-year’s depreciation is charged.v) Depreciation is not charged on assets in the year in which they are sold. During the year 2002, the following transactions took place in relation to the company’s fixed assets: Purchases on credit:10 February Machinery £50,00029 September Equipments £6,000 SalesOn 15 August, a machine was sold for £14,000 and the proceeds were received by cheque. The machine had been purchased on 12 October 2002

for £15,000.

Required:Prepare the following Ledger Accounts for the year ended 31 December 2002: i) Machineryii) Equipmentiii) Provision for depreciation of machineryiv) Provision for depreciation of equipmentv) Disposals on machinerya)