Depreciation Of Fixed Assets

CONTENT

• Causes of Depreciation
• Reasons for charging depreciation
• Factors to be considered in the computation of depreciation
• Methods of providing for depreciation

NOTES

Depreciation may be defined as the permanent and continuing diminution (or lessening) in the quality, quantity or value of an asset.

CAUSES OF DEPRECIATION

1. Physical factors – Assets may depreciate in value as a result of physical factors like humidity (or dampness), heat, erosion, evaporation of liquids, rust, rot and decay etc
2. Wear and Tear – An asset may depreciate as a result of constant usage.
3. Passage of Time – or Effluxion of Time; Assets like patents, copyrights, leaseholds etc have a fixed period of legal life.They therefore depreciate as a result of passage of time. The depreciation of these intangible assets is known as AMORTISATION
4. Obsolescence – Assets may be rendered out of use as a result of new technology or invention or change in fashion. The value of such obsolete assets (e.g. Black and White TV) will reduce drastically over a short period of time.
5. Inadequacy or Superfluity – Assets may be out of use because of increase in the output of a firm. In such a situation, assets will be replaced with new and bigger ones.
6. Depletion – Some natural resources like gold, crude oil, iron ore deposits, quarries etc reduces in value as they are being exploited or mined. These assets are known as WASTING ASSETS. The more they are extracted, the less the reserve that remains.

REASONS OR ADVANTAGES OF CHARGING DEPRECIATION

• Since it reduces net profit, the tax to be paid will be reduced
• The business will have fund to replace the asset at the end of the useful life
• The value of the assets will not be overstated in the Balance Sheet
• Rather than charging the cost of an asset to the profits in the year of purchase,the cost of an asset is spread over its useful life – this is a demonstration of the matching concept in accounting.
• To ascertain the profit or loss on the disposal of assets.

FACTORS TO BE CONSIDERED IN THE COMPUTATION OF DEPRECIATION

1. The historical (or original) cost of the asset
2. The estimated useful life of the asset
3. The estimated scrap value (or salvage) value of the asset
4. The method of depreciation to be used e.g. straight line, reducing balance, revaluation method etc
5. The internal causes of depreciation
6. The external causes of depreciation .

METHODS OF PROVIDING FOR DEPRECIATION

1. Straight line Method
2. Reducing Balance Method (or Diminishing Balance Method)
3. Sum of the years digit
4. Revaluation Method
5. Depletion Unit Method

Other less common methods include:

• Sinking Fund Method
• Insurance Policy Method
• Annuity Method etc

EVALUATION QUESTIONS

      1     Define the term depreciation

      2    State four causes of depreciation of assets.

STRAIGHT LINE MEHOD

Under this method, an equal amount is charged for depreciation yearly throughout the useful  of an asset.

Formula =     Cost – Scrap Value

                         No. of years

ADVANTAGES OF THE STRAIGHT LINE METHOD

1. It is simple (or easy) to calculate
   1. It is widely used
   1. It is time oriented
   1. It is judicially recommended – Edwards v. Sauntons Hotels

DISADVANTAGES OF THE STRAIGHT LINE METHOD

1. It is not suitable (or ideal) for all type of fixed assets. For example, it cannot be used for loose tools
2. It is not scientific – as it does not take the efficiency of the asset into consideration
3. The assumption of equal depreciation per year is unrealistic

EVALUATION

1. List and explain five factors that would be considered in the computation of the annual depreciation of an asset.
2. Differentiate between the terms – Depreciation and Amortization

GENERAL EVALUATION

1. State six characteristics of depreciable assets
2. Explain three differences between a trial balance and a balance sheet
3. List seven errors that will affect the agreement of the trial balance
4. Explain the following : (i) real account (ii) nominal account (iii) personal account
5. List eight items that cause disagreement between Cash Book and bank statement balance

