Definition of basis depreciation terms
According
to statement of Accounting Standard SAS 9, Depreciation represents an estimate
of the portion of the historical cost or revalued amount of a fixed asset
chargeable to operations during an accountant period. In determining
depreciation, cognizance is usually taken of the wear and tear on an asset
resulting from use, affluxion of time, or obsolescence dictated by changes in
technology and market forces.
to statement of Accounting Standard SAS 9, Depreciation represents an estimate
of the portion of the historical cost or revalued amount of a fixed asset
chargeable to operations during an accountant period. In determining
depreciation, cognizance is usually taken of the wear and tear on an asset
resulting from use, affluxion of time, or obsolescence dictated by changes in
technology and market forces.
Depreciable
Assets are item of property, plant and equipment with the following
characteristics:
Assets are item of property, plant and equipment with the following
characteristics:
i. Have lives of over one year;
ii. Are acquired primarily for use in
production of goods or services for an enterprise;
production of goods or services for an enterprise;
iii. Have limited useful economic live; and
iv. Are not intended for sale in the
ordinary course of business.
ordinary course of business.
Investment
property is an investment in Land or Building held primary for generating
income or capital appreciation and not occupied substantially for use in the
operations of enterprise.
property is an investment in Land or Building held primary for generating
income or capital appreciation and not occupied substantially for use in the
operations of enterprise.
Depreciable
value refers to that part of the net book value of a depreciable asset that an
enterprise can allocate to future operations through depreciation.
value refers to that part of the net book value of a depreciable asset that an
enterprise can allocate to future operations through depreciation.
Residual
value of A Depreciable Asset is the estimated net amount recoverable from its
disposal after its expected economic life.
value of A Depreciable Asset is the estimated net amount recoverable from its
disposal after its expected economic life.
Estimated useful life of an Asset is the shorter
of:
of:
i. The pre-determined physical life; and
ii. The useful economic life during which it
could be profitably employed in the operations of the enterprise.
could be profitably employed in the operations of the enterprise.
Revaluation
of Depreciable Assets is process by which a new value is determined for a
depreciable asset having regard to its state, the prevailing economic and
market conditions at the time of the revaluation.
of Depreciable Assets is process by which a new value is determined for a
depreciable asset having regard to its state, the prevailing economic and
market conditions at the time of the revaluation.
Other Definitions of Depreciation
The most
commonly accepted definition of depreciation is that it is a systematic and
rational method of allocating costs to periods which benefits are received. In
other words, depreciation is the process of allocating (in a systematic and
rational manner) the cost a tangible asset, less salvage or residual value, if
any, over the estimated useful life. Depreciation does not involve each outlay.
It is merely a book entry.
commonly accepted definition of depreciation is that it is a systematic and
rational method of allocating costs to periods which benefits are received. In
other words, depreciation is the process of allocating (in a systematic and
rational manner) the cost a tangible asset, less salvage or residual value, if
any, over the estimated useful life. Depreciation does not involve each outlay.
It is merely a book entry.
Depreciation
could be defined as the systematic and periodic allocation of the historical
cost revalued amount less estimated useful life.
could be defined as the systematic and periodic allocation of the historical
cost revalued amount less estimated useful life.
IAS 4
defines depreciation as the allocation of the depreciable amount of an asset
over its estimated useful life. The depreciable amount of a depreciable asset
is its historical cost or other amount substituted for historical cost in the
financial statements, less the estimated residual value.
defines depreciation as the allocation of the depreciable amount of an asset
over its estimated useful life. The depreciable amount of a depreciable asset
is its historical cost or other amount substituted for historical cost in the
financial statements, less the estimated residual value.
Misconceptions about depreciations
It is
sometimes wrongly believed that depreciation:
sometimes wrongly believed that depreciation:
(a) Is a valuation process attempting to
determine the value or worth of a depreciable asset:
determine the value or worth of a depreciable asset:
(b) May not be provided on an asset that is
appreciating in value example building; and
appreciating in value example building; and
(c) Is intended to provide enterprise with
funds with which to replace their assets.
funds with which to replace their assets.
Depreciation
is not a valuation process because it is not the means by which a value or
worth is assigned to an asset. Also depreciation does not necessarily by itself
provide an enterprise with funds for the replacement of its depreciable assets.
is not a valuation process because it is not the means by which a value or
worth is assigned to an asset. Also depreciation does not necessarily by itself
provide an enterprise with funds for the replacement of its depreciable assets.
Because
depreciation represents an estimate of that option of the historical cost or
revalued amount of a fixed asset chargeable to operations during an accounting
period, it is chargeable to operations irrespective of any appreciation in the
value of asset that may have occurred during the accounting period.
depreciation represents an estimate of that option of the historical cost or
revalued amount of a fixed asset chargeable to operations during an accounting
period, it is chargeable to operations irrespective of any appreciation in the
value of asset that may have occurred during the accounting period.
