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    BOOK KEEPING: FORM THREE: Topic 5 – DEPRECIATION

    Msomi BoraBy No Comments21 Mins Read


    TOPIC 5: DEPRECIATION

    Depreciation
    If an asset id used for more than one year, it should be capitalized. Assets accounts names such as Vehicles, Office equipment or Buildings. at the end of each accounting period, depreciation for the period is debited to the depreciation expense. Accumulated Depreciation shows all depreciation that has been taken during the asset’s file.
    Cost of a Fixed Asset
    Determine the cost of a fixed asset
    Depreciation is the systematic reduction in the recorded cost of a fixed asset. Examples of fixed assets that can be depreciated are buildings, furniture, leasehold improvements, and office equipment. The only exception is land, which is not depreciated (since land is not depleted over time, with the exception of natural resources).
    An Asset Account
    Write up an asset account
    Accounts maintained on fixed assets are called Asset Accounts. In other words, assets accounting deal with fixed assets by providing detailed information on transactions. It deals with fixed assets from the date of acquisition to the date of retirement or sale. Assets accounts include depreciation, partial sale of asset and appreciation.
    Difference between Capital and Revenue Expenditure
    Distinguish between copula and revenue expenditure
    Capital expenditures represent major investments of capital that a company makes to maintain or, more often, to expand its business and generate additional profits. Capital expenses are for the acquisition oflong-term assets, such as facilities or manufacturing equipment. Because such assets provide income-generating value for a company for a period of years, companies are not allowed to deduct the full cost of the asset in the year the expense is incurred; they must recover the cost through year-by-yeardepreciationover theuseful lifeof the asset. Companies often usedebt financingorequity financingto cover the substantial costs involved in acquiring major assets for expanding their business.
    Revenue expenses are shorter-term expenses required to meet the ongoing operational costs of running a business, and thus are essentially the same as operating expenses. Unlike capital expenditures, revenue expenses can be fully tax-deducted in the same year the expenses occur. In relation to the major asset purchases that qualify as capital expenditures, revenue expenditures include the ordinary repair and maintenance costs that are necessary to keep the asset in working order without substantially improving or extending the useful life of the asset. Revenue expenses related to existing assets include repairs and regular maintenance as well as repainting and renewal expenses. Revenue expenditures can be considered to be recurring expenses in contrast to the one-off nature of most capital expenditures.
    The purpose of capital expenditures is commonly to expand a company’s ability to generate earnings, whereas revenue expenditures are more commonly for the purpose of maintaining a company’s ability to operate. Capital expenditures appear as an asseton a company’s balance sheet; revenue expenses are listed with liabilities.
    Relationship between Depreciation and the Matching Principle
    Explain the relationship between depreciation and the matching principle
    The reason for using depreciation is to match a portion of the cost of a fixed asset to the revenue that it generates; this is mandated under the matching principle, where you record revenues with their associated expenses in the same reporting period in order to give a complete picture of the results of a revenue-generating transaction. The net effect of depreciation is a gradual decline in the reported carrying amount of fixed assets on the balance sheet. It is very difficult to directly link a fixed asset with a revenue-generating activity, so we do not try – instead, we incur a steady amount of depreciation over the useful life of each fixed asset, so that the remaining cost of the asset on the company’s records at the end of its useful life is only its salvage value.
    Computing Depreciation
    Several methods are used to compute depreciation. It can be calculated by straight-line method, declining balance method, and Sum-of -the Years’-Digits Method. When choosing a depreciation method,much consideration is given to the matching principle. The main goal is to match the cost of assets to the periods when the assets provide benefits to the business.
    Computing Depreciation by the Straight Line
    Compute depreciation by the straight line
    Straight-Line method is the simplest method used to calculate depreciation of an asset. accountants in favor of this method believe that an asset provides equal benefits over its useful life.
    Straight-line Depreciation
    The simplest and most commonly used method, straight-line depreciation is calculated by taking the purchase or acquisition price of an asset, subtracting the salvage value (value at which it can be sold once the company no longer needs it) and dividing by the total productive years for which the asset can reasonably be expected to benefit the company (or its useful life).
    Example 1
    Example:
    For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts.
    Depreciation Expense = Total Acquisition Cost – Salvage Value / Useful Life
    Straight-line depreciation produces a constant depreciation expense. At the end of the asset’s useful life, the asset is accounted for in the balance sheet at its salvage value.
