Financial Accounting – DFA 1200

UNIT 2 DEPRECIATION

Unit Structure

2.0 Overview

2.1 Learning Objectives

2.2 What is Depreciation?

2.3 Depreciation Methods

2.3.1 The Straight-line Method

2.3.2 The Reducing Balance Method

2.4 The Effects of Depreciation on the Income Statement

2.5 Disposal of a Fixed Asset

2.6 Comprehensive Example

2.7 Summary

2.8 Practice Question

2.0 OVERVIEW

Economic benefits are derived from the use of an asset over its useful life. As the benefits are
being enjoyed, the carrying amount of the asset is reduced to reflect this use. The cost of using
the asset is depreciation. The estimation of the useful life of an asset is a matter of judgement
based on the experience of the enterprise and will depend on the expected utility of the asset.

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2.1 LEARNING OBJECTIVES

By the end of this Unit, you should be able to the following:

1. Outline the nature and purpose of depreciation.
2. Explain the nature of the various methods of calculating depreciation.
3. Identify the profit or loss arising upon the disposal of fixed assets.

2.2 WHAT IS DEPRECIATION?

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful
life. Depreciable amount is the cost of an asset less its residual value. The cost of an asset
comprises its purchase price, including any import duties, and non-refundable purchase taxes,
and any directly attributable costs of bringing the asset to working condition for its intended use.

Land and buildings are separable assets and are dealt with separately for accounting purposes,
even when they are acquired together. Land normally has an unlimited life and therefore is not
depreciated. Buildings have a limited life and therefore, are depreciable assets.

The following factors need to be considered when determining the useful life of an asset:

(a) the expected usage of the asset, e.g, drilling equipment in the construction industry
(b) the expected physical wear and tear, e.g, plant in a factory
(c) technical obsolescence arising from better models or improvements, e.g, computers
(d) time factor, e.g, lease on premises

2.3 DEPRECIATION METHODS

The matching concept requires the depreciation cost to be charged to the accounting periods
which benefit from the use of the asset. A variety of depreciation methods can be used to allocate
the depreciable amount of an asset on a systematic basis over its useful life. The most common

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methods of calculating depreciation are the straight-line method and the reducing balance
method.

Each method is based on the historical cost of the asset and requires an estimate of:

• The expected life of the asset, e.g if a motor vehicle is expected to last for 5 years, then
the depreciation is spread over the 5 years, as each year benefits from use of the asset and
should therefore share in its reduction in value.
• The residual value of the asset (the estimated value at the end of the asset’s expected life
with the owner, i.e. what the owner feels he will be able to get, if he sells the motor
vehicle at the end of 5 years, as expected).

2.3.1 The Straight-line Method

The straight-line method charges an equal amount of depreciation in each year of the asset’s life.

Example 1
Motor vehicle, at cost Rs 700,000
Expected life 5 years
Estimated residual value Rs 200,000
Date of purchase 1 January, 2000

Calculation
Total depreciation over 5 years = Rs 700,000 - Rs 200,000 = Rs 500,000
Annual depreciation = Rs 500,000 = Rs 100,000
5
or, expressed as a formula:

Cost – Estimated value = Annual depreciation

Number of years of expected life

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2.3.2 The Reducing Balance Method

This method applies a fixed percentage each year to the net book value of the asset at the
beginning of the financial year.

Example 2

We are going to use the same data as in Example 1, and a fixed percentage of 22.17 % per
annum.
Rs

Cost 1 January, 2000 700,000

Depreciation charge for year 2000 @ 22.17 % 155,190
Net book value/balance sheet value at 31.12.2000 544,810
Depreciation charge for year 2001 @ 22.17 % 120,785
Net book value/balance sheet value at 31.12.2001 424,025
Depreciation charge for year 2002 @ 22.17 % 94,006
Net book value/balance sheet value at 21.12.2002 330,019
Depreciation charge for year 2003 @ 22.17 % 73,165
Net book value/balance sheet value at 31.12.2003 256,854
Depreciation charge for year 2004 @ 22.17 % 56,854
Net book value/balance sheet value at 31.12.2004 200,000

As illustrated above, the reducing balance method charges more depreciation in the earlier years.
For certain assets such as industrial equipment, charging more depreciation in the earlier years
may be considered more appropriate, as the main benefits from the use of the asset are obtained
in the earlier years.