Factors considered in estimating useful of an asset
Some
factors which are usually taken into consideration when estimating the useful
economic life of a depreciable asset are;
factors which are usually taken into consideration when estimating the useful
economic life of a depreciable asset are;
(a) Expected physical wear and tear due to
usage;
usage;
(b) Obsolescence due to changes in technology;
(c) Legal or other restrictions placed on the
asset, for example, by a lesser or government.
asset, for example, by a lesser or government.
Concepts of depreciation
Capital maintenance concept: Capital here may mean the accountant’s concept of
capital which refers to equity holder (owner) investment in a firm or the
economist’s capital which refers to the resources of a firm. Adam Smith (1776),
defined income as that amount a person can consume without encroaching upon
capital fixed or circulating. However capital must be maintained before a
business entity earns income on that capital.
capital which refers to equity holder (owner) investment in a firm or the
economist’s capital which refers to the resources of a firm. Adam Smith (1776),
defined income as that amount a person can consume without encroaching upon
capital fixed or circulating. However capital must be maintained before a
business entity earns income on that capital.
A broader
concept of depreciation is that income emerges only if the invested capital at
the end of a period exceeds the invested capital at the beginning (assuming no
capital transactions or dividend payments during the period).
concept of depreciation is that income emerges only if the invested capital at
the end of a period exceeds the invested capital at the beginning (assuming no
capital transactions or dividend payments during the period).
This
assumes that it is the service potential or its equivalent in terms of the
original cost of services used that should be maintained.
assumes that it is the service potential or its equivalent in terms of the
original cost of services used that should be maintained.
The
advantages of the capital maintenance concept are that it permits the
recognition of changes in the value of the naira and the changes in specific
replacement values.
advantages of the capital maintenance concept are that it permits the
recognition of changes in the value of the naira and the changes in specific
replacement values.
The main
disadvantage of the capital maintenance concept is that it results in a failure
to permit a separation of operating income from extra ordinary gain and losses.
disadvantage of the capital maintenance concept is that it results in a failure
to permit a separation of operating income from extra ordinary gain and losses.
Allocation of current replacement cost
Depreciation
is presumed to present an allocation of current replacement costs, and the
current depreciation charge for a specific period is the current cost of the
services consumed in that period.
is presumed to present an allocation of current replacement costs, and the
current depreciation charge for a specific period is the current cost of the
services consumed in that period.
It should
however be noted that current replacement costs are more significant than
historical costs particularly when some significant event occurs in the
organization of the firm.
however be noted that current replacement costs are more significant than
historical costs particularly when some significant event occurs in the
organization of the firm.
The main
advantage of current replacement cost depreciation is that it permits a
matching of current costs against current revenues resulting in current net
operating concept of income.
advantage of current replacement cost depreciation is that it permits a
matching of current costs against current revenues resulting in current net
operating concept of income.
Decline in the current market price of the asset
Depreciation
is the decline in the current market price of the asset measured by the resale
price in a second hand market. The main advantage of this procedure is that it
avoids the need to make allocations and rely on subjective expectations.
is the decline in the current market price of the asset measured by the resale
price in a second hand market. The main advantage of this procedure is that it
avoids the need to make allocations and rely on subjective expectations.
However,
it too has some major disadvantages. In the case of non reducible durable, the
entre assets must be written of at the date of acquisition or some amortization
procedure must be used as substitute.
it too has some major disadvantages. In the case of non reducible durable, the
entre assets must be written of at the date of acquisition or some amortization
procedure must be used as substitute.
Depreciation as a process of matching costs with
expected benefits
expected benefits
In most discussions
of depreciation allocations, there is an assumption, explicit or implicit, that
the amount of the cost or rather basis of the asset allocated to each period
should represent the amount that is being matched with the expected revenues or
net revenue contribution of period. This matching of the input valuation with
the expected benefits can take the form of:
of depreciation allocations, there is an assumption, explicit or implicit, that
the amount of the cost or rather basis of the asset allocated to each period
should represent the amount that is being matched with the expected revenues or
net revenue contribution of period. This matching of the input valuation with
the expected benefits can take the form of:
(a) Time – adjusted depreciation which uses an
average internal rate of return during the entire life of the asset:
average internal rate of return during the entire life of the asset:
(b) Depreciation allocations that are
proportional to the net revenue contribution of each period: and
proportional to the net revenue contribution of each period: and
(c) Depreciation allocations that are in the
same relative proportion as a surrogate for net revenue contributions such a
measure of service provided by the asset.
same relative proportion as a surrogate for net revenue contributions such a
measure of service provided by the asset.
