Assume the Position. ACT 1100 Introduction to Accounting Lecturer: Troy J. Wishart Summer Course.

Assume the Position

ACT 1100

Introduction to Accounting

Lecturer: Troy J. Wishart

Summer Course

ACT 110Is EASY

POP!

Our Confession

And I am Going to get an “A”!

Depreciation

Lecture 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.

[Keiso & Weygandt 1990:543]

Depreciation

Definition• Where natural resources, such as

timber, gravel, oil and coal, are involved, the term depletion is employed.


Depreciation

Definition• The expiration of intangible assets,

such as patents, or goodwill is called amortization


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.


Depreciation

Depreciation in Accounting• To accountants, depreciation is not

a matter of valuation but a means of cost allocation.

•


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.


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]

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]

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,


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.


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]

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]

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]

Depreciation

Depreciation Methods1. Activity Method • (units or use or production)

2. Straight Line Method • (Equal Instalment Method)

Depreciation

Depreciation Methods3. Decreasing Charge Methods –

a) Sum-of-the-years digitsb) Declining-Balance

method/Reducing Balance Method

Depreciation

Depreciation Methods3. 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 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.

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

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,

Depreciation

Straight Line MethodAdvantages• Complies with the Income Tax Act

in the vast majority of the cases.

Depreciation

Straight Line MethodDisadvantage• 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,

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.

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 MethodHow 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]

Depreciation

Reducing Balance MethodAdvantages• 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 MethodAdvantages

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.

(Whitehead 1974:218).

Depreciation

Reducing Balance MethodDisadvantages• 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.

Depreciation

Depreciation and Disposal Policy• It 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.

Depreciation

Depreciation and Disposal PolicySome of the policies that be adopted are:-

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

Double Entry For Depreciation• 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


As at December 31, 2013


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.

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

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.

Depreciation

Disposal of an Asset – Accounting Entries

1. Transfer the cost of the Asset sold to Disposal Account

Debit Assets Disposal AccountCredit Asset Account

Depreciation


2. Transfer total depreciation of asset to Disposal A/cDebit Accumulated Depreciation

AccountCredit Assets Disposal Account

Depreciation


3. Record Receipt of money for asset sold

Debit Cash AccountCredit Assets Disposal Account

Depreciation


4. Determine if there is a gain or loss on Sale of Asset (Difference or balance on Disposal Account)

Depreciation


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

Depreciation


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

Assume the Position. ACT 1100 Introduction to Accounting Lecturer: Troy J. Wishart Summer Course.

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