Mada za sehemu hiiAdjustmentsMada 6
Depreciation is that part of the original cost of a non-current asset that is consumed during its period of use by the business. It needs to be charged in the profit and loss account every year. The amount charged in a year for depreciation is based upon an estimate of how much of the overall economic usefulness of non-current assets have been used up in that accounting period.
i. Physical deterioration
- Wear and tear. When a motor vehicle or machinery is used they eventually wear out. Some last many years, others last only a few years.
- Erosion, rust, rot and decay. Land may be eroded or wasted away by the action of wind, rain sun and other elements of nature. Similarly, the metals in motor vehicles or machinery will rust away. Wood will rot eventually. Decay is a process which will also be present due to the elements of nature and the lack of proper attention.
ii. Economic factors
- Obsolescence: This is a process of becoming out of date.
- Inadequacy: This arises when an asset is no longer used because of the growth and changes in the size of the business.
iii. Time factor
Some assets lose their value simply with the passage of time. Intangible fixed assets such as leases, patents, copyrights, etc., lose their working capacity over a period of time if such assets are not used at all.
iv. Depletion
Some assets like coal mines, ore and oil deposits lose their utility and value due to the extraction of deposits from them. The charge of depletion is made on the basis of the consumption of the concerned asset.
i. Straight line method
The straight-line basis is a method of calculating depreciation and amortization, the process of expensing an asset over a longer period of time than when it was purchased.
It is calculated by dividing the difference between an asset's cost and its expected salvage value by the number of years it is expected to be used. The straight-line basis is popular because it is easy to calculate and understand, although it also has several drawbacks.
In this method, the number of years is estimated. The cost is then divided by the number of years. This gives the depreciation charge for each year.
Example: Nangela Corporation purchases the Procrastinator Deluxe machine for Tshs 60,000. It has an estimated salvage value of Tshs 10,000 and a useful life of five years. Nangela calculates the annual straight-line depreciation for the machine as:
The purchase cost of Tshs 60,000 – estimated salvage value of Tshs 10,000 = Depreciable asset cost of Tshs 50,000
-year useful life = 20% depreciation rate per year
20% depreciation rate x Tshs 50,000 depreciable asset cost = Tshs 10,000 annual depreciation
ii. Reducing balance method
Under the reducing balance method, the amount of depreciation is calculated by applying a fixed percentage to the book value of the asset each year.
In this way, the amount of depreciation each year is less than the amount provided for in the previous year. This is because the book value used to compute the depreciation expense is continually reduced from year to year.
This method is also known as the diminishing balance method or diminishing debit balance method.
Use the following formula to calculate depreciation under the reducing balance method:
Depreciation = Asset book value × Depreciation Rate
Also, the formula used to find the percentage to apply with this method is
Where = the number of years
= the net residual value (this must be a significant amount or the answer will be absurd since the depreciation rate would amount to nearly one)
= the cost of the asset
= the rate of depreciation to be applied
Example: Calculating Depreciation Under Reducing Balance Method
On 1 January 2018, ABC Limited purchased a truck for Tshs 75,000. Depreciation is estimated at 20% per year on the book value.
Required: Calculate the truck's depreciation for 2018, 2019, and 2020.
Solution
2018: The book value at the beginning of 2016 is Tshs 75,000. Depreciation for 2016 is Tshs 75,000 × 0.2 = Tshs 15,000.
2019: The book value at the beginning of 2017 is Tshs 75,000 – Tshs 15,000 = Tshs 50,000. Depreciation for 2017 is Tshs 50,000 × 0.2 = Tshs 10,000.
2020: The book value at the beginning of 2018 is Tshs 50,000 – Tshs 10,000 = Tshs 40,000. Depreciation for 2018 is Tshs 40,000 × 0.2 = Tshs 8,000.
Notes
Notice that the depreciation provided in 2020 (Tshs 8,000) is less than the amount of depreciation provided in 2019 (Tshs 10,000). In turn, this is less than the amount provided in 2018 (Tshs 15,000).
The reason for this is that the rate of depreciation (20% in this case) is being applied to the book value, which continually reduces each year.
In 2018, the book value was Tshs 75,000, while in 2019, it fell to Tshs 50,000. A year later, it reduced to Tshs 40,000. Remember that the rate of depreciation remains constant but it is applied to a lesser amount (i.e., book value) each year. Hence, the amount of depreciation each year is lower.
iii. Revaluation method
The revaluation method of depreciation is the easiest method of depreciation. In this method, the asset value is assessed at the start of the year and at the end of the year and the difference between them is considered as depreciation to be charged.
The revaluation method of depreciation is applied to the following −
- When the accurate life of an asset is unknown.
- When the life of an asset is uncertain.
- When other depreciation methods can't be used.