Methods for calculating depreciation
The
method which is chosen for calculating depreciation on a depreciation asset may
be based on the usage or contribution contemplated or on the passage of time.
Usually, the nature of the asset determines the appropriate method to be used.
method which is chosen for calculating depreciation on a depreciation asset may
be based on the usage or contribution contemplated or on the passage of time.
Usually, the nature of the asset determines the appropriate method to be used.
Statement
of accounting standard (SAS), No. 9 categorized depreciation methods into two:
of accounting standard (SAS), No. 9 categorized depreciation methods into two:
(a) Methods Based on Passage of Time
(b) Methods Based on the Level of Usage or
Output.
Output.
Methods based on passage of time
Some
depreciation methods based the passage of time are:
depreciation methods based the passage of time are:
(a) Straight – line.
(b) Decreasing charge
(i) Sum – of – the years-digit; (ii)
Reducing balance
Reducing balance
(c) Annuity and sinking fund.
Straight-line method
The
straighter-line method of allocation is based is based on the assumption that
depreciation is a function of time than of use. Obsolescence and deterioration
over time are considered to be determining factors in the decline in service
potential as opposed to physical wear and tear caused by use.
straighter-line method of allocation is based is based on the assumption that
depreciation is a function of time than of use. Obsolescence and deterioration
over time are considered to be determining factors in the decline in service
potential as opposed to physical wear and tear caused by use.
Under
this method, the depreciable value of an asset is allocated equally to
operations over the relevant years on the basis of the estimated useful
economic life of the asset. Thus the service potential of the asset assumed to
decline by an equal amount each period.
this method, the depreciable value of an asset is allocated equally to
operations over the relevant years on the basis of the estimated useful
economic life of the asset. Thus the service potential of the asset assumed to
decline by an equal amount each period.
The total
cost of the services used in any period is assumed to be the same regardless of
the extent of use.
cost of the services used in any period is assumed to be the same regardless of
the extent of use.
The
depreciation charge per year can determine using this formula:
depreciation charge per year can determine using this formula:
Example:
XYZ Company purchased as asset for
N13,000 with the intention of using it
for 5 years. It estimates that the trade-in-value of the automobile after that
time will beN1,000. The amount of
depreciation charge per year can be determined thus:
for 5 years. It estimates that the trade-in-value of the automobile after that
time will be
depreciation charge per year can be determined thus:
We should
note that the original cost of an asset less accumulated depreciation is often
referred to as the book value or the carry value of an asset. Book value is not
the same thing as the value of an asset in the open market referred to as
market value of an asset.
note that the original cost of an asset less accumulated depreciation is often
referred to as the book value or the carry value of an asset. Book value is not
the same thing as the value of an asset in the open market referred to as
market value of an asset.
The table
compares book values of an asset to its market value
compares book values of an asset to its market value
|
Original
Cost (a) |
Depreciation
to Date (b) |
Accumulated
depreciation (c) (a-b) (Book Value) |
Estimated
Market Value (d) |
1
|
|
|
|
|
2
|
13,000
|
4,800
|
8,200
|
6,200
|
3
|
13,000
|
7,200
|
5,800
|
3,800
|
4
|
13,000
|
9,600
|
3,400
|
2,200
|
5
|
13,000
|
12,00
|
1,000
|
1,000
|
The
estimated market values figure used are hypothetical. It is important to note
that it is only in the most indirect sense that it can be said that
depreciation account provides fund for the fund for the future replacement of
assets. This is true.
estimated market values figure used are hypothetical. It is important to note
that it is only in the most indirect sense that it can be said that
depreciation account provides fund for the fund for the future replacement of
assets. This is true.
Depreciation,
like other expenses, is deducted from revenues in order to calculate the annual
profit or income. To the extent it reduces income, it also reduces income
taxes. In so far as it reduces income
tax, it enables the firm to save for asset replacement; more cash than it would
if had not recorded depreciation.
like other expenses, is deducted from revenues in order to calculate the annual
profit or income. To the extent it reduces income, it also reduces income
taxes. In so far as it reduces income
tax, it enables the firm to save for asset replacement; more cash than it would
if had not recorded depreciation.
Decreasing Charge Methods:
(a) Sum-of-the years-digit method
Under
this method, a fraction of the assets net depreciable cost is charged off each
year.
this method, a fraction of the assets net depreciable cost is charged off each
year.
The
denominator of the fraction remains constant over the life of the asset. It is determined by taking a sum of numbers
starting with 1 and continuing to the estimated life of the asset.
denominator of the fraction remains constant over the life of the asset. It is determined by taking a sum of numbers
starting with 1 and continuing to the estimated life of the asset.
