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Assume the Position. ACT 1100 Introduction to Accounting . Lecturer: Troy J. Wishart. Summer Course. Our Confession. ACT 110 Is EASY POP!. And I am Going to get an “A”!. Lecture Notes 6. Depreciation. Depreciation. Definition Depreciation is the measure of the: wearing out,

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act 1100 introduction to accounting

ACT 1100Introduction to Accounting

Lecturer: Troy J. Wishart

Summer Course

act 110 is easy pop

Our Confession

ACT 110

Is EASY POP!

And I am Going to get an “A”!

depreciation1
Depreciation

Definition

Depreciationis the measure of the:

  • wearing out,
  • consumption
  • or other reductions in the useful economic life of a fixed asset,

whether arisingfrom:

  • use,
  • passage of time or
  • obsolescence.
depreciation2
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.

[Keiso & Weygandt 1990:543]

depreciation3
Depreciation

Definition

  • Where natural resources, such as timber, gravel, oil and coal, are involved, the term depletion is employed.

[Keiso & Weygandt 1990:543]

depreciation4
Depreciation

Definition

  • The expiration of intangible assets, such as patents, or goodwill is called amortization

[Keiso & Weygandt 1990:543]

depreciation5
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.

[Keiso& Weygandt 1990:543]

depreciation6
Depreciation

Depreciation in Accounting

  • To accountants, depreciation is not a matter of valuation but a means of cost allocation.

[Keiso & Weygandt 1990:543]

depreciation7
Depreciation

Depreciation in Accounting

  • 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]

depreciation8
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]

depreciation9
Depreciation

Depreciation in the Financial Statements

  • 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]

depreciation10
Depreciation

Service Life – vs. – Physical Life

  • Basic difference
    • A piece of machinery may be physically capable of producing a given product for many years beyond its service life,

[Keiso & Weygandt 1990:544]

depreciation11
Depreciation

Service Life – vs. – Physical 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]

depreciation12
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.

[Favell 1977:104]

depreciation13
Depreciation

How does an Asset Depreciate?

  • Through effluxion or passage of time
    • as in the case of leases of factories and other buildings and of patent rights.

[Favell 1977:104]

depreciation14
Depreciation

How does an Asset Depreciate?

  • Through obsolescence where,
    • for example, a machine is rendered out of date through the invention of a more efficient machine.

[Favell 1977:104]

depreciation15
Depreciation

Depreciation Methods

  • Activity Method
    • (units or use or production)
  • Straight Line Method
    • (Equal Instalment Method)
depreciation16
Depreciation

Depreciation Methods

  • Decreasing Charge Methods –
    • Sum-of-the-years digits
    • Declining-Balance method/Reducing Balance Method
depreciation17
Depreciation

Depreciation Methods

  • Special Depreciation Methods –
    • Inventory Method
    • Retirement & Replacement Methods
    • Group & Composite Methods
    • Compound Interest Methods
depreciation18
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

Total Production Measure

depreciation19
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.
depreciation20
Depreciation

Straight Line Method

  • 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

depreciation21
Depreciation

Straight Line Method

Advantages

  • 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,
depreciation22
Depreciation

Straight Line Method

Advantages

  • Complies with the Income Tax Act in the vast majority of the cases.
depreciation23
Depreciation

Straight Line Method

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.
depreciation24
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,
depreciation25
Depreciation

Sum-of –the year’s Digits Method

    • 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.
depreciation26
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

depreciation27
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.
depreciation28
Depreciation

Reducing Balance Method

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.
depreciation29
Depreciation

Reducing Balance Method

Formula

  • 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
depreciation30
Depreciation

Reducing Balance Method

Advantages

  • No recalculation is necessary when additional assets are purchased. [Whitehead 1974:218]
depreciation31
Depreciation

Reducing Balance Method

Advantages

  • 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.
depreciation32
Depreciation

Reducing Balance Method

Advantages

  • In the later years, when repairs are heavy, this is counterbalanced by the decreasing charge for depreciation.
depreciation33
Depreciation

Reducing Balance Method

Disadvantages

  • The percentage figureto be calculated each year is difficult to calculate.

(Whitehead 1974:218).

depreciation34
Depreciation

Reducing Balance Method

Disadvantages

  • For assets with a very short life, the percentage figure is so high that it becomes ridiculous.

