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After you have studied this chapter, you should
Understand the meaning of depreciation
Be able to explain the need to charge depreciation as an expense
Understand the causes of depreciationAble to calculate depreciation using
different methodsRecord the disposal of fixed assets
and the adjustments needed for the provision of depreciation accounts
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What is Depreciation?
Depreciation is a part of the original
amount of fixed asset consumed during its period of use.It is an
expense for services consumed / rendered by the fixed asset.
What is Depreciation Expense?
Because it is an expense, depreciation is
charged to the P/L Account andconsequently reduces net profit
Depreciation
Income Statement
Net profit
What factors make assets lose their values?Depreciation is a loss in value of an
asset due to number of factors, they are:
Due to use (wear and tear)Due to technological changes.Due to obsolesces.Due to effusion of time.Any loss in value of fixed assets
become an expenditure in the Profit and Loss Account.
Provisions for DepreciationProvision for depreciation is a
charge against Profit and Loss account for a loss in value of fixed assets
The double entry is:Debit Profit and Loss AccountCredit Provision for depreciation
Remember…
Provision for depreciation isaccumulative.So, to last years provisions(Shown in the Trial balance),
current years charge will be added and the
totalwill be shown in the Balance Sheet
as a deduction from the cost of the
FixedAssets.
HOW TO COMPUTE THE AMOUNT OF DEPRECIATION?To compute the amount of depreciation,
the following factors are necessary:The cost.The scrap value.The useful life.The method.The amount of depreciation for the year
Cost less Scrap Value Useful Life
Methods of depreciation The most commonly used
methods are :Straight line methodReducing Balance methodSum Of Digits MethodUsage Method
Straight line methodUnder this method, the amount
charged to Profit and Loss account for each year over its useful life is an equal amount.
Ex. A Machine costing $10600 has a useful life of five years and it can be sold as scrap for $600 at the end of its useful life.
Required: compute the charge for depreciation for each of the first three years and show (1) the profit and loss charge and (2) the Balance Sheet Disclosure.
Machine
2005Jan 1 cash 10600
Accumulated Provision for Depreciation
2005 2005Dec 31 balance c/d 2000 Dec 31
Profit and Loss $2000 ======
2006 2006Dec 31 Balance c/d 2000 Jan 1 balance b/d $2000
Dec 31 Profit and Loss $2000 ======
$4000
profit and loss
2005Dec 31 Acc. prov. for Depr. Machinery $20002006Dec 31 Acc. prov. for Depr. Machinery $20002007Dec 31 Acc. prov. for Depr. Machinery $2000
Income statement (extract) for the year ending 31 December
2005 Depreciation $20002006 Depreciation $20002007 Depreciation $2000
Advantages of straight line method
This method is very simple to understand and easy to calculate.
The value of the asset is reduced to zero at the end of its lifetime.
The annual charge to the Profit and Loss account is equal in all years.
Disadvantages of straight line methodWhen additions are made to assets,
calculations are required for each asset having a different estimated lifetime.
It does not take into account the cost by way of interest on the money invested.
Actual depreciation (wear and tear, machine downtime, etc) in the later years is likely to be more than the earlier years, which is not recognised by this method.
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Here, the depreciation charge is calculated on the net book value of the Fixed Asset at the end of the last accounting
period.
Reducing Balance Method
E.g. A plant costing $6000 is depreciated at 20% using the Reducing Balance Method.
Required: Compute the charge for each of the three years and show the amount to be (1) debited in the Profit and Loss account (2) the Balance Sheet of the three years disclosure for each
Balance sheet (extract)
As at 31 December 2005Plant at cost $ 6000Less: Accumulated Depr. $ (1200) Net book value
$4800
Income Statement for the year ending 31 December 2005
Depreciation expense: plant$1200
Balance sheet
As at 31 December 2006Plant at cost $ 6000Less: Acc-ed Depr. $ (2160) (1200+960)Net book value
$3800Income Statement for the year
ending 31 December 2006Depreciation expense: plant$ 960
Advantages of reducing balance method
Separate calculations are not required for each addition in the asset account.
The total of depreciation and amount spent on repairs is equated over the years.