Thus if
life of an asset is 3 years, the denominator would be 1+2+3=6. If it were 5
years, it would be 1 + 2 + 3 + 5 = 15.
life of an asset is 3 years, the denominator would be 1+2+3=6. If it were 5
years, it would be 1 + 2 + 3 + 5 = 15.
A short
cut to this method be:
cut to this method be:
Example
A firm
purchases an automobile forN 13,000. It estimates that the automobile will have a useful life of 5
years, after which it can be sold forN 1,000. The net amount to be depreciated is N 12,000, that is, original cost less estimated salvage value.
Depreciation charges using the sum of the year’s digits method would be as
follows:
purchases an automobile for
years, after which it can be sold for
Depreciation charges using the sum of the year’s digits method would be as
follows:
Yr
|
Net
Depreciation amount |
Depreciation
Fraction |
Depreciation
Charges |
1
|
12,000
|
5/15
|
4,000
|
2
|
12,000
|
4/15
|
3,200
|
3
|
12,000
|
3/15
|
2,400
|
4
|
12,000
|
2/15
|
1,600
|
5
|
12,000
|
1/15
|
800
|
Sum of the
year’s digit method is used to allocate the cost of an asset to various period
during which the asset will be used.
year’s digit method is used to allocate the cost of an asset to various period
during which the asset will be used.
The use of the
method results in depreciation charges which decline over the life of the
asset. That is, depreciation expenses are greater in the beginning of the years
of the asset life than they are at the end.
method results in depreciation charges which decline over the life of the
asset. That is, depreciation expenses are greater in the beginning of the years
of the asset life than they are at the end.
The basic
journal entry to record depreciation using the sum of the years digit method
is;
journal entry to record depreciation using the sum of the years digit method
is;
Dr
Cr
Cr
Depreciation
Expenses 4,000
Expenses 4,000
Accumulated
depreciation 4,000
depreciation 4,000
To record depreciation charge for
the first year using sum of years
digit (SYD) method.
(ii) Reducing
balance method:
balance method:
This
method applies a constant rate to a declining net book value of asset (original
cost less accumulated depreciation to data). The percentage rate may not equal
twice the straight line rate.
method applies a constant rate to a declining net book value of asset (original
cost less accumulated depreciation to data). The percentage rate may not equal
twice the straight line rate.
In the straight line method depreciation in which the asset has a useful
life of 5
Example
Assume an asset to be considered cost N 13,000 and has a useful life of five years and an
estimated salvage value ofN 1,000. Depreciation charges on yearly basis using the reducing balance
method may be based on a rate of 40%, that is, twice the straight-line rate of
20%. The below illustrates the calculation process.
estimated salvage value of
method may be based on a rate of 40%, that is, twice the straight-line rate of
20%. The below illustrates the calculation process.
Yr
|
Accumulated
depreciation (Book Value) |
Depreciation
Rate (%) |
Depreciation
Expenses |
Remaining
Book Value |
1
|
|
40%
|
|
|
2
|
7,800
|
40%
|
3,120
|
4,680
|
3
|
4,680
|
40%
|
1,872
|
2,808
|
4
|
2,808
|
40%
|
1,123
|
1,685
|
5
|
1,685
|
40%
|
674
|
1,011
|
The reducing
method does not automatically assure that assets will be depreciated exactly
down to the salvage value.
method does not automatically assure that assets will be depreciated exactly
down to the salvage value.
At the end of
the 5th year, the book value would beN 1,011 more than the estimated salvage value of N 1,000.
the 5th year, the book value would be
To the extent
that the firm continues to hold on to the asset beyond its original estimated
five year life, than the additionalN 11 depreciation would be taken in the 6th years.
that the firm continues to hold on to the asset beyond its original estimated
five year life, than the additional
In some cases,
examiners may require candidates to determine the depreciation rate when using
the reducing balance method.
examiners may require candidates to determine the depreciation rate when using
the reducing balance method.
If this
situation arises, a mathematical formula can be applied to calculate the
percentage of the salvage value, cost of the asset and the useful life of the
asset can be ascertained.
situation arises, a mathematical formula can be applied to calculate the
percentage of the salvage value, cost of the asset and the useful life of the
asset can be ascertained.
The formula is
given by:
given by:
Observations pertaining to the Accelerated
Depreciation methods:
Depreciation methods:
Some
accountants argue that the decreasing charge methods are preferable to the
straight line method since they tend to result in book values that more closely
approximate market values. The values of many assets like cars decline by
greater amounts in the years of their lives than later years.
accountants argue that the decreasing charge methods are preferable to the
straight line method since they tend to result in book values that more closely
approximate market values. The values of many assets like cars decline by
greater amounts in the years of their lives than later years.