READING ASSIGNMENT

Simplified and Amplified Financial Accounting Page 151 – 167

WEEKEND ASSIGNMENT

.  1   Which of the following fixed assets is not depreciable (a) building (b) tools (c) land (d)

furniture

   2   Patents and Trade marks are classified under (a) Fixed Assets (b) Current Assets

    (c)Wasting Assets (d) Intangible Assets

   3   Which of the following does not lead to depreciation of assets (a) Wear and tear (b)

    Devaluation of Naira (c) Obsolescence (d) Usage

   4   Which of the following does not belong to the group (a) straight line (b) insurance

policy (c) accumulated depreciation (d) diminishing balance

   5   Depreciation is (a) the cost of replacing fixed assets (b) the cost of repairs incurred on a    

fixed asset (c) a charge for the wear and tear of a fixed asset (d) the loss incurred on the     

sale of a fixed asset

THEORY

1. Give two examples of assets associated with Depreciation and Amortization

A machine cost N60,000. It will be kept for 5 years and then sold at an estimated figure of N10,000. Show the calculations for depreciation for each year using the Straight Line

• Methods of providing for depreciation

REDUCING BALANCE METHOD (or DIMINISHING BALANCE METHOD)

Under this method, a fixed percentage is written off the reducing (or diminishing) balance of the asset yearly.

This method charges higher depreciation in the early years of the asset and lower in the later   years

The depreciation rate (%) to be applied is computed using the formula below:

S   

        Depreciation rate (%)   =    1   –       C

where:

        n =    No. of  years

s  =   Scrap value

c  =   Cost

ADVANTAGES OF THE DIMINISHING BALANCE METHOD

1.   It is widely used.

2.   Depreciation is more scientifically provided for.

3.   It recognizes the efficiency of an asset by charging higher amounts in the early years and lower amounts in the later years.

4.   Higher depreciation amounts and low maintenance cost in the early years even out with low depreciation amounts and higher maintenance cost in the later years

DISADVANTAGES OF THE DIMINISHING BALANCE METHOD

1. Calculating the rate of depreciation may be difficult
2. It is not ideal for all fixed assets. For example it cannot be used for loose tools.

SUM OF THE YEARS DIGIT

Under this method, the years in the life of the asset are represented with digits and are added. The fraction of the asset cost is then charged to the years in reverse order.

EVALUATION QUESTIONS

1.         Explain the following methods of depreciation:

(a)  reducing balance method  (b) sum of the years digit

2.         Write short notes on the following:

(a)  Depreciation      (b) Salvage value     (c) Obsolescence

REVALUATION METHOD

Under this method the asset is revalued each year, any difference being charged to the profit and loss account.

This method is good for assets which cannot be easily depreciated because of their nature e.g. loose tools (i.e. bolts, nuts, hammer, chisel, screws) livestock, farm crops/plantations e.t.c.The value of the assets at the beginning and end of the year will be estimated and used in the calculation of the depreciation.

Illustration:

On 1^st January 2005, the value of loose tools was N25,000. Purchases of loose tools during the year was N7,000. On 31^st December 2005, the loose tools were revalued at N24,000

Required:  Calculate the depreciation on loose tool for the year.

SOLUTION:

N

Balance of loose tools 1 Jan 2005                     25,000

Add : Purchases of loose tools in 2005               7,000

                                                                                  32,000

       Less:  Balance of loose tools 31 Dec 2005        24,000

                Depreciation on loose tools for 2005          8,000

ADVANTAGES OF THE REVALUATION METHOD

It is suitable (or ideal ) for loose tools, livestock e.t.c.

DISADVANTAGES OF THE REVALUATION METHOD

1.         It cannot be used for all classes of assets.

2.         Revaluation of assets on yearly basis may be cumbersome

DEPLETION UNIT METHOD (or PRODUCTION UNIT METHOD )

This method is used for wasting assets such as quarry, mine, timber, and other assets ( like machines) whose useful life can be estimated in hours.

Illustration

A machine costing N100,000 can work for 800 hours. If it works for 120 hours in 2005 and 200hours in 2006. Calculate the depreciation charges for each year.

