Week 5 Depreciation of fixed assets

1. Week 5 Depreciation of fixed assets

2. Chapter 11 Depreciation of fixed assets

3. After this lecture students should be able to: • Distinguished between capital expenditure and revenue expenditure; • Describe the nature, recognition and valuation of fixed assets ; • Discuss the nature of depreciation and compute the amount of depreciation using the straight line, reducing balance and sum of the years’ digits the methods; • Enter the relevant entries in the journal, ledger, profit and loss account and balance sheet.

4. EXPENDITURE On fixed assets. e.g. machinery, buildings, cars, etc. On goods for resale and overheads CAPITAL EXPENDITURE REVENUE EXPENDITURE To balance sheet Revenue and Capital Expenditure To profit and loss account

5. Capital Expenditure • Capital expenditure is incurred when a business spends money either to buy fixed assets or add to the value of an existing fixed assets. • Including in such amounts should be total amount of money spent on 1) acquiring the fixed assets 2) delivery cost to bring the asset to the business 3) legal cost spent on acquiring the asset 4) installation cost and 5) any cost needed to get the fixed asset ready for use.

6. Revenue Expenditure • Revenue expenditure is all items incurred in the day-to-day revenue earning activities of the business and whose value will be completely used up within an accounting period.

7. Example 1 • The following example illustrates the difference between capital and revenue expenditure. • Adopted from “Business Accounting 1” of Frank Wood, Prentice Hall 2005

8. Expenditure Buying van Petrol cost for van Repairs to van Putting extra headlights on van Buying machinery Electricity cost of using machinery Painting outside of new building Repainting outside of building in (8) three years later Type of Expenditure Capital Revenue Revenue Capital Capital Revenue Capital Revenue Difference between capital and revenue expenditure

9. THE NATURE OF FIXED ASSETS Fixed assets are items not specifically bought for resale but to be used in the production or distribution of those goods normally sold by the business. They are durable goods that usually last for several years, and are normally kept by a business for more than one year. A fixed asset must also be expected to generate revenue over a number of future years, and be of a material amount. Referred to as capital expenditure. All other costs are revenue expenditure.

10. THE CLASSIFICATION OF FIXED ASSETS • Tangible– ‘assets that have physical substance and are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes on a continuing basis in the reporting entity’s activities.’ • Intangible – ‘non-financial fixed assets that do not have physical substance but are identifiable and are controlled by the entity through custody or legal rights.’ • Investments– held on a long-term basis (i.e. for more than one year).

11. TYPES OF FIXED ASSETS • Tangible – land & buildings; plant & machinery; motor vehicles; furniture, fixtures & fittings; office equipment; loose tools. • Intangible – goodwill, patents, trade marks, development expenditure.

12. THE VALUATION OF FIXED ASSETS In historical cost accounting fixed assets are valued at their historical cost less the accumulated / provision for / aggregate / depreciation from the date of acquisition to the date of the balance sheet. This is known as the written down value (WDV), net book value (NBV), or net carrying amount (NCA).

13. The Valuation of Fixed Assets: WDV NBV = Cost – Accumulated Dep’n NCA ( Provision for Dep’n) (Aggregate Dep’n)

14. The historical cost of fixed assets can include: • legal expenses, extensions and improvements, as in the case of buildings, but not repairs and renewals; • delivery charges and installation expenses, as in the case of plant and machinery. The historical cost of fixed assets must exclude: • the costs of any extended warranty, maintenance agreement and replacement/spare parts where these have been included in the invoice price of, for example, machinery or vehicles; • any road tax and fuel included in the invoice price of a vehicle.

15. THE NATURE OF DEPRECIATION Depreciation is the allocation of the cost of a fixed asset over the accounting periods that comprise its useful economic life to the business according to some criterion regarding the amount which is ‘used up’ or ‘consumed’ in each of these periods.

16. THE NATURE OF DEPRECIATION Depreciation is ‘the measure of the cost or revalued amount of the economic benefits of the tangible fixed asset 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 fixed asset whether arising from use, effluxion of time or obsolescence through either changes in technology or demand for the goods and services produced by the asset.’

17. THE ESSENTIAL DATA TOCOMPUTE DEPRECIATION • Historical cost. 2. The length of the asset’s expected useful economic life to the business. 3. The estimated residual value of the asset at the end of its useful economic life.