Others
maintain that assets often provide greater services to the firm in their
early years than they do in their later years. The productivity of many assets
decrease with time as they operate less efficiently, require more maintenance,
and are out of service for greater periods of time. This is consistent with the
basis accounting concept of matching costs with related revenue.
maintain that assets often provide greater services to the firm in their
early years than they do in their later years. The productivity of many assets
decrease with time as they operate less efficiently, require more maintenance,
and are out of service for greater periods of time. This is consistent with the
basis accounting concept of matching costs with related revenue.
However, the
two methods of depreciation have received wide acceptance primarily because
they provide an expedient and easily applied means for attaining a decreasing
annual charge.
two methods of depreciation have received wide acceptance primarily because
they provide an expedient and easily applied means for attaining a decreasing
annual charge.
Annuity method
By this
method, it is assumed that the capital sunk in the purchase of an asset might,
if otherwise expended, have earned a certain rate of interest.
method, it is assumed that the capital sunk in the purchase of an asset might,
if otherwise expended, have earned a certain rate of interest.
Interest on
the diminishing balance is accordingly debited to the account of the asset, and
a fixed annual charge for depreciation is credited thereto, the balance of the
account being completely extinguished (or reduced to scrap value) at the end of
life of the asset.
the diminishing balance is accordingly debited to the account of the asset, and
a fixed annual charge for depreciation is credited thereto, the balance of the
account being completely extinguished (or reduced to scrap value) at the end of
life of the asset.
Sinking fund method
In this
method, annual charges for depreciation are ascertained from interest tables is
debited to the Profit and Loss Account, and credited to “Depreciation Sinking
Fund Account”.
method, annual charges for depreciation are ascertained from interest tables is
debited to the Profit and Loss Account, and credited to “Depreciation Sinking
Fund Account”.
An equivalent
amount is withdrawn from cash and invested in gilt-edged securities, the
interest thereon as and when received being credited to the Depreciation
Sinking Fund and invested with the nest installment.
amount is withdrawn from cash and invested in gilt-edged securities, the
interest thereon as and when received being credited to the Depreciation
Sinking Fund and invested with the nest installment.
Under this
method, the asset remains at the original cost in the Balance Sheet while
Depreciation Sinking Fund is shown on the liabilities side of the Balance Sheet
and the Investment Account as an asset.
method, the asset remains at the original cost in the Balance Sheet while
Depreciation Sinking Fund is shown on the liabilities side of the Balance Sheet
and the Investment Account as an asset.
Sinking Fund
is normally introduced in a firm to cost of assets that are very costly. At the
end of every year, the profit and loss account is debited with the appropriate
annual charge for depreciation while the depreciation and account is credited.
The most relevant argument for the sinking fund method is that it permits
public utility to earn a constant rate of return on its total investment when
its revenue is held constant through regulation.
is normally introduced in a firm to cost of assets that are very costly. At the
end of every year, the profit and loss account is debited with the appropriate
annual charge for depreciation while the depreciation and account is credited.
The most relevant argument for the sinking fund method is that it permits
public utility to earn a constant rate of return on its total investment when
its revenue is held constant through regulation.
Observation pertaining to annuity and sinking fund
method
method
The two methods
regard each item of property, plant and equipment as an investment that is
expected to generate cash in-flows and make a rate of return equal to or
greater than the internal rate of return of the reporting enterprise.
regard each item of property, plant and equipment as an investment that is
expected to generate cash in-flows and make a rate of return equal to or
greater than the internal rate of return of the reporting enterprise.
Under each
method, depreciation is equal to the excess of the cash in flow for the period
over the return on the book value using the internal rate of return. These two
methods are rarely used in practice.
method, depreciation is equal to the excess of the cash in flow for the period
over the return on the book value using the internal rate of return. These two
methods are rarely used in practice.
Methods based on the Level of Usage or Output:
Some depreciation methods based on the level of
usage or output are:
usage or output are:
(a) Service-hour; and
(b) Productive output
Service-hour method
Under this
method, the life span of the depreciable asset is determined by the total
number of hours it can be used in producing goods and services. The depreciable
amount of the asset is divided by the estimated total service hours to obtain
an hourly depreciation rate which is then applied to the total hours of use
during the period.
method, the life span of the depreciable asset is determined by the total
number of hours it can be used in producing goods and services. The depreciable
amount of the asset is divided by the estimated total service hours to obtain
an hourly depreciation rate which is then applied to the total hours of use
during the period.