Disadvantages of Reducing Balance Method
The book value of the asset will never become zero under this method
It is very difficult to ascertain the correct rate of depreciation to write off the asset during its lifetime.
Sum of the years’ digits method
Under this method, the digits or the remaining useful life of the asset is calculated.
The digits are added up to get the sum of digits.
The corresponding ratio of digits is then obtained.
A machinery costing $12,000, which will beused for 5 years, will be depreciated asfollows:From purchase the asset will last for 5 yearsFrom the 2nd year the asset will last for 4 yearsFrom the 3rd year the asset will last for 3 yearsFrom the 4th year the asset will last for 2 yearsFrom the 5th year the asset will last for 1 year
15 ==
Depreciation expense
1st year 5/15 of $12,000 is charged= 4000
2nd year 4/15 of $ 12,000 is charged= 3200
3rd year 3/15 of $ 12,000 is charged= 2400
4th year 2/15 of $ 12,000 is charged= 1600
5th year 1/15 of $ 12,000 is charged= 800
12,000
=====
Usage Method
Usage method calculates the number of hours for which an asset has been used throughout its entire lifetime.
The usage is calculated every year at a particular rate.
A machine is expected to be able to produce 10,000 widgets over its useful life. It has cost of $6,000 and its expected salvage value is of $1,000.
Year 1 – 1,500 widgets are produced
Year 2 – 2,500 widgets are produced
period’s production
(Cost – salvage value) x total ex-ed prod-n
Year 1: $6,000 – $1,000$5,000x 1,500 = $750 depreciation 10,000Year 1: $5,000x 2,500 = $1,250
depr-n. 10,000
Fixed asset disposalWhen we sell a non-current asset, we
want to remove it from our ledger.So, we take the cost of the asset
from our asset account.We also must take out the
accumulated provision that the asset has.
If we get profit or loss on sale, we must calculate it and post to the Profit and Loss account.
Reason for accounting entries
Whenever a businessdisposes/sells/trade-in an old asset, an Asset disposal account will be opened to ascertain profit or loss on disposal
which will be transferred to Profit and Loss account.
The entries raised in the books of account will depend on the way the business is maintaining its records.
If the fixed asset account is kept at cost , the following entries will be raised:
Transfer the cost of the asset being disposed to disposal account.
Debit : Fixed Asset Disposal Account
Credit: Asset Account
With the provisions related to the asset being disposed,
Debit: Provision for depreciation and Credit: Fixed disposal Account.With the sale proceeds or the
trade-in valueDebit: Bank/New asset andCredit: Fixed Asset Disposal Account.
If the Credit side of the fixed asset disposal is greater than the Debit side, it is a profit on disposal with this profit,
Debit: Fixed Asset Disposal account and Credit: Profit and Loss Account.If the Debit side of the Fixed Asset Disposal is greater than the Credit side ,it is a loss on disposal, with this loss,
Debit: Profit and Loss Account and Credit: Fixed Asset Disposal Account.
Worked exampleA company has a machinery whose
cost is $5,000 and its accumulated depreciation is $2000. The machinery was agreed to be sold for $3,500.
Machinery Disposals Machinery $5,000 Accum. Dep.
$2,000Profit and Loss $500 Cash
$3,500 $ 5,500 $ 5,500
==== =====
Income Statement Gross profit
xxxAdd Gain on sale of Machinery
$500
Worked exampleA company has a machinery whose cost is
$5,000 and its accumulated depreciation is $2000. The machinery was agreed to be sold for $1,500.
Machinery Disposals
Machinery $5,000 Accum. Dep. $2,000 Cash $1,400 P&L $1,600 $5,000 $5,000
==== ======
Income Statement Gross profit
xxxLess Loss on sale of Machinery
$1,400
Where Fixed Assets are Kept at Net Book ValueThere will be no provision for depreciation
account.i.e. The provision for depreciation is
charged to the fixed asset account and the fixed Asset Account shows a Net book Value at the end of each Accounting period;
The entries in such a situation are:With the net book value of the asset being
disposedDebit: the Asset disposal Account and Credit: the Asset Account.
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Good luck for your mid-term exam!
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