    Computing Depreciation by Units of Output
    Compute depreciation by Units of output
    You have learned that, under straight line method, depreciation is calculated as a function of time. For some assets, depreciation can be direct related to the unit of work it produced. The unit-of-output method is used to calculate depreciation at the same rate for each unit produced. It can measure depreciation in terms of number of hours the asset is used or physical quantities of production.
    Unit-of-Production Depreciation
    This method provides for depreciation by means of a fixed rate per unit of production. Under this method, one must first determine the cost per one production unit and then multiply that cost per unit with the total number of units the company produced within an accounting period to determine its depreciation expense.
    Depreciation Expense = Total Acquisition Cost – Salvage Value / Estimated Total Units
    Estimated total units = the total units this machine can produce over its lifetime
    Depreciation expense = depreciation per unit * number of units produced during an accounting period
    Example 2
    Example:
    Company ABC purchased a machine for $2 million that can produce 300,000 products over its useful life. The company estimates that this machine has a salvage value of $200,000.
    Unit-of-production depreciation produces a variable depreciation expense and is more reflective of production-to-cost (see matching principle).
    At the end of its useful life, the asset’s accumulated depreciation is equal to its total cost minus its salvage value. Furthermore, its accumulated production units equal the total estimated production capacity. One of the drawbacks of this method is that if the units of products decrease (due to slowing demand for the product, for example), the depreciation expense also decreases. This results in an overstatement of reported income and asset value.
    Computing Depreciation by Declining Balance
    Compute depreciation by Declining balance
    The declining- balance method is an accelerated method of depreciation. It allocates greater amount of depreciation to an asset’s earl years of useful life.
    Reducing Balance Depreciation Method
    Reducing Balance Method charges depreciation at a higher rate in the earlier years of an asset. The amount of depreciation reduces as the life of the asset progresses. Depreciation under reducing balance method may be calculated as follows:
    Depreciation per annum = (Net Book Value – Residual Value) x Rate%
    Where:
    • Net Book Value is the asset’s net value at the start of an accounting period. It is calculated by deducting the accumulated (total) depreciation from the cost of the fixed asset.
    • Residual Value is the estimated scrap value at the end of the useful life of the asset. As the residual value is expected to be recovered at the end of an asset’s useful life, there is no need to charge the portion of cost equaling the residual value.
    • Rate of depreciation is defined according to the estimated pattern of an asset’s use over its life term.
    Example 3
    Example:
    An asset has a useful life of 3 years.
    Cost of the asset is $2,000.
    Residual Value is $500.
    Rate of depreciation is 50%.
    Depreciation expense for the three years will be as follows:
    NBV R.V Rate Depreciation Accumulated Depreciation
    Year1: (2000 – 500) x 50% = 750 750
    Year2: (1250 – 500) x 50% = 375 1125
    Year3: (875 – 500) x 50% = 375* 1500
    *Under reducing balance method, depreciation for the last year of the asset’s useful life is the difference between net book value at the start of the period and the estimated residual value. This is to ensure that depreciation is charged in full.
    As you can see from the above example, depreciation expense under reducing balance method progressively declines over the asset’s useful life.
    Reducing Balance Method is appropriate where an asset has a higher utility in the earlier years of its life. Computer equipment for instance has better functionality in its early years. Computer equipment also becomes obsolete in a span of few years due to technological developments. Using reducing balance method to depreciate computer equipment would ensure that higher depreciation is charged in the earlier years of its operation.
    Example 4
    Example
    • An asset has a useful life of 3 years
    • Cost of the asset was £4,000
    • Residual or Scrap Value is £300
    • Rate of depreciation is 50%
    Depreciation to be expensed for the three years will be:
    NBV R.V Rate Depreciation Accumalated Depreciation
    Year1: (4,000 – 300) x 50% = 1,850 1,850
    Year2: (2,150 – 300) x 50% = 925 2,775
    Year3: (1,225 – 300) x 50% = 925* 3,700
    Computing Depreciation by Sum of the Years Digits
    Compute depreciation by Sum of the years digits
    Sum-of-Year Method:
    Depreciation In Year i = ((n-i+1) / n!) * (total acquisition cost – salvage value)
    Example 5
    Example:
    For $2 million, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts. n! = 1+2+3+4+5 = 15 n = 5
    The sum-of-year depreciation method produces a variable depreciation expense. At the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straight-line depreciation.