Productive output or units of output method
Under this
method, the life span of the depreciable asset is estimated in terms of the
total number of units it could produce. The depreciable amount of the asset is
divided by the estimated total number of units to obtain depreciation expense
for the period.
method, the life span of the depreciable asset is estimated in terms of the
total number of units it could produce. The depreciable amount of the asset is
divided by the estimated total number of units to obtain depreciation expense
for the period.
For example,
the useful life of a car can be expressed as 100,000 kilometers. The cost of
the asset is then allocated to each period in proportion to the amount of
service actually consumed.
the useful life of a car can be expressed as 100,000 kilometers. The cost of
the asset is then allocated to each period in proportion to the amount of
service actually consumed.
Example
Assume again
that an automobile costN13,000 but the firm has a policy of using the automobile for 100,000
kilometer and then selling them regardless of how many an years an automobile
has actually been in serve. The company estimates that after many kilometers,
the resale value is approximatelyN 1,000.
that an automobile cost
kilometer and then selling them regardless of how many an years an automobile
has actually been in serve. The company estimates that after many kilometers,
the resale value is approximately
The following
schedule indicates the actual number of kilometers driven in each year and the
applicable depreciation charge.
schedule indicates the actual number of kilometers driven in each year and the
applicable depreciation charge.
Alternatively:
Yr
|
Kilometer
Driven |
Depreciation
Charge Per Kilometer |
Depreciation
Charge Expenses |
1
|
25,000
|
0.12
|
0.12 x
25,000 = 3,000 |
2
|
17,000
|
0.12
|
0.12 x
17,000 = 2,040 |
3
|
18,000
|
0.12
|
0.12 x
18,000 = 2,160 |
4
|
26,000
|
0.12
|
0.12 x
26,000 = 3, 120 |
5
|
14,000
|
0.12
|
0.12 x
14,000 = 1,680 |
|
100,000
|
|
= 12,000
|
In so far as
units of service provided by an asset can be related to the revenue produced by
asset, the unit-charge method provides a much better match of costs with
related revenue than do the other depreciation methods.
units of service provided by an asset can be related to the revenue produced by
asset, the unit-charge method provides a much better match of costs with
related revenue than do the other depreciation methods.
As an asset
productivity increase, so also does the percentage of the asset cost charge off
as an expense.
productivity increase, so also does the percentage of the asset cost charge off
as an expense.
Unit of output
methods of depreciation however, are not widely in use. Their back of
acceptance can be attributed to difficulties of application.
methods of depreciation however, are not widely in use. Their back of
acceptance can be attributed to difficulties of application.
Change in depreciation rate
A charge in
depreciation rate may be made by an enterprise due to new information about the
actual useful life of such as asset. Such a change is usually considered as a
change in an accounting estimate. Accordingly, no restatement of the
depreciation charge in the prior periods is required.
depreciation rate may be made by an enterprise due to new information about the
actual useful life of such as asset. Such a change is usually considered as a
change in an accounting estimate. Accordingly, no restatement of the
depreciation charge in the prior periods is required.
A change from one depreciation method to another
A change from
one depreciation method to another may be necessitated by the desire to show
better the ’true and fair’ view of an enterprise. Such a change is usually
considered a change in an accounting policy and should be treated in accordance
with the provisions of SAS I Disclosure of Accounting Policies, and SAS 6,
Extraordinary Item and Prior Year Adjustments.
one depreciation method to another may be necessitated by the desire to show
better the ’true and fair’ view of an enterprise. Such a change is usually
considered a change in an accounting policy and should be treated in accordance
with the provisions of SAS I Disclosure of Accounting Policies, and SAS 6,
Extraordinary Item and Prior Year Adjustments.
Accounting for depreciation
In accounting
for depreciation, the following points should be borne in mind.
for depreciation, the following points should be borne in mind.
(a) The depreciable value of an item of
property, plant or equipment should be either the historical cost or the
revalued amount computed in accordance with SAS 3 and SAS 9.
property, plant or equipment should be either the historical cost or the
revalued amount computed in accordance with SAS 3 and SAS 9.
(b) The useful economic life over which the
allocation of the depreciable value place should be determined after
consideration of:
allocation of the depreciable value place should be determined after
consideration of:
(i) Expected physical wear and tear due to
usage;
usage;
(ii) Obsolescence
due to changes in technology, production
due to changes in technology, production
requirements
or consumer taste; and
or consumer taste; and
(iii) Legal or other restrictions
placed on the asset, for example, by a lesser or government.
placed on the asset, for example, by a lesser or government.
(c) Several methods for
calculating depreciation are available. The method that is selected by an
enterprise should reflect the characteristics of the asset, its intended use
and the practices in the industry in which the enterprise operates. The only
methods that currently meet these requirements are the straight-line Reducing
Balance methods.
calculating depreciation are available. The method that is selected by an
enterprise should reflect the characteristics of the asset, its intended use
and the practices in the industry in which the enterprise operates. The only
methods that currently meet these requirements are the straight-line Reducing
Balance methods.