The rate used in the Reducing Balance Method is found by a complex formula, which you are
not expected to know at this stage. The rate to be used will be given to you.

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2.4 THE EFFECTS OF DEPRECIATION ON THE INCOME STATEMENT

The depreciation charge for the year is an expense and as such is deducted from the income
statement when calculating the net profit for the year. The choice of method will therefore affect
the amount of depreciation charged to each year’s income statement. It will also affect the
reported value of the fixed asset in the balance sheet because the accumulated (total)
depreciation charged over the life of the asset is deducted from the cost of the asset in the
balance sheet.

The reducing balance method charges a higher amount in the earlier years and a lower amount
in the later years, whereas the straight-line method charges the same amount each year.

Here is an illustration of the effects of adopting the straight line and reducing balance method (
from examples 1 and 2 ) on the income statement and balance sheet for year 2000.

Table 2.1 Income Statement extract for year ended 31 December, 2000

Straight line Reducing Balance

Rs Rs Rs Rs
Gross profit 600,000 600,000
less expenses
Rent 120,000 120,000
Salaries 180,000 180,000
Provision for depreciation 100,000 155,190
400,000 455,190
Net profit 200,000 144,810

Table 2.2 Balance Sheet extract at 31 December, 2000

Rs Rs Rs Rs

Fixed Assets

Motor vehicle at cost 700,000 700,000

less provision for depreciation 100,000 155,190
Net Book Value 600,000 544,810

2.5 DISPOSAL OF A FIXED ASSET

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Let us look again at Example 2:

Motor vehicle, at cost Rs 700,000

Expected life 5 years
Estimated residual value Rs 200,000

Date of purchase 1 January, 2000

Depreciation: reducing balance method at 22.17 % per annum

At 31 December 2002, the net book value was Rs 330,019

Suppose , we sell the motor vehicle for Rs 400,000 on that date; how are
we going to account for this disposal?

1. As we no longer own the motor vehicle, we need to remove its value from our accounting
records, together with all its related depreciation.

2. Record the receipt of Rs 400,000

3. Record the disposal of the vehicle in a disposal account.

The entries we would make in our “T” accounts are:

Provision for Depreciation Account

Rs Rs
31.12.2002 Disposal of 369,981 31.12.2000 Depreciation charge 155,190
motor vehicle 31.12.2001 Depreciation charge 120,785
31.12.2002 Depreciation charge 94,006
369.981 369,981

Motor Vehicle Account

Rs Rs
1.1.2000 Bank 700,000 31.12.2002 Disposal of motor vehicle 700,000

Bank Account
Rs

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31.12.2002 Disposal of
Motor vehicle 400,000

Disposal of Motor Vehicle Account

Rs Rs

31.12.2002 Motor vehicle 700,000 31.12.2002 Provision for

depreciation 369.981
31.12.2002 Profit on
disposal 69,981 31.12.2002 Bank 400,000
769,981 769,981

Profit on Disposal Account

Rs Rs
31.12.2002 Income statement 69,981 31.12.2002 Disposal of 69,981
motor vehicle

The “T” account for the profit on disposal of motor vehicle will be closed off
and the Rs 69,981 credited to the income statement.

The profit or loss on disposal of an asset is a book profit or loss. This arises
because the estimated residual value is different from the actual sale proceeds.