18. THE STRAIGHT LINE METHOD The annual depreciation expense/charge to the profit & loss account = • ___Cost – Residual value____ Useful economic life (in years) , or • Given percentage rate x Historical cost This gives the same amount of depreciation in each year of the assets useful economic life.

19. THE DIMINISHING/REDUCINGBALANCE METHOD The annual depreciation expense/charge to the profit & loss account = Depreciation Rate x WDV at the start of the year This gives a decreasing annual amount of depreciation over the assets useful life.

20. THE SUM-OF-THE-YEARS DIGITS METHOD The annual depreciation expense/charge to the profit & loss account = Years of remaining useful life at start of year x Depreciable * Sum-of-the-years-digits amount This gives a decreasing annual amount of depreciation over the assets useful life. (*Depreciable amount = cost – estimated residual value)

21. EXAMPLE 11.1COMPUTATION OF DEPRECIATION Plant and machinery that was bought on the 1 January 20X1 at a cost of $1,000, has an expected useful economic life of 3 years, and an estimated residual value of $343. 1. Straight line method: ($1,000 - $343)  3 = $219 p.a. • Reducing balance method, assuming deprecation rate used is 30%: 20X1: 30% x $1,000 = $300 20X2: 30% x ($1,000 - $300) = $210 20X3: 30% x ($1,000 – [$300 + $210]) = $147

22. Sum-of-the-years-digits method: Depreciable amount = $(1000 – 343) = $657 Sum-of-the-years-digits = 3+2+1 = 6 Annual depreciation: For 20X1: 3/6 x $657 = $329 For 20X2: 2/6 x $657 = $219 For 20X3: 1/6 x $657 = $109

23. THE LEDGER ENTRIESFOR ANNUAL DEPRECIATION DebitDepreciation expense account Credit Provision for depreciation account Debit Profit & loss account Credit Depreciation expense account These are usually shortened to: Debit Profit & loss account Credit Provision for depreciation account

24. EXAMPLE 11.1LEDGER ENTRIES FOR DEPRECIATION P & L Extract ( Depreciation) X1, X2, X3 .. Expenses: Provision for Depreciation 219

25. EXAMPLE 11.1LEDGER ENTRIES FOR DEPRECIATION

26. EXAMPLE 11.1BALANCE SHEET EXTRACT FOR THEPROVISION FOR DEPRECIATION Balance sheet as at 31 December 20X1 20X2 20X3 $ $ $ Fixed assets: Plant & machinery at cost 1,000 1,000 1,000 Less: accumulated depreciation 219438657 Written down value 781 562 343

27. THE LEDGER ENTRIES FORDISPOSALS OF FIXED ASSETS Profit on sale = Proceeds of sale > WDV Loss on sale = Proceeds of sale < WDV Ledger entries • Proceeds of sale: Debit Cash /Bank (new asset a/c if exchange) Credit Asset Disposal • Cost of the asset at disposal: Debit Asset Disposal Credit Fixed Asset

28. Accumulated depreciation on disposal: • Debit Provision for Depreciation • Credit Asset Disposal • 4. Profit on sale: • Debit Asset Disposal • Credit Profit & Loss , OR • 5. Loss on sale: • Debit Profit & Loss • Credit Asset Disposal Closing Entries

29. EXAMPLE 11.1PROFIT ON DISPOSAL The plant & machinery was sold on the 31 December 20X3 for $400. WDV = $1,000 - $657 = $343 Profit on sale = $400 - $343 = $57

30. EXAMPLE 11.1LEDGER ENTRIES FOR DISPOSAL Profit & loss account Extract Other income: Profit on sale of plant 57

31. EXAMPLE 11.1LEDGER ENTRIES FOR DISPOSAL

32. PARTIAL YEAR DEPRECIATION When a fixed asset is bought or sold part way through an accounting year, the depreciation expense is computed either: • on a strict time basis – • in the year of acquisition, from the date of purchase to the end of that accounting year, and • in the year of disposal, from the start of the accounting year to the date of sale; or • if the date of acquisition or disposal is not given- • a full years charge in the year of purchase, and • none in the year of sale.

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