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Lect 11a Depreciation (Part 1)

1) Depreciation is the allocation of the cost of a tangible asset over its useful life. It reflects the decline in value due to wear and tear, obsolescence, or age. 2) There are several methods to calculate depreciation including straight-line, reducing balance, and machine hour methods. The choice of method depends on how the asset's benefits are expected to be realized over time. 3) Accumulated depreciation is a contra-asset account that tracks the total depreciation recorded on an asset to date. It has a credit balance that increases with each period's depreciation expense.

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90 views18 pages

Lect 11a Depreciation (Part 1)

1) Depreciation is the allocation of the cost of a tangible asset over its useful life. It reflects the decline in value due to wear and tear, obsolescence, or age. 2) There are several methods to calculate depreciation including straight-line, reducing balance, and machine hour methods. The choice of method depends on how the asset's benefits are expected to be realized over time. 3) Accumulated depreciation is a contra-asset account that tracks the total depreciation recorded on an asset to date. It has a credit balance that increases with each period's depreciation expense.

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11Co sarah
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Lecture 11a

Depreciation (IAS 16) (Part 1):


Nature and Calculations
Objectives
 You should be able to:
 Define depreciation and why depreciation is
required.
 Learn the causes of depreciation
 Calculate depreciation using the straight line,
reducing balance, revaluation and machine hour
method
Introduction
 Nature of non-current assets:
 Long life
 Bought to be used in the business
 Not bought with the main purpose of resale
 If we want to sell the non-current assets as a second-hand item,
we would not be able to sell it for the same price that we bought
it (the selling price will definitely be lower)
 Depreciation causes the value of the non-current assets to drop as
time passes by.
 Therefore, depreciation is an expense and should be charged to the
Income Statement.
 The purpose of recording depreciation is to spread the cost of the
non-current asset over their useful life.
 Depreciation is in line with IAS 16.
Causes for depreciation:
 Physical deterioration:
 Wear and tear
 Erosion, rust, rot and decay
 Economic factors:
 Obsolescence- old equipments may be out of date
 Inadequacy- the growth of business has rendered the assets
inadequate to support the business
 The time factor:
 some assets like patents, lease etc have a legal fixed life.
However, instead of depreciation, amortization is being used
for these assets.
 Depletion:
 Some assets are of wasting character, perhaps due to the
extraction of raw material from them. Natural resources such
as mines, quarries and oil wells are some of the examples.
Methods of calculating depreciation
(a) Straight Line method:
 Depreciation can be calculated in two ways:

Situation 1:

Depreciation=Cost – Estimated disposal(residual/scrap) value


Number of years

Situation 2:

Depreciation = % x Cost
Example on Situation 1:
A machine which was bought for $ 40,000 is
expected to have a useful life of 4 years and an
estimated disposal value at the end of the life of
$ 4,000. The annual depreciation charge
calculated using the Straight Line method would
be as follows:

Depreciation = $ 40,000 – $ 4,000


4
= $ 9,000.
Example on Situation 2:
A motor vehicle was bought for $ 40,000.
Depreciation is to be calculated using the
Straight Line method at 10%.
The annual depreciation charge calculated using
the Straight Line method would be as follows:

Depreciation = 10% x $40 000 = $4 000.


(b) Reducing Balance Method
 This method is also known as the diminishing balance
method.
 Under this method, a fixed percentage is written off the net
book value of the previous year.

 Depreciation for any given year can be calculated using the


reducing balance method as follows:
% x Net Book Value (Net Book Value = Cost – Acc. Depr)
OR
r x (1-r)n-1 x cost
whereby r = depreciation rate
n = current year
Example:
 A vehicle is bought for $ 10,000 and depreciation is to be
provided for , at 60%. The expected disposal value is
expected to be $256. The calculations for the annual
depreciation would be as follows:
$
Cost 10,000
Year 1 depreciation (60% of $10,000) 6,000
Net Book Value at Year 1 4,000
Year 2 depreciation (60% of $4,000) 2,400
Net Book Value at Year 2 1,600
Year 3 depreciation (60% of $1,600) 960
Net Book Value at Year 3 640
Year 4 depreciation (60% of $ 640) 384
Net Book Value at Year 4 256
Comparison of Straight Line and Reducing
Balance methods
 Example: a business just bought a vehicle for $ 8000. It will be kept in use
for four years, where it is disposed off for an estimated amount of $ 500. For
reducing balance method, 50% will be the depreciation rate.
 Depreciation value for straight line method= (8000-500) ÷ 4 = $1875