2.6 COMPREHENSIVE EXAMPLE

Table 2.3 Trial Balance as at 31 December 2005

Dr Cr
Rs Rs

Purchases and sales 550,000 988,000

Inventory at 1 January 2005 102,000
Land and Buildings 800,000
Motor vehicles at cost 800,000
Provision for depreciation at 1 January 2005:
motor vehicles 520,000
Electronic equipment at cost 125,000
Provision for depreciation at 1 January 2005:
electronic equipment 75,000

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electronic equipment
Debtors 120,000
Cash in hand 28,000
Bank 256,000
Creditors 128,000
Capital 1,000,000
Long term loan 330,000
Salaries 130,000
Office Expenses 60,000
Electricity 15,000
Insurance 30,000
Telephone 25,000

3,041,000 3,041,000

Notes

1. Depreciation is to be charged on motor vehicles at an annual

rate of 20 % per annum on cost.
2. On 1 January 2005, a motor vehicle which originally cost Rs
300,000 on 1 January 2003 was sold for Rs 150,000, cash. No
accounting entries have been made for this sale.
3. Depreciation on electronic equipment is to be charged at 20 %
per annum on a reducing balance basis.
Required:

(a) Calculate the profit or loss on the disposal of the motor vehicle on 1
January, 2005.

(b) Calculate the depreciation charge for the year for

(i) motor vehicles.
(ii) electronic equipment.

(c) Prepare the balance sheet extract for fixed assets at 31 December

2005.

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Solution

(a) Calculation of Profit/loss on disposal of vehicle disposed on

1 January, 2005.

From Note 2, accumulated depreciation to date of sale

= 2 years x 20% x Rs 300,000 = Rs 120,000

Therefore, Net book value of vehicle at date of sale

= Rs 300,000 - 120,000 = Rs 180,000

Sales proceeds = Rs 150,000

Loss on disposal = Rs 180,000-150,000 = Rs 30,000

(b) Calculation of depreciation charge for the year on

(i) Motor vehicles

Before we can calculate the depreciation charge for the year for the motor
vehicles, we must deal with the disposal made on 1 January 2005. Otherwise
we would charge depreciation for the year on an asset which no longer belongs
to the enterprise.

As explained in 2.5, we need to remove the motor vehicle disposed of, and its
accumulated depreciation from the accounting records.
Rs
Motor vehicles at cost per trial balance = 800,000
Motor vehicle at cost, which has been disposed = 300,000
Balance at cost at 31.12.2005, on which depreciation
will be calculated = 500,000

Depreciation charge for the year = 20 % x Rs 500,000 = 100,000

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(ii) Electronic equipment

Per trial balance: Rs

Electronic equipment at cost = 125,000
Accumulated depreciation at 1 January, 2005 = 75,000
Net Book value at 1 January 2005 , on which
depreciation will be calculated = 50,000

Depreciation charge for the year = 20 % x Rs 50,000 = 10,000

(c) Balance sheet extract for fixed assets as at 31 December 2005

Assets Rs
Non-current assets
Property, plant and equipment (Note 1) 40,000

Note 1:

Cost Accumulated Net Book

Depreciation Value
Rs Rs Rs

Motor vehicles See (b) (i) 500,000 500,000 * -

Electronic equipment (Trial balance) 125,000 85,000 ** 40,000

625,000 585,000 40,000

Rs
* Accumulated depreciation at 1 January 2005 per trial balance = 520,00
Less :
Accumulated depreciation on assets disposed
on 1 January 2005 ( from ( a ) ) = 120,000
400,000
Depreciation charge for the year ( from (b (i) ) = 100,000
Accumulated depreciation at 31 December 2005 = 500,000

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** Accumulated depreciation on 1 January 2005, per trial balance = 75,000

Add: depreciation charge for the year (b)(ii) = 10,000
Accumulated depreciation at 31 December, 2005 = 85,000

2.7 SUMMARY

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful
life. The most common methods of calculating depreciation are:
the straight-line method and the reducing balance method.

The matching concept requires that depreciation be charged to the accounting periods which
benefit from the use of the asset.

4. The profit or loss on disposal of an asset is a book profit or loss. This arise because the
estimated residual value is different from the actual sales proceeds.

2.8 PRACTICE QUESTION

A motor tractor is bought for Rs 600,000. It will be used for three years and at the end of the
third year, it will be sold back to the supplier for Rs 307,200.

Required:

(a) Calculate the depreciation for each year up to the date of sale, using the reducing balance
method at the rate of 20 % per annum.

(b) Calculate the profit/loss on disposal of the motor tractor.

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