Accounting Adjustments

Section 6
Part 2
Objectives

 Discuss the nature of depreciation.

 Calculate annual depreciation expenses using straight line method and
reducing balance method.
 Prepare journal entries and ledger accounts for provision for
depreciation
 Distinguish between capital expenditure and revenue expenditures
 Determine the amount of expenses or revenues to be transferred to the
Income Statement.
 Prepare income statements to reflect adjusting entries
 Prepare Financial Statements after adjustments.
Depreciation

 Depreciation is that part of cost of the fixed asset consumed during its
period of use by the firm.
Terms associated with depreciation

 Depreciation expenses – an amount representing the value of the

service of a fixed assets used up during an accounting period.
 Provision for depreciation – the value of the fixed asset service
utilized in earning revenue can only be estimated and, therefore, it must
be provided for on a periodic basis.
 The cost of the asset – refers to all expenditure incurred in bringing
the asset to its required location.
 The asset’s useful life – refer to the number of years the asset is
expected to be useful economically to the business.
 Accumulated depreciation – the total amount of value lost or used up
over a number of accounting periods, that is, total depreciation as at a
given date.
 The net book value (NBV) – refers to the unused portion of the cost of
the asset, that is, the value of the asset minus the accumulated
depreciation as at a given date.
 The residual value (scrap value/trade in value) – the business best
estimate of the worth of the asset at the end of its useful life. This
amount reduces the value to be depreciated.
 Depreciation amount – the cost minus the residual value.
Methods of depreciation

 Two methods are commonly used to estimate the annual expense. They
are the straight-line method and the reducing balance method.
Straight-line method

 This method calculates an equal amount for depreciation expenses to

the Income Statement each month or quarter or year. This is done
under the assumption that each accounting accounting period benefits
equally from the use of the asset.
 Steps in applying the straight-line method

a. Calculate the depreciation amount (cost minus any residual value) of the asset.
b. Divide the depreciable amount by the years the asset is expected to provide service
(its useful life).
The formula look like this:
Annual depreciation charge = cost of asset – residual value
Useful life in years

Monthly depreciation charge = cost of asset – residual value

useful life in months

 OR
 Apply a fixed annual percentage to the depreciable amount. The
formula looks is:

 Annual Depreciation charge = Fixed percentage x Cost of asset –

residual value
Activity

1. On January 1, 2020, Sharon Enterprises purchased a machine costing

$124 000. The machine has a life expectancy of approximately 5 years.
At the end of that time the machine is expected to have a trader-in
value of $24 000. The financial year of the business ends on December
31, each year.

2. On June 30, 2020, Tableland Processes bought a machine costing $30

000. At the end of the first year, a note to the trial balance read
“depreciation is to be calculated on the machine at the rate of 15% on
cost.”

Using both sets of information use the appropriate formula and calculate
the annual depreciation using the straight-line method.
Individual activity

 Rocket Cricket Club keeps records for a financial period which ends on
31 December each year. Cricket gear was purchased on 1 April 2020 for
$18 000 and was expected to last for 5 years. Calculate the
depreciation on the cricket gear as at 31 December 2020.
Reducing balance method/ diminishing balance
method

 This method calculates a vary amount of depreciation each year. In the

early years of use there will be a higher annul depreciation than in the
later years. This is done under the assumption that the early years
benefits more as the asset is new and productive. There are also
greater cost of use and maintenance in the later years as the asset
decreases in productivity.
Steps in applying the method

 Calculate the net book value of the asset at the beginning of

each year. (In year 1 this is equal to the cost.) In subsequent
periods, the net book value is equal to the cost minus all the
deprecation charged up to that time (accumulated depreciation).
At the end of the asset’s useful life, the net book value is equal
to the expected residual value.

 Apply a fixed annual percentage to the net book value of the

asset at the beginning of each year. The depreciation calculation
is at a lesser amount every following period.
The formula is:

 Annual depreciation = Net Book Value x depreciation rate

 Net Book Value = Cost – Accumulated depreciation
Activity

 On April 1, 2020, a business purchased a machine costing $224 000 with

a useful life of five years. At the end of that time, the machine will be
sold at its residual value. The owner plan to depreciate it at a rate of 40
% per annum using the reducing balance method. The financial year of
the business ends on December 31 each year. Using the format below:
1. Calculate the depreciation at the end of the five years
2. Give the residual value of the machine at the end of its five year life.
Individual activity

 The Thomas Enterprises bought a machine costing $60 000. the

estimated useful life of the machine is eight years. The method of
depreciation used in the first four years was the Straight line method,
after which the Reducing Balance method was applied at the rate of
20% per annum. Determine the depreciation expenses to be charged to
Thomas’s Profit and loss account in each of the eight’s years of the
machine’s useful life and give the residual value of the machine after
the eight years.
What is revenue expenditure?

 Revenue expenditure is expenditure incurred on everyday running costs.

The effect of revenue expenditure is not expected to last more than 12
months. Examples include:
rent payable
insurance
Administration expenses
Repair of motor vehicles
Maintenance of machinery
What is capital expenditure?

 Capital expenditure is expenditure incurred on non-current assets,

including the purchases, amendment or improvement of non-current
assets. The effect of capital expenditure is expected to last more than
12 months. Examples include:
permanent improvement of non-current asset, for example
the installation of air conditioning within a
property.
Installation of computer equipment
Delivery charges paid on a non-current asset
Legal cost of buying a property, for example solicitor’s
costs concerned with obtaining a lease.
 The following table gives some examples of
revenue and capital expenditure.
Non-current asset (Fixed Assets) Revenue expenditure Capital expenditure
Buildings Maintenance Cost of purchase
Redecoration Legal fees of purchase cost of
Repairs improvement/ extension:
 Labour
 Carriage on materials installation of
facilities:
 Gas, electricity and water

Vehicle Fuel Cost of purchase

Road tax Cost of number plates
Insurance Bodywork improvements
Service costs Delivery costs
Car repairs
Car advertising artworks
Extended warranty

Equipment Computer memory sticks Cost of purchase

Printer and copier paper Installation of equipment
Insurance Modification/improvements to
Computer software equipment
Printer ink
Journal Entries and Ledger Entries for Provision
Accounts

 Journal entries are made after calculating the period’s depreciation amount.
These entries are posted to accounts in the ledger.
Journal Entries
There are two ways to account for depreciation. In the first method, the annual
expense is charges directly to the Profit and Loss Account:
 Debit Depreciation Expenses account, Credit the Provision for Depreciation
account.
In the alternative method, an expense account is opened each year for the
annual amount and then the amount is transferred to the income statement.
 Debit Depreciation expenses account, credit the provision for depreciation
account.
 Debit the Income Statement, Credit Depreciation Expense account.
Activity

 Mars Products Company closes its accounts on 31 December every year.

The company bought a building on 1 January . The company uses the
straight line method of depreciation and has calculated annual
depreciation of $20 000 per year on its building.
Demonstrate the journal entries that would be made to record depreciation
over the first year of useful life using both methods.
Adjustment Financial Statement

 To prepare the income statement and balance sheet. The amounts

shown were unadjusted for accruals, prepayments, bad debts or
depreciation. These end of period adjustments appear as notes
accompanying in Trial Balance. The financial statements are prepared
showing the adjustments (workings) to figures clearly.
 Complete exercise 23. 2 and 23.3 now