Example: A hotel purchased crockery on 1 January 2015 for Tshs 1,500. On 31 December 2016, it was valued by a chef at Tshs 1,250. In 2016, the hotel purchased more crockery items for Tshs 2,000. At the end of the year, the stock of crockery was valued at Tshs 2,850.
Required: Calculate the amount of depreciation to be charged for 2015 and 2016.
Solution
Depreciation for 2015 = Book value on 1 January 2015 – Value placed on 31 December 2015
= Tshs 1,500 – Tshs 1,250
= Tshs 250
Depreciation for 2016 = Book value on 1 January 2016 + Purchases during the year – Value placed on 31 December 2016
= Tshs 1,250 + 2,000 – Tshs 2,850
= Tshs 400
iv. Depletion unit method
The Depletion method of depreciation is a cost allocation method that works for depleting natural resources. The accounting working for depletion works similarly to the depreciation of tangible assets or amortization with intangible assets. As the natural resources or assets "deplete" with extraction over time, the term is used as a depletion method of depreciation.
Example: If a quarry was bought for Tshs 5,000,000 and it was expected to contain 1,000 tonnes of saleable materials, then for each tonne taken out we would depreciate it by Tshs 5,000 since Tshs 5,000,000 ÷ 1,000 = Tshs 5,000
This can be shown as:
= Depreciation of that period
v. Machine hour method
Machine hour rate is useful for calculating the value of different overheads fast. Because depreciation is one of the main overheads of the business, so, we can use the machine hour rate method for calculating the value of depreciation.
As per the machine hour rate method of depreciation, we calculate the total life of any fixed asset on the basis of its working hour life. After this, we divide the actual cost of fixed assets by the life of fixed assets in hours. After dividing, we will obtain the depreciation rate per hour. This method will apply mostly to the machines. So, in the following formula, we have used the word machine instead of a fixed asset. You can also find any other fixed asset's hourly depreciation rate with the following formula by changing the cost of the machine, scrap value and estimated life in hours.
Hourly Depreciation rate =
Now, we have to see, how many hours our fixed asset worked. By multiplying the working hours of fixed assets in the year by the depreciation rate per hour, we will calculate the amount of annual depreciation.
Annual depreciation = Working machine in a year × Hourly depreciation rate
Example
A machine was acquired on 1st April 2004 at a cost of Tshs 45000, the cost of installation was Tshs. 5000. It is expected that its total life will be 1,00,000 hours. During 2004, it worked for 8,000 and during 2005 for 12000 hours. Write up the machinery account for 2004 and 2005.
Hourly Depreciation Rate = Cost of machine + cost of installation / estimated life
HDR = 45000 + 5000 / 1,00,000 = Tshs. 0.50 per hour
| Dr. | Machinery Account | | | | Cr. | | Date | Particular | Amount | Date | Particular | Amount | | 31.12.04 | Bank Account (Buying the machine) | 45,000 | 31.12.04 | Depreciation Account {8000 hours X Tshs. 0.50 per hour} | 4,000 | | | Bank Account (Installation cost) | 5,000 | | Balance C/d | 46,000 | | | | 50,000 | | | 50,000 | | 31.12.05 | Balance B/D | 46,000 | 31.12.05 | Depreciation Account {12000 hrs X Tshs. 0.50 per hour} | 6,000 | | | | | 31.12.05 | Balance C/d | 40,000 | | | | 46,000 | | | 46,000 | | 31.12.06 | Balance B/D | 40,000 | | | |
vi. Sum of year digit method
Sum-of-the-years' digits (SYD) is an accelerated method for calculating an asset's depreciation. This method takes the asset's expected life and adds together the digits for each year; so if the asset was expected to last for five years, the sum of the years' digits would be obtained by adding: 5 + 4 + 3 + 2 + 1 to get a total of 15. Each digit is then divided by this sum to determine the percentage by which the asset should be depreciated each year, starting with the highest number in year 1.
As an example, assume an asset has an original cost of Tshs 100,000. It has a useful life of four years and a salvage value of Tshs 15,000. This means the depreciable value of the asset is Tshs 100,000 minus Tshs 15,000, or Tshs 85,000. The sum-of-digits depreciation schedule is as follows:
Year 1: Starting book value is Tshs 100,000 and the depreciation amount is 40%, or Tshs 34,000. The ending book value is Tshs 66,000.
Year 2: Starting book value is Tshs 66,000 and the depreciation amount is 30%, or Tshs 25,500. The ending book value is Tshs 40,500.
Year 3: Starting book value is Tshs 40,500 and the depreciation amount is 20%, or Tshs 17,000. The ending book value is Tshs 23,500.