    Computing Depreciation by Revaluation
    Compute depreciation by Revaluation
    Under this method the fixed assets are valued at the end of each accounting period. The difference between the value at the beginning of the period and the value at the end of the period represents the depreciation value which is charged against the profit and loss account. This method is used in case of assets like loose tools, packages, Farmers’ livestock etc.
    Formula for Calculating:Depreciation = Value of asset at the end – Value of asset at the beginning + Any new purchases
    Example 6
    A firm had purchased loose tools costing $ 62500 on 1st april 2000. The tools were independent valued at the end of every year and the values placed on them were as under :
    • 31st Dec. 2000 $ 60,000
    • 31st Dec. 2001 $ 50,000
    • 31st Dec. 2002 $ 42,500
    • 31st Dec. 2003 $ 32,500
    Find out the Amount of Depreciation for each year.
    Solution
    AnnualDepreciation Formula=Value at the Beginning-Estimated Value at the End
    Year Value at the Beginning Estimated Value at the End AnnualDepreciation
    2000 62500 60000 2500
    2001 60000 50000 10000
    2002 50000 42500 7500
    2003 42500 32500 10000
    Computing Depreciation by Double Declining Balance
    Compute depreciation by Double declining balance
    The double declining balance method is an accelerated form of depreciation under which the vast majority of the depreciation associated with a fixed asset is recognized during the first few years of its useful life. This approach is reasonable under either of the following two circumstances:
    • When the utility of an asset is being consumed at a more rapid rate during the early part of its useful life; or
    • When the intent is to recognize more expense now, thereby shifting profit recognition further into the future (which may be of use for deferring income taxes).
    However, this method is more difficult to calculate than the more traditionalstraight-line methodof depreciation. Also, most assets are utilized at a consistent rate over their useful lives, which does not reflect the rapid rate of depreciation resulting from this method. Further, this approach results in the skewing of profitability results into future periods, which makes it more difficult to ascertain the true operational profitability of asset-intensive businesses.
    To calculate depreciation under the double declining method, multiply the book value at the beginning of the fiscal year by a multiple of the straight-line rate of depreciation. Thedouble declining balance formula is:
    Double-declining balance (ceases when the book value = the estimated salvage value)
    2 × Straight-line depreciation rate × Book value at the beginning of the year
    A variation on this method is the 150% declining balance method, which substitutes 1.5 for the 2.0 figure used in the calculation. The 150% method does not result in as rapid a rate of depreciation at the double declining method.
    Example 7
    ABC Company purchases a machine for $100,000. It has an estimated salvage value of $10,000 and a useful life of five years. The double declining balance depreciation calculation is:
    Year Net book value,beginning of year Double-declining bal­ance depreciation computed as 2 × SLrate × beginning NBV Net book value,end of year
    1 $100,000 $40,000 $60,000
    2 60,000 24,000 36,000
    3 36,000 14,400 21,600
    4 21,600 8,640 12,960
    5 12,960 2,960 10,000 salvage value
    Total $90,000
    The Asset Account, the Provision for Depreciation Account as Balance Sheet Extracts
    Show the asset account, the provision for depreciation account as balance sheet extracts
    Double entry involved in recoding depreciation may be summarized as follows:
    Debit Depreciation Expense (Income Statement)
    Credit Accumulated Depreciation (Balance Sheet)
    Every accounting period, depreciation of asset charged during the year is credited to the Accumulated Depreciation account until the asset is disposed. Accumulated depreciation is subtracted from the asset’s cost to arrive at the net book value that appears on the face of the balance sheet. Using the last example, following double entries will be recorded in respect of depreciation:
    Depreciation Expense Account
    Debit $ Credit $
    2001 Accumulated Depreciation 333.3 2001 Income Statement 333.3
    2002 Accumulated Depreciation 333.3 2002 Income Statement 333.3
    2003 Accumulated Depreciation 333.4 2003 Income Statement 333.4
    Accumulated Depreciation Account
    Debit $ Credit $
    2001 Balance c/d 333.3 2001 Depreciation Expense 333.3
    333.3 333.3
    2002 Balance c/d 666.6 2002 Balance b/d 333.3
    2002 Depreciation Expense 333.3
    666.6 666.6
    2003 Balance c/d 1000 2003 Balance b/d 666.6
    2003 Depreciation Expense 333.4
    1000 1000
    An asset Disposal Account and Extracts from the Balance Sheet
    Write up an asset disposal account and extracts from the balance sheet
    A disposal account is a gain or loss account that appears in the income statement, and in which is recorded the difference between the disposal proceeds and the net carrying amount of the fixed asset being disposed of. The account is usually labeled “Gain/Loss on Asset Disposal.”