(d) Where a group of assets is
depreciated as though it were a single asset, effort should be made to ensure
that the applicable rate is representative, consistently applied and constantly
reviewed to reflect internal changes in the group.
depreciated as though it were a single asset, effort should be made to ensure
that the applicable rate is representative, consistently applied and constantly
reviewed to reflect internal changes in the group.
(e) Where an item of property,
plant and equipment is revalued, the previously determined depreciation rate or
an appropriately adjusted rate should not be charged partly to income and
partly against revaluation surplus on the basis of a prorate allocation between
the historical cost of the item and the surplus which arose on its revaluation.
plant and equipment is revalued, the previously determined depreciation rate or
an appropriately adjusted rate should not be charged partly to income and
partly against revaluation surplus on the basis of a prorate allocation between
the historical cost of the item and the surplus which arose on its revaluation.
(f) A piece of property
qualifies to be treated as an investment property if it is not occupied
substantially for use in the operations of an enterprise. According to SAS 9,
an occupation of more than 15% of the property should be considered
substantial.
qualifies to be treated as an investment property if it is not occupied
substantially for use in the operations of an enterprise. According to SAS 9,
an occupation of more than 15% of the property should be considered
substantial.
(g) When on a revaluation there
is an increase over original cost in the carrying amount of a depreciable asset
or an investment property, an enterprise should take the increase to Capital
Reserve as a revaluation surplus.
is an increase over original cost in the carrying amount of a depreciable asset
or an investment property, an enterprise should take the increase to Capital
Reserve as a revaluation surplus.
Provided that the
surplus had not been earlier reversed or utilized, any subsequent decrease on a
revaluation of the same asset should be charged against the revaluation
surplus. In case where the decrease is more than the previous increase, the
difference should be charge to income, either through the charging of
depreciation or arising from a revaluation should be credited to income to the
extent that it offsets the previously recorded decrease.
surplus had not been earlier reversed or utilized, any subsequent decrease on a
revaluation of the same asset should be charged against the revaluation
surplus. In case where the decrease is more than the previous increase, the
difference should be charge to income, either through the charging of
depreciation or arising from a revaluation should be credited to income to the
extent that it offsets the previously recorded decrease.
(h) When a price of property is
reclassified as an investment property and it is decided to be accounted for as
such, the property should be removed from its group of depreciable assets. The
accumulated depreciation on it to the extent that it is no longer required,
should be taken to the Profit and Loss Account. Any related revaluation surplus
should not be transferred to income or retained earning but should be
transferred to Capital Reserve.
reclassified as an investment property and it is decided to be accounted for as
such, the property should be removed from its group of depreciable assets. The
accumulated depreciation on it to the extent that it is no longer required,
should be taken to the Profit and Loss Account. Any related revaluation surplus
should not be transferred to income or retained earning but should be
transferred to Capital Reserve.
Depreciation accounting entries
To present a
true and fair view of the financial position of a firm, proper records must be
made in the firms’ books. This includes matching the costs for a particular
period. Thus depreciation charge for a period is charge against the revenue for
that period. Also to present a balance sheet, the net assets must be
determined. Net assets represent costs of the assets less their accumulated
depreciations.
true and fair view of the financial position of a firm, proper records must be
made in the firms’ books. This includes matching the costs for a particular
period. Thus depreciation charge for a period is charge against the revenue for
that period. Also to present a balance sheet, the net assets must be
determined. Net assets represent costs of the assets less their accumulated
depreciations.