Year 4: Starting book value is Tshs 23,500 and the depreciation amount is 10%, or Tshs 8,500. The ending book value is Tshs 15,000.
vii. Units output method
This method establishes the total expected units of output expected from the asset. Depreciation is based on cost less salvage value, is then calculated for the period by taking that period's units of output as a proportion of the total expected output over the life of the asset.
An instance of this could be a machine which is expected to be able to produce 10,000 widgets over its useful life. It has cost Tshs 60,000 and has an expected salvage value of Tshs 1000. In year 1 a total of 1,500 widgets are produced, and in year 2 the production is 2,500 widgets.
The journal entry for depreciation can be a simple entry designed to accommodate all types of fixed assets, or it may be subdivided into separate entries for each type of fixed asset. The basic journal entry for depreciation is to debit the Depreciation Expense account (which appears in the income statement) and credit the Accumulated Depreciation account (which appears in the balance sheet as a contra account that reduces the number of fixed assets). Over time, the accumulated depreciation balance will continue to increase as more depreciation is added to it, until such time as it equals the original cost of the asset. At that time, stop recording any depreciation expense, since the cost of the asset has now been reduced to zero.
Example: ABC Company calculates that it should have Tshs. 25,000 of depreciation expense in the current month. The entry is:
| Details | Debit | Credit |
|---|---|---|
| Depreciation Expenses | 25,000 | |
| Accumulated Depreciation account | 25,000 |
There are two main policies which are followed to calculate the provision for depreciation of assets bought or sold during any accounting period.
- Full year depreciation is calculated on the asset purchased irrespective of the date of purchase during any accounting period and no depreciation is charged in the year of sale of these assets.
- Depreciation is calculated on the basis of the number of months that asset was in the ownership of the business. Fractions of the months are usually ignored (time appropriating method)
Disposal of fixed assets is accounted for by removing the cost of the asset and any related accumulated depreciation and accumulated impairment losses from the balance sheet, recording receipt of cash and recognizing any resulting gain or loss in the income statement.
A company may need to de-recognize a fixed asset either upon sale of the asset to another party or when the asset is no longer operational and is disposed of.
At the time of disposal of any of its fixed assets, a company must update the asset's book value by recording any partial-year depreciation associated with the disposal year. It is because whether a gain or loss arises on disposal depends on whether the cash proceeds (if any) from the sale are higher than the carrying amount of the asset at the time of disposal.
Example 1
A firm whose trading period is on 31st December each year buys machinery for Shs. 100,000 cash on 1st April 2000. The firm estimates that the asset will be used for 5 years. After exactly 2½ years, the asset was suddenly sold for Shs. 50,000 cash. The firm always provides a full year depreciation in the year of purchase and no depreciation in the year of the proposal.
Required:
Write up the relevant accounts (including disposal account but not profit and loss account) for each of the years 2000, 2001 and 2002 using:
i. Straight-line method of depreciation (assume 20% depreciation rate)
ii. Reducing balance method of depreciation (assume 40% depreciation rate)
Solution
The amount to be written off as depreciation by using straight-line method (rate = 20%)
DR — MACHINERY ACCOUNT — CR
| Date | Details | Amount | Date | Details | Amount |
|---|---|---|---|---|---|
| 1/4/00 | Cash | 100,000 | 31/12/00 | Bal. b/d | 100,000 |
| 100,000 | 100,000 | ||||
| 1/1/01 | Bal. b/d | 100,000 | 31/12/01 | Bal. b/d | 100,000 |
| 100,000 | 100,000 | ||||
| 1/1/02 | Bal. b/d | 100,000 | 1/10/02 | Machinery Disposal | 100,000 |
| 100,000 | 100,000 |
