Topic 4: Depreciation

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1 Topic 4: Depreciation Depreciation accounting A method must be found of spreading the cost of the asset over its useful life The accruals concept states that the costs incurred in a period should be matched with the income produced in the same period. Definition: Depreciation is the measure of the cost of the economic benefits of the tangible on-current assets that have been consumed during the period. Consumption includes the wearing out, using up or other reduction in the useful economic life of a tangible non-current asset whether arising from use, time or obsolescence through either changes in technology or demand for the goods and services produced by the assets. AAT L3 AP 42

2 Terminology Useful economic life Useful life is either: The period which a depreciable asset is expected to be used by the enterprise; or The number of production or similar units expected to be obtained from the asset by the enterprise Should be reviewed at least annually The assessment of useful life requires judgement Estimated residual value The estimated residual value is the net amount which the entity expects to obtain for an assets at the end of its useful life after deducting the expected costs of disposal Carrying value Cost Less accumulated depreciation () Carrying value AAT L3 AP 43

3 Depreciation methods Depreciation is a means of spreading the cost of a non-current asset over its useful life, in order to match the cost of the asset with the profits it earns for the business The straight line method The annual depreciation charge is calculated as: Cost of asset residual value Expected useful life of asset A non-current asset costing 20,000 with an estimated life of 10 years and no residual value would be depreciated at the rate of: A non-current asset costing 60,000 has an estimated life of 5 years and a residual value of 7,000. The annual depreciation charge using the straight line method would be: AAT L3 AP 44

4 The diminishing (reducing) balance method The reduced balance method of depreciation calculates the annual depreciation charge as a fixed percentage of the carrying amount of the asset, as at the end of the previous accounting period. A non-current asset costing $10,000 with an estimated life of 10 years and an estimated residual value of $2,160. The business uses the reducing balance method to depreciate the asset, and calculates that the rate of depreciation should be 40% of the reducing (carrying) amount of the asset. AAT L3 AP 45

5 Apply Your Knowledge 1 A lorry bought for a business cost 17,000. It is expected to last for five years and then be sold for scrap for 2,000. Required Work out the depreciation to be charge each year under: A. The straight line method B. The reducing balance method (using a rate of 35%) AAT L3 AP 46

6 Assets acquired part-way through an accounting period It is reasonable to charge an amount for depreciation only from the date that the business has owned the asset, which might be part-way through an accounting period. Pro rata calculations for the straight line method of deprecation will be required if the company policy states that to be the case. Pro rata is not applicable for the diminishing balance method. There are two methods of expressing a depreciation policy. 1. Calculations on a monthly basis The policy may state that depreciation is to be charged on a monthly basis. Apply Your Knowledge 2 A business which has an accounting year which runs from 1 January to 31 December purchases a new non-current asset on 1 April 2013, at a cost of 24,000. The expected life of the asset is 4 years, and its residual value is nil. What should be the depreciation charge for 2013? AAT L3 AP 47

7 2. Acquisition and disposal policy The policy states A full year s depreciation is charged in the year of acquisition and none in the year of disposal. Apply Your Knowledge 3 A business purchased a motor van on the 7 th August 203 at a cost of 12,640. The depreciation rate straight line using an expected useful economic life of five years and estimated residual value of zero. Depreciation is charged with a full year s depreciation in the year of purchase and none in the year of sale. The business has a year-end of 30 th November. What is the carrying value of the motor van at the 30 th November 204? Kaplan example Activity 7 AAT L3 AP 48

8 Accounting treatment DEBIT Depreciation expense (income statement) CREDIT Accumulated depreciation account (statement of financial position) With the depreciation charge for the period Extract of the profit and loss STATEMENT OF PROFIT AND LOSS FOR THE YEAR ENDED 31 DECEMBER 203 Sales Less Cost of goods sold Inventory/stock, at cost on 1 January 203 ( opening inventory/stock ) $ $ $ Add Purchases of goods Less Inventory/stock, at cost on 31 December 203 ( closing inventory/stock ) () Gross profit Sundry income Discounts received Commission receivable Rent receivable Less Administrative expenses Rent Lighting and heating Telephone Postage Insurance Stationery Office salaries Depreciation Accountancy and audit fees Bank charges and interest Doubtful debts Distribution costs Delivery costs Van running expenses Van depreciation Advertising Discounts allowed Net profit () () () AAT L3 AP 49

9 THE STATEMENT OF FINANCIAL POSITION: FOR THE YEAR ENDED 31 DECEMBER 203 Assets $ $ $ Non-current assets Cost Accumulated Depreciation Carrying Value Buildings () Plant and machinery () Office equipment () Current assets Inventory/stock Receivables/debtors Less Allowances for doubtful debts () Cash Capital Capital Profit Less: drawings () Non-current/deferred liabilities Bank loan Current liabilities Trade payables/creditors Total capital and liabilities AAT L3 AP 50

10 Disclosure note IAS 16 requires a reconciliation of the opening and closing carrying amounts of non-current assets to be given in the financial statements. Total Land and buildings Plant and equipments Cost or valuation At 1 January 204 Revaluation surplus Additions in year Disposals in year () () () At 31 December 204 Depreciation At 1 January 204 Charge for year Eliminated on disposal () () () At 31 December 204 Carrying amount At 31 December 204 At 1 January 204 AAT L3 AP 51

11 Apply Your Knowledge 4 Paul Pox set up his own online business. He purchased a computer system on credit from a manufacturer, at a cost of 16,000. The system has an expected life of three years and a residual value of 2,500. Required Show the ledger accounts for each year of the asset s life and extracts from the statement of profit or loss (income statements) and statements of financial position. AAT L3 AP 52

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13 Apply Your Knowledge 5 ABC Co owns the following assets as at 31 December 206: Plant and machinery 5,000 Office furniture 800 Depreciation is to be provided as follows: Plant and machinery 20% reducing-balance method Office furniture 25% on cost per year, straight line method. The plant and machinery was purchased on the 1 st January 204 and the office furniture on the 1 st January 205. Required Show the ledger accounts for each year of the asset s life and extracts from the statement of profit or loss (income statements) and statements of financial position. Prepare a fixed asset register Kaplan example Activity 5 AAT L3 AP 53

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