To illustrate
this, let us assume that a firm bought plant and machinery worth 20,000 and
having an estimated useful life of 5 years. The estimated salvage value is put
atN 1,000. We can
use the straight line method of depreciation to show the basis entries in the
concerned accounts as follows:
this, let us assume that a firm bought plant and machinery worth 20,000 and
having an estimated useful life of 5 years. The estimated salvage value is put
at
use the straight line method of depreciation to show the basis entries in the
concerned accounts as follows:
Depreciation Account
Yr
|
Accumulated
Depreciation |
|
Yr
|
P & LA/c
|
|
1
|
3,800
|
1
|
3,800
|
||
2
|
Accumulated
Depreciation |
3,800
|
2
|
P & LA/c
|
3,800
|
3
|
Accumulated
Depreciation |
3,800
|
3
|
P & LA/c
|
3,800
|
4
|
Accumulated
Depreciation |
3,800
|
4
|
P & LA/c
|
3,800
|
5
|
Accumulated
Depreciation |
3,800
|
4
|
P & LA/c
|
3,800
|
Accumulated Depreciation Account
Yr 5
|
|
|
Yr
|
|
|
Dec. 31
|
Plant and
Machinery |
19,000
|
1
2
3
4
5
|
Depreciation
Depreciation
Depreciation
Depreciation
Depreciation
|
3,800
3,800
3,800
3,800
3,800
|
|
|
19,000 |
|
|
19,000
|
Let us assume
that the asset was sold forN 1,200 at the fifth year
that the asset was sold for
Plant and Machinery Account
Year 1
|
|
|
Yr. 5
|
|
|
Jan. 1
|
Cash
Gain on
sale
|
20.000
200
20,000
|
Dec. 31
|
Accumulated Depreciation
Cash
|
19,000
1,200
20,200
|
Gain on Sale of Plant and Machinery A/C
Yr. 5 Dec
|
|
|
YR. 5 Dec 31
|
|
|
31
|
P & LA/c
|
200
|
|
Plant &
Machinery |
200
|
Profit and Loss Account
Dr Cr
|
|
|
|
|
|
Yr. 1
Yr. 2
Yr. 3
Yr. 4
Yr. 5
|
Depreciation
Depreciation
Depreciation
Depreciation
Depreciation
|
3,800
3,800
3,800
3,800
3,800
|
Yr.5
|
Gain on Sale
of Sale |
200
|
Balance sheet, Dec. 31
Yr. 1 Plant and Machinery 20,000
Less
Accumulated
Accumulated
Depreciation
3,800 16,200
3,800 16,200
Yr. 2 Plant and Machinery 20,00
Less
Accumulated
Accumulated
Depreciation
7,600 12, 400
7,600 12, 400
Yr. 3 Plant and Machinery 20,000
Less
Accumulated
Accumulated
Depreciation 11,400 8,600
Yr. 4 Plant and Machinery 20,000
Less
Accumulated
Accumulated
Depreciation 15,200 4,800
Yr. 5 Plant and Machinery 20,000
Less Accumulated
Depreciation 19,000 1,000
Disclosure requirements
A reporting
enterprise should state its accounting policy with respect to depreciation.
enterprise should state its accounting policy with respect to depreciation.
In addition to
the disclosure requirements of SAS 2,
Information TO BE DISCLOSED IN FINANCIAL
STATEMENT, and SAS 3. Accounting for property, plant and Equipment,
the following disclosure are to be made in the Notes to the Accounts:
the disclosure requirements of SAS 2,
Information TO BE DISCLOSED IN FINANCIAL
STATEMENT, and SAS 3. Accounting for property, plant and Equipment,
the following disclosure are to be made in the Notes to the Accounts:
(a) The amount charged as depreciation during
the period
the period
(b) The effect of any change in depreciation
rate on the operating result of the period;
rate on the operating result of the period;
(c) Method or methods used in computing
depreciation in the period.
depreciation in the period.
(d) The accumulated depreciation for each
category or group of assets held by an enterprise; and
category or group of assets held by an enterprise; and
(e) The book value and the amount that would
otherwise have been charge by way of depreciation on any item of property,
plant or equipment reclassified during the accounting period as an investment
property.
otherwise have been charge by way of depreciation on any item of property,
plant or equipment reclassified during the accounting period as an investment
property.
Conclusion
Depreciation
represents an estimate of the period of the historical cost or revalued amount
of fixed assets chargeable to operation during an accounting period. In
determining deprecation, cognizance is usually taken of the wear and tear on an
asset resulting from use, affluxion of time or obsolescence dictated by changes
in technology and market forces.
represents an estimate of the period of the historical cost or revalued amount
of fixed assets chargeable to operation during an accounting period. In
determining deprecation, cognizance is usually taken of the wear and tear on an
asset resulting from use, affluxion of time or obsolescence dictated by changes
in technology and market forces.
To make sure
that the relevant cost for a period is charged against revenue for a period,
depreciation is chargeable to operations irrespective of any appreciation in
the value of the asset that may have occurred during the accounting period.
that the relevant cost for a period is charged against revenue for a period,
depreciation is chargeable to operations irrespective of any appreciation in
the value of the asset that may have occurred during the accounting period.
There are
several concepts and methods of depreciation used in firms. The method that is
selected by a firm should reflect the characteristics of the asset. It intended
used and the practice in the industry in which the enterprise operate.
several concepts and methods of depreciation used in firms. The method that is
selected by a firm should reflect the characteristics of the asset. It intended
used and the practice in the industry in which the enterprise operate.
The SAS 9 and
IAS 4 provide minimum requirements of depreciation accounting.
IAS 4 provide minimum requirements of depreciation accounting.