The following part is
solely on Depreciation & Disposal of Fixed Assets. Pls skip to
next part for all the examples and solutions.
Depreciation
Layman's explanation: Let's say the company buy a table for
$5000 and use it for 5 years. If they expensed the whole $5,000 in
the first year they bought, it's like the table costs $5,000 to use
for the first year, then the next 4 years is free. So a more
appropriate way is to have a certain expense for each of the 5
years the table is used.
The 5 years mentioned here is known as the useful life.
This will be provided in the question.
This is in line with the matching principle that you've earned -
to match cost of using the fixed asset in a particular year against
the revenue earned in that year to get the true profit.
If I don't use depreciation, let's say my revenue is $10K each
year.
My profit for year 1 will be = $10K - $5k = $5K
Year 2 - Year 5 is $10K each. This is an
understatement of the true profit in year 1 and
overstatement of the true profit in year 2 - 5
because I've only used 1/5 of the table in year
1.
2 methods to calculate
depreciation
1
Straight-line method
Annual depreciation = (original cost - scrap value) / no. of
years of useful life
E.g. If the table costs $5,000 and the scrap value (that is at
the end of the 5th year, it is expected to bring me $500 if I sold
it off) and useful life is 5 years.
Annual depreciation = ($5000 - $500) / 5 = $900 per year.
Annual
depreciation is constant every year.
Disadvantage of this method - it assumes that the fixed asset
gives the same service or I prefer to phrase it as - it
assumes we use the table for the same amount of frequency each
year. For some assets, we use it more in the first few
years when it's brand-new and use it less as it gets older and less
efficient etc. Sometimes when business is very good, we will use it
very often, while if economy is bad like now we use it less. So
straight-line method may not be the most appropriate choice.
2 Reducing
Balance/Diminishing Balance Method
I shan't explain this method using words but rather with an
example.
Let's say a van costs $10K and I expect to sell it for $256 at
the end of its life. Its useful life is 4 years, rate of
depreciation = 60%
Year 1 Depreciation expense = 60% x 10K = $6K
Book value now = $10K - $6K = $4K
Year 2 Depreciation expense = 60% x $4k = $2.4K
Book value now = $4k - $2.4K = $1.6K
Year 3 Depreciation expense = 60% x $1.6K = $960
Book value now = $1.6K - $960 = $640
Year 4 Depreciation expense = 60% x $640 = $384
Book value at end of year 4 = $640 - $384 = $256. (=
scrap value)
Advantage:
- Useful for assets that are most efficient in earlier years.
(more truthful allocation)
- Overall expenses is more or less constant for the use of a
fixed asset because the lower depreciation cost in the later years
is offset by the high maintenance and repair costs.
Disadvantages:
- Fixed asset takes a long time to be written off
- In order to write-off the whole cost of the asset, the rate of
depreciation has to be quite high. This will cause the book value
to be lower in the earlier years and not very realistic when
compared to current market value of the asset.
3
Revaluation method (ONLY FOR 'O' LEVELS
STUDENTS)
This method is used for items such as farmers' livestock (your
chickens, cows etc..).
You use this method when it is difficult to estimate with any
certainty the rate at which the asset will depreciate.
E.g. You (a farmer) have a herd of cows
Value of cows at beginning of
year
$20K
Add purchases during
year
$ 6K (purchase
extra cows)
-----------------------------------------------------------------------
$26K
Less value of cows at end of the
year
$17K
-----------------------------------------------------------------------
Depreciation expense for the
year
$9K
Depreciation expense = Value of asset at beginning of
year + purchases during the year - value at end of the
year
Advantage
- fixed asset is shown at its current value at end
of year in the Balance Sheet (more realistic)
Disadvantage
- you need more time and effort to revalue the assets (more
expensive for the business)
Recording
Depreciation
Once you calculate the expense,
Dr Depreciation account (expense
account) - the value = annual depreciation
Cr Provision for Depreciation Account
Fixed asset account is always maintained at the asset's
original cost so don't shift any depreciation stuffs inside
here.
The depreciation from year to year is recorded in Provision for
Depreciation Account which shows the accumulated
depreciation.
In the Balance
Sheet, the fixed asset is shown at its Book Value (
= Cost minus provision for depreciation)
--------------------------------------------------------------------------------------------------------------
Example, On 1 January 2010, a business bought a printing
machine for $8K. It decided to depreciate the machine at 20% using
the reducing balance method.
General
Journal
2010
Dec 31 Depreciation of
Equipment
$1.6K
Provision for depreciation of
equipment
$1.6K
Being depreciation for equipment
Profit and Loss
Account
$1.6K
Depreciation of
Equipment
$1.6K
Being transfer of depreciation for the year to Profit and
Loss Account.
2011
Dec 31 Depreciation of
Equipment
$1,280
Provision for depreciation of
equipment
$1,280
Being depreciation for equipment
Profit and Loss
Account
$1,280
Depreciation of
Equipment
$1,280
Being transfer of depreciation for the year to Profit and
Loss Account.
Ledger
Equipment Account
2010
$
2010
$
Jan 1
Bank
8,000
Dec 31 Balance c/d
8,000
2011
2011
Jan 1 Balance
b/d
8,000
Dec 31 Balance c/d
8,000
2012
Jan 1 Balance
b/d
8,000
Notice the balance is always at cost
price.
Depreciation for Equipment Account
2010
$
2010
$
Dec 31 Provision for depre.
1,600
Dec 31 Profit & Loss Account
1,600
2011
$
2011
$
Dec 31 Provision for depre.
1,280
Dec 31 Profit & Loss Account
1,280
Because depreciation account is an expense account,
it must be closed and "emptied" at the end of each year and the
balance transferred to Profit and Loss Account.
Profit and
Loss Account for the year ended 31 Dec 2010
$
Depreciation of
equipment
1,600
Profit and
Loss Account for the year ended 31 Dec 2011
$
Depreciation of
equipment
1,280
Balance Sheet
as at 31 December 2010 (assets only)
Fixed
Assets:
$
$
Equipment as
cost
8,000
Less provision for
depreciation
1,600
6,400
Balance Sheet
as at 31 December 2011 (assets only)
Fixed
Assets:
$
$
Equipment as
cost
8,000
Less provision for
depreciation
2,880
5,120
Book value on 31 Dec 2010 is $6,400.
Book value on 31 Dec 2011 is $5,120.
I hope students can see that depreciation expense is
an annual figure while provision for depreciation account gives you
the accumulated depreciation which you can use to prepare your
Balance Sheet.
Disposal of Fixed
Assets
All information regarding the fixed asset to be disposed of is
transferred to a temporary
account, which is open temporarily =)
1 To transfer the cost of the fixed asset
2 To Transfer Accumulated Depreciation
3 Value received on disposal of account
