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DEPRECIATION

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FIXED ASSETS

• Assets acquired not for resale.

Examples :

- A printing machine in a printing company.

- A van in a courier service company.

• Help to earn revenue for more than 1 financial year.

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• The portion of the cost allocated to a particular accounting period is charged as an expense against revenue (Matching principle).

DEFINITION OF DEPRECIATION

• Applies only to fixed assets.

• The whole cost of the fixed assets must be spread over its useful life.

• This portion of the cost is called Depreciation.

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CAUSES OF DEPRECIATION

Physical Deterioration

Obsolescence

Depletion of an asset

Passage of Time

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• Caused by physical wear and tear - rust, erosion, rot and decay

Examples - office furniture

- printing machines

PHYSICAL DETERIORATION

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• Fixed assets become out-of-date

- when new model or more efficient tool come into existence.

Examples - cars

- computers

OBSOLESCENCE

Pentium I

Pentium IV

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Examples - Gold mines

- Quarries - Little Guilin is a depleted granite quarry now turned into a beautiful lake.

DEPLETION OF FIXED ASSETS

• An asset that depletes over time as resources are extracted from it. Little Guilin

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• Some assets confer upon their holders the exclusive rights to enjoy certain privileges for a fixed period of time.

PASSAGE OF TIME

Examples - copyrights

- patent rights

- leases on land

• Revaluation

METHODS OF DEPRECIATION

• Straight-Line

• Reducing Balance

Units-of-output

Double-declining-balance

Sum-of-the-years'-digits

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• A fixed asset is depreciated by an equal amount per year.

STRAIGHT LINE METHOD

Example:

If an asset is depreciated by $1,000 in the first full year of usage, it will also be depreciated by $1,000 in the secondyear; $1,000 in the third year and this continues annuallyuntil it is fully depreciated.

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• Advantages

STRAIGHT LINE METHOD

• Disadvantage

- Easy to understand.

- Easy to calculate.

- Assumes fixed asset gives same amount of service annually throughout its useful life.

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A machine X costs $20,000 is expected to last 4 years.At the end of the 4th year, it can be sold for $2,000 as scrap.

Original cost - Residual value Expected useful life

Depreciation per year =

= $4,500

STRAIGHT LINE METHOD (I)

= 20,000 - 2000

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( Scrap value is the same as residual value.)

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Balance Sheet as at 31 Dec 1999

Fixed assetOffice equipment $16,000

Balance Sheet as at 31 Dec 2000

Fixed assetOffice equipment $16,000 Less Prov. for dep. 2,000 $14,000

Less Prov. For dep. 4,000 $12,000

DepO/E

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• Provision for Depreciation account shows accumulated depreciation of fixed asset.

IMPORTANT FEATURES:

• Fixed asset account shows original cost of asset.

• Net book value of fixed asset (in Balance Sheet) is original cost less Provision for Depreciation.

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REDUCING

BALANCE METHOD OF

DEPRECIATION

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REDUCING BALANCE METHOD

• The amount of depreciation per year diminishes with every successive year.

Example:

- If an asset is depreciated by $2,000 in the first full year of usage, it will be depreciated by less than $2,000 (eg $1,600) in the second year; and even less (eg $1,300) in the third year. This continues until it is fully depreciated.

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• Advantage

REDUCING BALANCE METHOD

• Disadvantages

- Overall expenses ( including repairs and maintenance) charged for the use of a fixed asset would be fairly constant.

- Assets are always left with a small value at the end of useful life.

- Difficult to calculate.

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REDUCING BALANCE METHOD

Depreciation per year

= Rate of depreciation X Net book value at beginning of accounting period

Net book value = Original cost - Accumulated depreciation

Accumulated depreciation is the sum of the yearly depreciation.

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A machine Y costs $10,000 is depreciated at 20% per annumon the reducing balance method. Show depreciation for the first 3 years.

Net Book Value Depreciation

Year 1

Year 2

Year 3

20 100

X 10,000

20 100

X 8,000

20 100

X 6,400

= $2,000 $10,000-2,000=$8,000

= $1,600 $10,000-3,600= $6,400

= $1,280 $10,000-4,880=$5,120

REDUCING BALANCE METHOD

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REVALUATION

METHOD OF

DEPRECIATION

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• The fixed asset is revalued at the end of every accounting

period.

REVALUATION METHOD

• The amount of depreciation varies every year.

• Depreciation is the difference between the value of the fixedasset at the beginning and end of the accounting period.

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Example:

- An asset can be depreciated by $1,000 in the first full year of usage, it can be depreciated by a different amount in the second year (eg $500 ); and a different amount in the third year (eg $1,200 ) depending on the valuation at the end of the accounting period and the cost or valuation at the beginning of the accounting period.

REVALUATION METHOD

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• Advantage

REVALUATION METHOD

• Disadvantage

- Fixed asset is shown at current or realisable value.

- Time consuming and costly to value the fixed asset.

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Cost of printing machine on 1 Jan 2000 = $15,000.Market value on 31 Dec 2000 = $13,000.

REVALUATION METHOD (I)

Depreciation of printing machine for FY2000

= cost on 1 Jan 2000

= 15,000 – 13,000

= $2,000

– market value on 31 Dec 2000

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REVALUATION METHOD (II)

Depreciation expense

This method is normally used for loose tools where it is difficult to estimate the rate of depreciation.The value of the asset may be inflated by new purchasesand this has to be taken into account when calculating depreciation.

= Value of asset at the beginning

- Value of asset at the end

+ Any new purchases

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On 1 Jan 2000 loose tools in the workshop were valued at $2,000. During the year, tools worth $1,000 were bought.On 31 Dec 2000, the estimated market value of the tools was$2,600.

REVALUATION METHOD (II)

Depreciation expense

= Value of tools on 1 Jan 2000

= 2,000

= $400

- Value of tools on 31 Dec 2000

+ New purchases

- 2,600 + 1,000

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THE UNITS-OF-OUTPUT METHOD

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THE DOUBLE-DECLINING BALANCE METHOD

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THE SUM-OF-THE-YEARS'-DIGITS METHOD