depreciation

depreciation

that part of the original cost of the fixed asset that is consumed during its period of use by the business

decline/fall in value of fixed asset over its useful life

nature of depreciation

expense

useful life

estimate of no of days/months/yrs a fixed asset is likely to remain in service/use by business

other names of useful life

expected usage, estimated life, life

causes of depreciation

1. physical deterioration= erosion, rust, rot, decay, wear and tear

2. economic factors= obsolete/obsolescence which means out of date/outdated, inadequacy when asset no longer remains in use bcs of change of nature or size of business

3. time= legal life/from govt on agreement on funding/expiration

4. depletion= due to consumption/waiting characteristics

residual value/scarp value/salvage value/remaining value/disposal value

estimated value of a fixed asset after full depreciation or at the end of its useful life

value expected to receive when the asset will be put out of use from the business or at the end of its useful life

cost

price as which bought the asset

historical cost/original cost/purchase price/list price

straight line method

normally used for: furniture, fixtures, fittings, buildings

in this amount of depreciation ramains same throughout its useful life

will lose its value each year

cost-scarp value upon useful life

OR

(cost-scarp value) × % rate

pros of striaght line method

1. simple, easy to understand and apply

2. same amount is charged as depreciation to income statement every year which makes comparison of profits of different years easy

3. same amount of depreciation each year which makes it really predictable

4. suitable for acids used equally each year like buildings

cons of straight line method

Unrealistic for many assets because repairs increase as assets age.

reducing balance/diminishing method

normally used for technological assets like machines, equipment, vehicles, computer

under it depreciation decreases year by year

(cost- accumulated depreciation) ×rate %

accumulated depreciation=total depreciation/provision for depreciation

pros of reducing balance

1. Charges more depreciation in early years, which is realistic.

2. Matches higher depreciation with lower repair costs in early years.

3. Suitable for assets that lose value quickly (e.g. machinery, vehicles).

cons of reducing balance

1. More difficult to calculate than straight line.

2. Depreciation amount changes every year.

3. Asset value never becomes zero in theory.

revaluation method

normally used for low cost items like loose tools, crockery, laboratory items

opening value+addition-disposal-closing value

pros of revaluation

1. simple and striaght forward

2. avoids the need fir keeping detailed records

cons of revaluation

1. Requires physical checking and revaluation each year.

2. Results can be less reliable if valuation is inaccurate.

3. to vaule the asset accurately at end of year is time consuming

policies for charging depreciation

1) Full year method

Full year depreciation in year of purchase of asset but no depreciation in year of sale/disposal

Used when dates are not given

2) Pro-rata (time basis) method

Depreciation charged for time used

Used when dates are given

double entry for depreciation (to record the depreciation expenses for the year)

income statement dr

provision for depreciation cr

provision for depreciation is contra asset

disposal entries - to write off cost of an asset

disposal acc dr

machine/equipment/machinery cr

(to write off an assets account on its disposal)

disposal entries - to write off total depreciation charged from date of purchase to date of sale

accumulated dep/provision for dep dr

disposal acc cr

(to write off the total depreciation of the asset sold)

disposal entries - to record the cash or cheque receipt on disposal

cash/bank/debtor dr

disposal acc cr

(to record the cash or cheque received on sale)

disposal entries - to record gain/loss on disposal

gain entry

disposal acc dr

income statement (gain) cr

loss entry

income statement dr

disposal acc cr

why do we charge depreciation

depreciation is charged to spread the cause of asset over its useful life

why land dies not depreciate

land has indefinite life

explain why depreciation is in application of the matching/accurals principle

Accrual concept means recording expenses and income in the period to which they relate, regardless of cash movement. Depreciation is charged yearly even though no cash is paid.

depreciation is a non cash expense why

depreciation is a non cash expense the reason is that company does not pay any cash or cheque against depreciation expense like other expenses like rent or insurance