Principle of Accounting

Chapter 12 &14

Depreciation of non-current assets

BA. in International BusinessForeign Trade University

Outline

The meaning of depreciationThe meaning of costMethods of calculating depreciation

Straight-line method Reducing balance method

A comparison of the two methodsDepreciation methods: Which one to

use?The adjusting entry for depreciation

Outline (cont’d)Depreciation and the statement of

financial position and the statement of financial performance

Historical cost versus fair valueRevenue recognition

The meaning of depreciationDepreciation is the allocation of the cost of

a non-current asset over its effective working life.

An asset’s effectiveness gradually diminishes because of physical deterioration such as wear and tear and becomes obsolete. At the end of its useful working life, it may be scrapped or sold.

Depreciation complies with the matching principle as non-current assets are used to generate revenue, some amount of cost (depreciation) should be matched with this revenue.

The meaning of cost Two elements to be identified in

measuring the cost of a non-current asset:1. The historical (original) cost of the asset2. All other costs incurred to get the asset into a

revenue-earning capacity.

Other costs relating to the purchase of an asset are necessary to make the asset ready to earn revenue. Those costs may include delivery, installation, stamp duty, dealer charges, etc.

Consider the examples in the text book, pg. 215

Depreciation – Straight line methodThe straight line method of depreciation

(fixed instalment method) allocates the same amount of cost each reporting period.

The formula to calculate depreciation under the straight line method:

Cost - ScrapDepreciation expense = -------------------------

Useful lifeDepreciation can also be expressed as a

percentage rate per annum

Depreciation – Straight line methodThe following details relate to a vehicle

bought on 1 Jan 05:Purchase price of van:

$16,000Estimated useful life: 4 yearsEstimated residual (scrap) value $6,400

Depreciation expense = (16,000 – 6,400) / 4 = $2,400 per year

Depreciation rate per annum = $2,400 / $16,000 = 15%

Depreciation – Straight line method

YearDepreciation

expenseAccumulated

depreciationCarrying

value

2005 2,400 2,400 13,600

2006 2,400 4,800 11,200

2007 2,400 7,200 8,800

2008 2,400 9,600 6,400

Depreciation – Reducing balance methodSome assets tend to be much more efficient in

their early years. Therefore, they are likely to generate more revenue in early years of their life and less in later years.

The matching principle requires revenue earned to match with expense incurred. The reducing balance method follows the principle that If an asset earns more revenue in a particular year, greater amount of depreciation is allocated in that year.

Depreciation – Reducing balance methodThe following details relate to a vehicle

bought on 1 Jan 05:Purchase price of van: $16,000Estimated useful life: 4 yearsEstimated residual (scrap) value $6,400

Assume the depreciation rate under reducing balance method is 1.5 times the straight line method.Depreciation rate = 1.5 * 15% = 22.5%

Depreciation – Reducing balance method

YearDepreciation

expense (1)=(3)*22.5

Accumulated depreciation

(2)Carrying value(3)=16,000-(2)

2005

3,600

3,600 12,400

2006

2,790

6,390 9,610

2007

2,162

8,552 7,448

2008

1,048

9,600 6,400

Depreciation methods: a comparison

As the years pass, the amount of depreciation allocated under the reducing balance method decreases.

Depreciation under straight line method will be constant throughout the asset’s life.

The difference between depreciation methods is the amount of cost to be allocated in a particular reporting period.

Over the life of the asset, both methods allocate the same amount of cost and end up with the estimated scrap value.

Depreciation methods: which one to use?

The method to be selected should be chosen on the basis of best satisfying the matching principle.

The choice of depreciation method should be linked to the nature of asset being considered.

A business may use both methods for different assets that have different revenue-earning patterns. Shop fittings Straight lineOffice furniture Straight lineMachinery Reducing balanceVehicles Reducing balance

The adjusting entry for depreciationDepreciation is usually allocated on the last

day of each reporting period and is therefore known as a balance-day adjustment.

The debit entry to “depreciation expense” is an increase in expense to match with the revenue for the period.

The credit entry to “Accumulated depreciation” is an increase in a negative asset account.

The accumulated depreciation account is used to add up the total depreciation. The account is a negative asset account because it is shown as a deduction to the asset account on the statement of financial position.

Journal entries for depreciation

Date Accounts Debit Credit

Dec 31 Depreciation of vehicle

Accumulated depreciation of vehicle

Adjusting entry for depreciation:

Straight line method at 15% pa

2,400

2,400

Dec 31 Profit and loss summary

Depreciation of vehicle

Closing entry for depreciation expense

2,400

2,400

Depreciation and the statement of financial position

Statement of financial position (extract) as at 31.12.05

Non-current assetsVehicle 16,000less Accumulated depreciation 2,400

$13,600

$16,000: historical cost of the asset and other incidental cost incurred in getting the asset in a revenue-earning capacity.

$2,400: accumulated depreciation (expired cost)$13,600: book value (carrying value) includes the

value of the asset yet to be depreciated and the estimated scrap value.

Depreciation and the statement of financial performance

Depreciation is an expense item, it is reported in the statement of financial performance.

Depreciation is based on two estimates (residual value and useful life), the amount depreciated can not be reliably measured.

However, depreciation is a relevant expense, therefore it should be included in the statement of financial performance.

Therefore, the relevance outweighs the concern of not being able to verify depreciation.

Historical cost versus fair valueTraditionally, non-current assets have been

reported at historical cost.Historical cost may become irrelevant in the

time of inflation. In recent times, the accounting standards

allow business to value non-current assets at fair value.

The adjustment made to reflect non-current assets at fair value is known as revaluation.

If an asset increases in value, an upward adjustment may be made to the asset account. It is a revaluation increment.

If an asset decreases in value, a downward adjustment may be recorded (a revaluation decrement).

Historical cost versus fair valueGeneral journal entry for revaluation increment:

Dr Non-current AssetCr Asset revaluation reserve

General journal entry for revaluation decrement:

Dr Asset revaluation reserveCr Non-current asset

The “Asset revaluation reserve” account is a part of owner’s equity and should be reported as a separate item under owner’s equity section in the statement of financial position.

If an asset revaluation reserve is not yet created, downward adjustment is written off as a reduction in equity at that time.

Depreciation and fair valueIf an asset is shown at fair value, depreciation

must also be based on its fair value. Depreciation will change if there is any

change in the asset value or estimated residual value or estimated useful life of the asset.

Adjustments may be made to the fair value of the asset to satisfy the relevance. However, it is difficult to ensure the reliability of the fair value of the asset.

The value of relevant information can outweigh the doubt about its reliability. Businesses can seek for professional valuers to determine the fair value of the asset.

Revenue recognition At what point should a business recognise

revenue? Point of sale: this method recognises revenue

as being earned as soon as it is possible to determine that a sale has occurred.

Two requirements that need to be satisfied for revenue to be recognised at point of sale

1. The business must have fulfilled its obligations to the customer. In most cases this means that the goods required have been supplied.

2. Objective, verifiable evidence must be available to confirm the amount of revenue earned (invoice, receipt or contract).

Revenue recognition (cont’d)Point of cash transfer: this method recognises

revenue only when cash is received from customers.

It relies on verifiable evidence as receipts can be issued to customers by the business when cash is received.

The inherent weakness is that it ignores revenue unless cash changes hands.

It includes cash receipts that belong to transactions in a next period or cash receipts that relate to sales from previous periods as revenue.

Once a method of revenue recognition is chosen, it should be applied consistently to each reporting period.

Practice questionsExercise 12.1Exercise 12.2Exercise 14.1Exercise 14.2

HomeworkExercise 12.3Exercise 12.4