BY STRAIGHT-LINE METHOD
| DR | PROVISION FOR DEPRECIATION A/C | CR | |||
|---|---|---|---|---|---|
| 31/12/00 | Bal. c/d | 20,000 | 31/12/00 | Profit and Loss a/c | 20,000 |
| 31/12/01 | Bal. c/d | 40,000 | 1/1/01 | Balance b/d | 20,000 |
| 31/12/01 | Profit and Loss a/c | 20,000 | |||
| 40,000 | 40,000 | ||||
| 1/10/02 | Disp.l a/c | 40,000 | 1/1/02 | Balance b/d | 40,000 |
MACHINERY DISPOSAL A/C
| DR | CR | ||||
|---|---|---|---|---|---|
| Date | Details | Amount | Date | Details | Amount |
| 1/10/02 | Machinery | 100,000 | 1/10/02 | Provision for depreciation | 40,000 |
| 1/10/02 | Cash | 50,000 | |||
| 31/12/02 | Profit and loss A/C (Loss on disposal) | 10,000 | |||
| 100,000 | 100,000 |
ii. Workings
Amount to be written off as depreciation by using reducing balance method (rate = 40%)
DR — MACHINERY DISPOSAL A/C — CR
| Date | Details | Amount | Date | Details | Amount |
|---|---|---|---|---|---|
| Machinery | 100,000 | Provision for depreciation | 64,000 | ||
| Profit and Loss a/c | 14,000 | Cash | 50,000 | ||
| 114,000 | 114,000 |
DR — PROVISION FOR DEPRECIATION A/C — CR
| Date | Details | Amount | Date | Details | Amount |
|---|---|---|---|---|---|
| 31/12/00 | Bal. b/d | 40,000 | 31/12/00 | P&L A/C | 40,000 |
| 40,000 | 40,000 | ||||
| 31/12/01 | Bal. b/d | 64,000 | 1/1/01 | Bal. b/d | 40,000 |
| 31/12/01 | P&L A/C | 24,000 | |||
| 64,000 | 64,000 | ||||
| 1/10/02 | Machinery disposal | 64,000 | 1/1/02 | Bal. b/d | 64,000 |
| 64,000 | 64,000 |
DR — MACHINERY DISPOSAL A/C — CR
| Date | Details | Amount | Date | Details | Amount |
|---|---|---|---|---|---|
| 1/10/02 | Machinery | 100,000 | 1/10/02 | Provision for depreciation | 640,000 |
| 31/12/02 | Profit and loss A/C (Profit on disposal) | 14,000 | 1/10/02 | Cash | 50,000 |
| 114,000 | 114,000 |
Example 2
Container Company Ltd was formed on 1st January 1998 and the following information is available for its first four years of operation.
1998: Bought motor car costing Shs. 90,000 on 1.1.1998 and motor car costing Shs. 60,000 on 1.10.1998.
2000: Bought motor car costing Shs. 55,000 on 1.7.2000.
2001: A sold motor car which was bought for Sh. 90,000 on 1.1.98 for the sum of 27,500 on 30th September 2001.
Container Company Ltd depreciates its motor car at the rate of 20% per annum, straight-line method, for each month of ownership. The accounting period for Containers Company Ltd ends in December each year.
Required:
For each of the years 2000 and 2001, prepare the following accounts:
i. Motor car account
ii. Provision for depreciation account
iii. Depreciation account
iv. Disposal account
v. Extracts from the balance sheet.
i.
DR — MOTOR CAR A/C — CR
| 1/1/2000 Bal. b/d | 150,000 | 31/12/2000 Bal. c/d | 205,000 |
| 1/7/2000 Cash | 55,000 | ||
| 205,000 | 205,000 | ||
| 1/1/2001 Bal. b/d | 205,000 | 30/9/2001 Motor car Disposal | 90,000 |
| 31/12/2001 Bal. c/d | 115,000 | ||
| 205,000 | 205,000 | ||
| 1/1/2002 Bal. b/d | 115,000 |
ii.
DR — PROVISION FOR DEPRECIATION A/C — CR
| 31/1/2000 Balance b/d | 86,500 | 1/1/2000 Balance b/d | 51,000 |
| 31/12/2000 Depreciation | 35,500 | ||
| 86,500 | 86,500 | ||
| 30/9/2001 Motor car disposal | 67,500 | 1/1/2001 Balance b/d | 86,500 |
| 31/12/2001 Bal. c/d | 55,500 | 31/12/2001 Depreciation | 36,500 |
| 123,000 | 123,000 |
iii.
DEPRECIATION TABLE
| Date | Type | Cost | 1998 | 1999 | 2000 | 2001 | Acc. Depr. disposal |
|---|---|---|---|---|---|---|---|
| 1/0/98 | A | 90,000 | 18,000 | 18,000 | 18,000 | 13500 | 67,500 |
| 1/10/98 | B | 60,000 | 3,000 | 12,000 | 12,000 | 12,000 | |
| 1/07/00 | C | 55,000 | - | - | 5,500 | 11,000 | |
| 21,000 | 30,000 | 35,500 | 36,500 |
iv.
DR — MOTOR CAR DISPOSAL A/C — CR
| 30/9/2001 Motor Car | 90,000 | 30/9/2001 Provision for depreciation | 67,500 |
| 31/12/2001 P & L (Profit) | 5,000 | 30/9/2001 Cash | 27,500 |
| 95,000 | 96,500 |
CONTAINER COMPANY LTD BALANCE SHEET (EXTRACTS)
| LIABILITIES | ASSETS | ||||
|---|---|---|---|---|---|
| 2000 | |||||
| Motor car | 205,000 | ||||
| Less: Acc. Depr. | 86,500 | ||||
| 118,500 | |||||
| 2001 | |||||
| Motor car | 115,000 | ||||
| Less: Acc. depr. | 55,500 | ||||
| 59,500 |
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