Straight Reducing balance ($)


line ($)
Cost 8000 8000

Depreciation 1st year 1875 4000

Depreciation 2nd year 1875 (8000-4000)x50% = 2000

Depreciation 3rd year 1875 (8000-4000-2000)x50%= 1000

Depreciation 4th year 1875 (8000-4000-2000-1000)x 50%= 500

Residual value 500 500


(c) Annual Revaluation Method
• Under this method, we use the following formula:

NBV b/d + Addition –NBV of disposal – Depreciation = NBV c/d

Depr = NBV b/d +Addition –NBV of disposal –NBV c/d


Example:
On 1 January 20X1, X commenced trading as a mobile
mechanic, introducing small tools with an estimated nbv of
$ 2,400 as part of the opening capital. During the year,
small tools costing $ 980 were purchased.
On 31December 20X1, X estimated the value of the small
tools at $ 3,150.
Using the revaluation method, the depreciation charge for
the year is:
$
Opening estimated nbv
2,400
Add: Additional items purchased 980

3,380
Less: Closing estimated nbv
(3,150)
Depreciation for the period 230
 This depreciation charge of RM 230
represents the total loss in the estimated
cost of small tools during the period. If
there had been any disposals during the
year for which sales proceeds were
received, the proceeds received would
have been deducted in the above
calculation.
(d) Machine Hour method
With a machine, the depreciation provision may be based
on the number of hours that the machine was operated
during the period compared with the total expected running
hours during the machine’s life with the business.

Example 1:
A business which bought a machine costing $2 000 having
an expected running life of 1 000 hours, and no scrap value,
the depreciation charge will be:
$2 000/ 1000 hrs. = $2 for every hour it was operated during
a particular accounting period.
Example 2:
On 1 January 20X1, a business purchased a laser
printer costing $1 800. The printer has an estimated
life of 4 years after which it will have no residual
value. It is expected that the output from the printer
will be:
year 20X1 35 000 sheets printed
20X2 45 000
20X3 45 000
20X4 55 000
180 000
Calculate the annual depreciation for each year using
(a) straight line (b) reducing balance at 60%
(c) units of output method
Choice of method
 The purpose of depreciation is to spread the total cost of
fixed asset over the period which it is used in
accordance with the proportion of the overall economic
benefit yield from that asset during the period.
 Thus, if the main value of an asset is obtained in its
earliest year, then reducing balance method should be
used as it charges more in the earlier years. If the
benefits are gained evenly over the years, then straight
line method would be more appropriate.
 It is possible to make a change in the method of
calculating depreciation but this should not be done
frequently and only be undertaken after a thorough
review as this contradict with the Consistency principle.
Depreciation in the year of purchase
 When non-current assets are purchased during an
accounting period, there is a need to determine what is
the depreciation to be provided for that period. Students
should read the questions carefully for instructions.
 If no instructions are given, check whether the exact date
of purchase is given. If no exact date is given, then we
must provide a full year’s depreciation. If the exact date is
given, provide partial date depreciation from the date of
purchase to the end of the financial year.
 If the question says “calculate a full year’s depreciation
on those assets owned at the end of the period”, then a
full year’s depreciation is required for assets purchased
during the period irrespective of when they were
purchased during the year.
 Instructions may come in many forms, so you should
read the question carefully before determining the action
to be taken.
Accumulated Depreciation(Provision for Depreciation)
- Accumulated depreciation refers to the total cumulative
depreciation to date(from the first year to our current year).
- It is classified as a “provision account”; therefore it is a
credit balance account.(credit means increase and debit
means decrease).
- Format of an Accumulated Depreciation a/c:
- Provision for Depreciation a/c
Disposal X Bal b/d X
Bal c/d X I/S X
XX XX
Bal b/d X

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