(Whitehead 1974:218).

depreciation35
Depreciation

Depreciation and Disposal Policy

  • In addition to the basis or method of depreciation, the Disposal Policy adopted by the organisation is important.
depreciation36
Depreciation

Depreciation and Disposal Policy

  • It determines how depreciation is charged against profits for assets acquired and disposed of during an accounting period.
depreciation37
Depreciation

Depreciation and Disposal Policy

Some of the policies that be adopted are:-

  • Full depreciation in the year of acquisition and none in the year of disposal.
  • Full depreciation in the year of disposal and none in the year of acquisition.
depreciation38
Depreciation

Depreciation and Disposal Policy

Some of the policies that be adopted are:-

  • Half depreciation in the year of acquisition and half in the year of disposal
  • Prorated depreciation.
depreciation39
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
depreciation40
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.
depreciation41
Depreciation

Comparison of Straight Line to Reducing Balance Method

Straight Line Method Reducing Balance Method

Cost Price 8,000

Depreciation Y1 1,875

Net Book Value 6,125

Depreciation Y2 1,875

Net Book Value 4,250

Depreciation Y3 1,875

Net Book Value 2,375

Depreciation Y4 1,875

500

Cost Price 8,000

Dep. Y1 – 50% 4,000

Net Book Value 4,000

Dep. Y2 – 50% 2,000

Net Book Value 2,000

Dep. Y3 – 50% 1,000

Net Book Value 1,000

Dep. Y4 – 50% 500

Net Book Value 500

depreciation42
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
depreciation43
Depreciation

Double Entry For Depreciation

  • Accumulated Depreciation – Total depreciation provided on asset from date of purchase to date on current balance sheet
depreciation44
Depreciation

Posting Depreciation

Exercise – 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 Depreciation

Cost Price 20,000

Dep. Y1 – 20% 4,000

Net Book Value 16,000

Dep. Y2 – 20% 3,200

Net Book Value 12,800

Dep. Y3 – 20% 2,560

Net Book Value 10,240

depreciation45
Depreciation

Posting Depreciation

Step 2 – Post Accumulated Depreciation Account

Accumulated Depreciation Account

Dec 31

4,000

Balance c/d

4,000

Dec 31

Profit and Loss A/c

Jan 1

Balance b/d

4,000

Dec 31

Profit and Loss A/c

3,200

Dec 31

7,200

Balance c/d

7,200

7,200

Jan 1

Balance b/d

7,200

Dec 31

Profit and Loss A/c

2,560

Dec 31

9,760

Balance c/d

9,760

9,760

Jan 1

Balance b/d

9,760

depreciation46
Depreciation

Posting Depreciation

Step 2 – Post to Profit and Loss Account Extract

L Hart

Profit and Loss Account Extract

2011

Depreciation

4,000

Depreciation

3,200

2012

Depreciation

2,560

2013

depreciation47
Depreciation

Posting Depreciation

Step 3 – Charge Accumulated Depreciation against Assets in Balance Sheet

L Hart

Balance Sheet (Extracts) .

As at December 31, 2011

Machinery at Cost 20,000

Less Depreciation to date 4,000

Net Book Value 16,000

As at December 31, 2012

Machinery at Cost 20,000

Less Depreciation to date 7,200

Net Book Value 12,800

As at December 31, 2013

Machinery at Cost 20,000

Less Depreciation to date 9,760

Net Book Value 10,240

depreciation48
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.
depreciation49
Depreciation

Disposal of an Asset

  • 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

depreciation50
Depreciation

Disposal of an Asset

  • The gain or loss should be accounted for along with the removal of the assets and depreciation from the books of accounts.
depreciation51
Depreciation

Disposal of an Asset – Accounting Entries

  • Transfer the cost of the Asset sold to Disposal Account
    • Debit Assets Disposal Account
    • Credit Asset Account
depreciation52
Depreciation

Disposal of an Asset – Accounting Entries

  • Transfer total depreciation of asset to Disposal A/c
    • Debit Accumulated Depreciation Account
    • Credit Assets Disposal Account
depreciation53
Depreciation

Disposal of an Asset – Accounting Entries

  • Record Receipt of money for asset sold
    • Debit Cash Account
    • Credit Assets Disposal Account
depreciation54
Depreciation

Disposal of an Asset – Accounting Entries

  • Determine if there is a gain or loss on Sale of Asset (Difference or balance on Disposal Account)
depreciation55
Depreciation

Disposal of an Asset – Accounting Entries

  • If the account shows a credit balance, it is a gain on sale:
    • Debit Assets Disposal Account
    • Credit Profit and Loss Account
depreciation56
Depreciation

Disposal of an Asset – Accounting Entries

  • If the account shows a debit balance, it is a Loss on sale:
    • Debit Profit and Loss Account
    • Credit Assets Disposal Account
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