    The journal entry for such a transaction is to debit the disposal account for the net difference between the original asset cost and any accumulated depreciation (if any), while reversing the balances in the fixed asset account and the accumulated depreciation account. If there are proceeds from the sale, they are also recorded in this account. Thus, the line items in the entry are:
    • Debit the accumulated depreciation account to reverse the cumulative amount of depreciation already recorded for the asset, and credit the disposal account
    • Debit the cash account for any proceeds from the sale, and credit the disposal account
    • Debit the disposal account if there is a loss on disposal
    • Credit the fixed asset account to reverse the original cost of the asset, and debit the disposal account
    • Credit the disposal account if there is a gain on disposal
    It is also possible to accumulate the offsetting debits and credits associated with the elimination of an asset and related accumulated depreciation, as well as any cash received, in a temporary disposal account, and then transfer the net balance in this account to a “gain/loss on asset disposal” account. However, this is a lengthier approach that is not appreciably more transparent and somewhat less efficient than treating the disposal account as a gain or loss account itself, and so is not recommended.
    Example 8
    The following journal entry shows a typical transaction where a fixed asset is being eliminated. The asset has an original cost of $10,000 and accumulated depreciation of $8,000. We want to completely eliminate it from the accounting records, so we credit the asset account for $10,000, debit the accumulated depreciation account for $8,000, and debit the disposal account for $2,000 (which is a loss).
    Debit Credit
    Accumulated depreciation 8,000
    Loss on asset disposal 2,000
    Asset 10,000
    If the company had instead sold off the asset for $3,000, this would generate a net gain of $1,000, which is recorded with the following entry:
    Debit Credit
    Cash 3,000
    Accumulated depreciation 8,000
    Asset 10,000
    Gain on asset disposal 1,000
    Journal Entries to Record Depreciation on Fixed Asset
    Show journal entries to record depreciation on fixed asset
    Depreciation Journal Entries
    When you record depreciation, it is a debit to the Depreciation Expense account, and a credit to the Accumulated Depreciation account. The Accumulated Depreciation account is a contra account, which means that it appears on the balance sheet as a deduction from the original purchase price of an asset.
    Once you dispose of an asset, you credit the Fixed Asset account in which the asset was originally recorded, and debit the Accumulated Depreciation account, thereby flushing the asset out of the balance sheet. If an asset was not fully depreciated at the time of its disposal, it will also be necessary to record a loss on undercoated portion. This loss will be reduced by any proceeds from sale of the asset.
    Other Depreciation Issues
    Depreciation has nothing to do with the market value of a fixed asset, which may vary considerably from the net cost of the asset at any given time.
    Depreciation is a major issue in the calculation of a company’s cash flows, because it is included in the calculation of net income, but does not involve any cash flow. Thus, a cash flow analysis calls for the inclusion of net income, with an add-back for any depreciation recognized as expense during the period.
    Disposal of Fixed Assets Journal Entry – Write Off
    Account Debit Credit
    Fixed Assets 9,000
    Accumulated Depreciation 6,000
    Disposal of Fixed Assets Account 3,000
    Total 9,000 9,000
    The disposal of fixed assets account is an income statement account and is being used to hold all gains, losses, and write offs of fixed assets as they are disposed of. The account is sometimes called the disposal account, gains/losses on disposal account, or sales of assets account. In this case the amount is a debit representing a loss to the business.
    Methods of Providing Depreciation Employed
    Identify methods of providing depreciation employed
    The following are the various methods for providing depreciation:
    1. Straight Line or Fixed Percentage on Original Cost or Fixed Installment Method.
    2. Written Down Value or Fixed Percentage on Diminishing Balance or Reducing Installment Method.
    3. Insurance Policy Method.
    4. Sum of the Digits Method.
    5. Revaluation Method.
    6. Depletion Method.
    7. Machine Hour Rate Method.
    Straight Line Method
    Under this method, a fixed percentage of original cost is written off the asset every year. Thus, if an asset costs Rs.20,000 and 10 percent depreciation were considered adequate, Rs.2,000 would be written off every year. The amount to be written off every year is arrived at as under:
    = ( Cost – Estimated Scrap Value ) / Estimated Life
    The period for which the asset is used in a particular year should also be taken into account. This method is simple in calculation and also in such a case, the charge to the Profit and Loss Account is uniform every year. This method is useful when the service rendered by the asset is uniform from year to year. It is desirable, when this method is in use, to estimate the amount to be spent by way of repairs during the whole life of the asset and provide for repairs each year at the average actual repairs.