SOLUTION

Calculation of Depreciation on Machine

           2005               120   X  N100,000          =   N15,000

                                  800

           2006               200    X  N100,000         =   N25,000

                                  800

EVALUATION QUESTIONS

1.         List five methods of providing for depreciation of assets.

2.         Mention three characteristics of depreciable assets

GENERAL EVALUATION

1. What is depreciation
2.  Explain the following methods of calculating depreciation (i) staight line  (ii) reducing balance     (iii) sum of the years digit
3. What is the difference between depreciation and amortization
4. State ten uses of the general journal
5. Explain the principle of double entry system

READING ASSIGNMENT

Simplified and Amplified Financial Accounting Page 151 – 167

WEEKEND ASSIGNMENT

A machine cost N12,000 and has a useful life of 4 years and an expected disposal valueof N400

1.         Using the straight line method, the annual depreciation is (a) N3,100 (b) N3,000

(c)N2,900 (c) 2,300

2.         The accumulated depreciation at the end of year three using the straight line method    

Is (a) N6,900 (b) N8,700 (c) N9,300 (d) N9,600

3.         Using the reducing balance method and ignoring residual value, what will be the depreciation charge for year 2 at 20% (a) N3,000 (b) N2,900 (c) N2,400 (d) N1,920

4.         Using the reducing balance method and ignoring residual value, what is the net book value at the end of year 2 (a) N10,480 (b) N10,080 (c) N9,680 (d) N7,680

5..        Which of the following is true of the straight line method of depreciation (a) accurate depreciation charges are made yearly (b) the scrap value is zero (c) yearly depreciation charge decreases (d) yearly depreciation charges are constant

THEORY

1.         List four advantages enjoyed by a firm that charges depreciation of fixed assets in its final account

2.         A motor car cost N51,200. It will be kept for 5 years and then sold at an estimated figure of N12,150. Show the calculations of the figures for depreciation for each year using

                  (a)  Straight line method

                  (b)      Reducing balance method at 25% rate of depreciation

ACCOUNTING TREATMENT OF DEPRECIATION

There are two ways of treating depreciation in the ledgers. These are the Old Method and the Modern Method. However, the Modern Method which is preferred by accountants will be considered.

MODERN METHOD

An asset account is opened and a separate provision for depreciation account is also opened. The depreciation for each year is debited to the Profit and Loss Account and credited to the Provision for Depreciation Account

Therefore the following accounts should be prepared:

1. Asset account ( e.g. Machinery Account)
2. Provision for Depreciation Account
3. Profit and Loss Account
4. Balance Sheet

EVALUATION QUESTION

1.         A lorry cost N160,000.  It will be kept for 4 years and then sold at a scrap value of N256.  Show the necessary accounts using diminishing balance method.

GENERAL EVALUATION

1. What are books of prime entry?
2. List any seven books of prime entry
3. State six reasons for keeping accounting records
4. Explain six factors that are taken into consideration in determining annual depreciation charge
5. State six errors that would not affect the agreement of the trial balance

READING ASSIGNMENT

Simplified and Amplified Financial Accounting, Page 151-167

WEEKEND ASSIGNMENT

1.         The amount set aside out of profit for a specific purpose is _______

            (a) depletion                (b) reserve                   (c) provision                (d) depreciation

2.         Which of the following terms describes the provision made for the loss in the value of an asset that has a legal life span?

            (a) capitalization         (b) depreciation           (c) depletion    (d) amortization

3.         Which of the following is not a cause of depreciation?

            (a) inflation         (b) obsolescence           (c) erosion and decay         (d) wear and tear

Use the information below to answer questions 4 and 5

A motor van costs N60,000,000 at 1^st January, 2004.  It was depreciated at 8% using the fixedinstallment method.

4.         What was the accumulated depreciation as at December 31^st, 2005?

            (a) N9,600,000            (b) N9,216,000           (c) N4,800,000      (d) N4,416,000

5.         What was the net book value of the motor van as at December 31^st, 2005?

            (a) N55,584,000          (b) N55,200,000         (c) 50,784,000      (d)  N50,400,000

THEORY

A machine costing N40,000 and with an expected useful life of five years is to be depreciated by the reducing balance method.  The annual rate of depreciation is 30%.

Required:

1.         Prepare the Provision for Depreciation of Machinery account for years 1 to 5

2.         Prepare a Balance Sheet extract to show the fixed asset of machinery at the end of each of the five years.