Depreciation on Fixed Assets
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A business may acquire fixed assets such as land, buildings, machinery, office equipment, delivery equipment and natural resources (e.g. a piece if mining land)to help in the process of its operations to earn revenue in order to make a profit. Such assets, by their very nature, provide benefits to the business for more than one financial year or period. In fact, when a business buys a fixed asset at a certain cost (say $10,000), it is actually buying a bundle of service benefits that will be provided by that fixed asset over a period of time in the future (say 10 years). Take, for example, when a wholesaler buys a delivery van, it is in effect buying transporting services for his goods that will be provided by the van over its useful life that will help him (the wholesaler) earn revenue. Note that all reasonable and necessary costs to get an asset in position and condition ready for use may be included as part of its cost. Thus, the lawyer’s professional fees should be included in the cost of acquiring a building. Money spent to acquire fixed assets is called capital expenditure.
The fixed asset is maintained in the books based on its cost. There is no need to revalue it even though its market price has changed. This is in line with the historical cost concept. As an asset is used over time, the bundle of future service benefits available from it becomes smaller and smaller. The whole cost of the fixed asset cannot be charged as an expense in the year it is bought. This is in line with the matching principle. Only a portion of the total cost representing the amount of service benefits that has been used up during an accounting period has to be charged as an expense for that period in the final accounts against the revenue earned. This amount is called the depreciation expense. Depreciation, therefore, means the allocation of the cost ($10,000 in the above example) of a fixed asset over its useful life (10 years, in the above example). Causes of Depreciation
The business has to make provisions for depreciation for its fixed assets in recognition of the fact that the availability of the service benefits from them grows less and less over time because of the reasons stated below. The fixed asset is then shown as a reduced value in the books after deduction the accumulated depreciation. It is in line with the concept of conservatism which anticipates all losses. 1. Physical deterioration caused mainly by physical wear-and-tear when the asset is used; erosion, rust, rot and decay when the asset is exposed to rain, sun, wind and other elements of nature. 2. Obsolescence, or the process of becoming obsolete or out of date. A good example of this is computers. You may buy a Pentium computer today, but with the speed at which information technology is developing nowadays, you can be sure it will be considered ‘too slow’, in other words, obsolete, in five years’ time, even though the machine itself may still be mechanically fit to process information. 3. Depletion of an asset if it is one which is depleted over time, such as mining land or a quarry. Once the ‘goodness; of the land has been extracted, and then sold, it cannot be replenished.
Eventually, the asset would be totally depleted and it would be no longer economically viable for the owner to continue to extract more ‘goodness’ from it. 4. Passage of time which will shorten the life of assets such as copyrights, patent rights, and leases on hand. These assets confer upon their holder the exclusive right to enjoy certain privileges for a fixed period of time. Take, for example, the tenant (lessee) of a piece of land reserves the right to occupy the land for 10 years. During the period of the lease, the rightful owner (lessor) has no right to repossess it, as long as the tenant fulfils all the terms of the lease. However, at the end of the 10 years, the tenant no longer has any right to continue to occupy that piece of land. Thus, these assets fall in value as the expiry date of the rights they confer approaches. Calculation of Depreciation
It is very difficult to come to the ‘true’ value of the service benefits provided by a fixed asset that is used up or consumed during an accounting period. Depreciation is at best an estimate, depending on which method we use. It is only after the fixed asset is sold off that we can know for certain how much depreciation should actually have been. Depreciation can be calculated by one of the following methods: 1. The Straight Line or Fixed Instalment method;
2. The Reducing Balance or Diminishing Balance method; and 3.
The Revaluation method.
Straight Line or Fixed Instalment Method
By this method, the fixed asset is assumed to depreciate at equal amount for every year of its expected lifetime. The cost of the asset is spread evenly over its lifetime. Reducing Balance or Diminishing Balance Method
By this method, the asset is supposed to depreciate at a fixed percentage of its depreciated value (or book value) at the beginning of each year. The amount set aside for depreciation will diminish with every successive period since the value of the asset at the beginning of every successive period tends to diminish. The main advantage of this method is that in the Profit and Loss Account, the amount of overall expenses charged for the use of a fixed asset would be more or less constant throughout the asset’s lifetime. This is because depreciation is only one of the expenses involved. Other expenses may include maintenance and repairs. It is very likely that a diminishing depreciation with each successive year will be offset by higher and higher costs for repairs and maintenance as the fixed asset gets older. Revaluation Method
By this method, fixed assets are valued at the end of every accounting period. Then the difference between its value at the end of the period and that at the beginning of the period will be the depreciation for that period. This method is normally used for calculating depreciation of loose tools, farmers’ livestock where it is difficult to estimate with any certainty, the rate at which the asset will depreciate. At times, it may be found that the value of the asset at the end of the accounting period is greater than that at the beginning. This rise in value is calledappreciation. Disposal of a Fixed Asset
An asset can be sold off for cash, or traded in as part payment for another asset, at or before the end of its useful life. The business is said to make a ‘gain’ if the selling price of the existing asset is greater than its book value, i.e. price at cost minus total amount of accumulated depreciation. It is said to make a ‘loss’ if the book value of the asset is greater than the its selling price on disposal. Actually a ‘gain’ is made because the total accumulated depreciation (or total balance on Provision for Depreciation Account) was overestimated in the past. So the book value of the asset is below its actual market value. Similarly, a ‘loss’ is incurred due to the underestimation of its accumulated depreciation in the past. The gain on sale of the asset must be credited to the Profit and Loss Account and debited to the asset disposal account. Likewise, the loss on sale of the asset must be debited to the Profit and Loss Account and credited to the asset disposal account. Summary
* Fixed assets such as machinery, equipment and furniture are bought by the business to be used over several accounting periods and not for resale. * Fixed Assets lose value with the passage of time due to wear-and-tear, obsolescence and depletion and they are said to have depreciated. * Depreciation can be calculated in any of the following three ways: i. Straight Line method: A fixed percentage on original Cost of Asset. ii. Diminishing Balance method: A fixed percentage of the Asset’s book value (depreciated value) at the beginning of each accounting period. iii. Revaluation method: Value of Asset at the beginning of period less Value of Asset at end of period. * Depreciation is charged to the Profit and Loss Account as an expense. * Ledger entries –
(a) When a Provision for Depreciation Account is set up – i. To make provision for depreciation expense – debit Depreciation Account, and credit Provision for Depreciation Account. ii. To transfer Depreciation to Profit and Loss Account – debit Profit and Loss Account, and credit Depreciation Account. (b) When a Provision for Depreciation Account is not set up – i. To write off depreciation on Fixed Asset – debit Depreciation Account, and credit Fixed Asset Account. ii. To transfer Depreciation to Profit and Loss Account – debit Profit and Loss Account, and credit Depreciation Account. Note: The total credit balance on the Provision for Depreciation Account is the total accumulated depreciation on the fixed asset up to date. * The fixed asset is shown at its cost price less total accumulated depreciation. When a Provision for Depreciation Account is not available, the asset is shown simply at its depreciated value in the Balance Sheet. * Disposal of a Fixed Asset –
i. A gain on sale of a fixed asset is credited to the Profit and Loss Account. It has arisen due to previous undercharging of depreciation in the years prior to the sale. ii. A loss on sale of a fixed asset is debited to the Profit and Loss Account. It has arisen due to previous overcharging of depreciation in the years prior to the sale.