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DepreciationLecture Notes 6

Depreciation

DefinitionDepreciation 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.

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]

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]

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]

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]

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]

Depreciation

Depreciation Methods1. Activity Method (units or use or production)2. Straight Line Method (Equal Instalment Method)3. Decreasing Charge Methods –

a) Sum-of-the-years digitsb) Declining-Balance method/Reducing Balance Method

4. Special Depreciation Methods –a) Inventory Methodb) Retirement & Replacement Methodsc) Group & Composite Methodsd) Compound Interest Methods

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

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

Depreciation

Straight Line MethodAdvantages• 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.

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.

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

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.

Depreciation

Reducing Balance MethodFormula• 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

Depreciation

Reducing Balance MethodAdvantages• 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.

Depreciation

Reducing Balance MethodDisadvantages• 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).

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.

Depreciation

Depreciation and Disposal PolicySome 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.

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

DepreciationComparison of Methods

Lecture Notes 6

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.

Depreciation

Comparison of Straight Line to Reducing Balance Method

Straight Line Method Reducing Balance MethodCost Price 8,000

Depreciation Y1 1,875Net Book Value 6,125Depreciation Y2 1,875Net Book Value 4,250Depreciation Y3 1,875Net Book Value 2,375Depreciation Y4 1,875

500

Cost Price 8,000Dep. Y1 – 50% 4,000Net Book Value 4,000Dep. Y2 – 50% 2,000Net Book Value 2,000Dep. Y3 – 50% 1,000Net Book Value 1,000Dep. Y4 – 50% 500Net Book Value 500

Depreciation Double Entry and Posting

Lecture Notes 6

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

Depreciation

Posting DepreciationExercise – 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 DepreciationCost Price 20,000Dep. Y1 – 20% 4,000Net Book Value 16,000Dep. Y2 – 20% 3,200Net Book Value 12,800Dep. Y3 – 20% 2,560Net Book Value 10,240

DepreciationPosting DepreciationStep 2 – Post Accumulated Depreciation Account

2011

2012

2013

2014

2011

2012

2013

2014

Accumulated Depreciation Account

Dec 31 Balance c/d 4,000 Dec 31 Profit and Loss A/c 4,000

Balance b/d 4,000Jan 1Dec 31 Profit and Loss A/c 3,200Dec 31 Balance c/d

7,2007,2007,200

Balance b/d 7,200Jan 1Dec 31 Profit and Loss A/c 2,560Dec 31 Balance c/d

9,7609,7609,760

Balance b/d 9,760Jan 1

DepreciationPosting DepreciationStep 2 – Post to Profit and Loss Account Extract

L HartProfit and Loss Account Extract

2011

2012

Depreciation 4,000

Depreciation 3,200

2013 Depreciation 2,560

DepreciationPosting DepreciationStep 3 – Charge Accumulated Depreciation against Assets in Balance Sheet

L Hart Balance Sheet (Extracts)

. As at December 31, 2011

Machinery at Cost 20,000Less Depreciation to date 4,000Net Book Value 16,000

As at December 31, 2012

Machinery at Cost 20,000Less Depreciation to date 7,200Net Book Value 12,800

As at December 31, 2013

Machinery at Cost 20,000Less Depreciation to date 9,760Net Book Value 10,240

Depreciation & DisposalsLecture Notes 6

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.

DepreciationDisposal of an Asset – Accounting Entries1. 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

DepreciationDisposal of an Asset – Accounting Entries4. 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