    Written Down Value Method
    Under this method, the rate or percentage of depreciation is fixed, but it applies to the value at which the asset stands in the books in the beginning of the year. In other words, under this method, a fixed percentage is written off every year on the reduced balance of the asset. Thus, the percentage of depreciation is not applied to the original cost but only to the balance, which remains after charging depreciation in the beginning of a year. The percentage of depreciation remains fixed for all the years of the working life of an asset but the actual amount of depreciation written off every year goes on decreasing with the reduction in the value of the asset.
    Insurance Policy Method or Capital Redemption Policy Method
    Under this method the business takes a policy from an insurance company. The amount of the policy is such that it is sufficient to replace the asset when it is worn out. Cash, which is equal to the amount of depreciation, is paid by way of premium every year. The amount goes on accumulating with the insurance company at a certain rate of interest and is paid back to the insured at the maturity of the policy. The amount so made available by the insurance company is used for purchasing a new asset. This method to a great extent is similar to sinking fund method, but no doubt the procedure is a little different. In this method, instead of buying securities, the insurance policy is taken and premium is paid every year. Company, that receives premium, allows a small interest on compound basis.
    This method is a more suitable device for ensuring the availability of cash to replace the asset. The advantage under this system is that the company need not worry whether the investments as under the Depreciation Fund Method, will be sold at best prices or not.
    If an insurance policy is taken, it serves two purposes. Firstly, it insures the asset. Secondly, the insurance company will pay the stipulated amount to enable the company to replace assets. This method is more expensive as the insurance company has to keep its margin of profits. It is suitable for losses where the life of the asset is definitely known. It yields a very low rate of interest. It makes no adjustments for price-level changes.
    Sum of the Digits Method
    Under this method, amount of the depreciation to be written off each year is calculated by the following formula: = Remaining Life of the Asset (including the Current Year) / Sum of all the Digits of the Life of the Asset in Years x Cost of the Asset
    Suppose the life of an asset costing Rs.50,000 is 10 years. The sum of all the digits from 1 to 10 comes to 55 i.e., 10+9+8+7+6+5+4+3+2+I = 55. The depreciation to be provided in the first year will be:
    = 10 / 55 x 50,000 or Rs.9,091
    In the second year, it will be:
    9 /55 x 50,000 or Rs.8,181
    This method is similar to the Written Down Value Method described earlier.
    Revaluation Method
    This method is used only in case of small items like cattle (Livestock), or loose tools where it may be too much to maintain an account of each single item. The amount of depreciation to be written off is determined by comparing the value at the end of the year (valuation being done by some one having expert knowledge of the valuation of the asset) with the value in the beginning.
    Suppose on 1st April 2,007 the value of loose tools was Rs.10,000 and during the year Rs.30,000 worth of tools were purchased. Now if at the end of the year, the loose tools are considered to be worth only Rs.25,000 the depreciation comes to Rs.15,000 i.e. Rs.10,000+ Rs.30,000 – Rs.25,000.
    Depletion Method
    The depletion method is used in case of mines, quarries, etc., where an estimate of total quantity of output likely to be available should be available. Depreciation is calculated per ton of output.
    For example, if a mine is purchased for Rs.20,00,000 and it is estimated that the total quantity of mineral in the mine is 5,00,000 ton, the depreciation per ton of output comes to = 20,00,000 / 5,00,000 = Rs. 4.
    If the output in the first year is 30,000 then the depreciation will be 30,000 x Rs.4 = Rs. 1,20,000, in the second year, the output may be 50,000 ton; the depreciation to be written off will be Rs.2,00,000 i.e., 50,000 x Rs.4.
    Machine Hour Rate Method
    This is more or less like the depreciation method. Instead of the usual method of estimating the life of a machine in years, it is estimated in hours. Then, an accurate record is kept recording the number of hours each machine is run and depreciation is calculated accordingly.
    For example, the effective life of a machine may be 30,000 hours. If the cost of the machine is Rs.4,50,000, the hourly depreciation is
    = 4,50,000 / 30,000 = Rs. 15.
    The depreciation for a particular year during which the machine runs for 2,500 hours will be 2,500 x Rs.15 = Rs.37,500.
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