Depreciation

Definition allocation of the depreciable amount of an asset over its estimated life.

The Objective of DepreciationAccording to the matching concept, revenues should be matched with expenses in order to determine the accounting profit.The cost of the asset purchased should be spread over the periods in which the asset will benefit a company.

Depreciation Methods(A) Straight Line Method(B) Reducing Balance Method/Diminishing Balance Method(C) Revaluation Method(D) Sum of Digits Method/Sum of The Years Digits Method(E) Production Output Method/Units of Production Method

(A) Straight Line MethodDepreciation is computed by dividing the depreciable amount of the asset by the expected number of accounting periods of its useful life.Depreciation = Cost of Asset Estimated Residual Value Estimated Useful Economic Life

Useful Economic LifeUseful economic life is not equal to physical lifeIt is the period over which the present owner intends to use the asset

Residual ValueIt is the amount received after disposal of the assetCost of asset - Residual value = Total amount to be depreciated

Example Cost of asset $1200Residual/scrap/salvage value $200Estimated useful life4 yearsAnnual charge for depreciation= $1200-$200 4

= $1000 4=$250

Additional capital expenditures are made to increase the value of a fixed asset Depreciation of those extra capital expenditures should be charged over the remaining useful life of the asset

ExampleA company bought a machine for $1,000 on 1 January 1996Estimated life of 4 years, no scrap value1 January 1997, an additional motor of $90 was fitted into the machineExpected that the useful life of the machine would not be affected

Depreciation for 1996= $1000 4= $250Annual depreciation from 1997 onwards= $1000 4$90 3+= $280

(B) Reducing Balance Method / Diminishing Balance MethodReasonGreater benefit is to be obtained from the early years of using an assetAppropriate to use the reducing balance method which charges more in the earlier years.Annual Depreciation = Net Book Value x Depreciation Rate= (Cost Accumulated Depreciation) x Depreciation Rate

ExampleDepreciation RateCost of assets$10,000Residual value$256Useful life4 years

Annual DepreciationYear 1 10,000 x 60% = $6,000 Year 2 (10,000 6,000) x 60% = $2,400 Year 3 (10,000 8,400) x 60% = $ 960Year 4 (10,000 9,360) x 60% =$ 384Annual Depreciation = Net Book Value x Depreciation Rate= (Cost Accumulated Depreciation) x Depreciation Rate

(D) Sum of Digits Method / Sum of The Years Digits MethodIt provides higher depreciation to be charged in the early years, and lower depreciation in the later periods.Sum of digits = n(n+1) / 2Where n = Useful economic life (number of years)

Depreciation should be charged as follows:Year 1 (Cost Residual value) x n / Sum of digitsYear 2 (Cost Residual value) x (n-1) / Sum of digitsYear 3 (Cost Residual value) x (n-2) / Sum of digitsYear 4 (Cost Residual value) x (n-3) / Sum of digits

Year n (Cost Residual value) x 1 / Sum of digitsWith diminishing years of life to run

Example Cost of asset$9,000No scrap valueEstimated useful life5 yearsSum of digits = 5(5+1) / 2 = 15Depreciation charge:Year 1 $9,000 x 5/15 = $3,000Year 2 $9,000 x 4/15 = $2,400Year 3 $9,000 x 3/15 = $1,800Year 4 $9,000 x 2/15 = $1,200Year 5 $9,000 x 1/15 = $ 600

Production Output Method / Units of Production Method Depreciation is computed with reference to the use or output of the asset in that period.

ExampleA company bought a machine at $10,000 and expects that the machine would run for 2,000 hours during its life. It is expected to have no scrap value.

Depreciation charge:Year 1 800 hoursYear 2 600 hoursYear 3 350 hoursYear 4 250 hoursDepreciation charge:Year 1 $10,000 x 800/2,000 = $4,000Year 2 $10,000 x 600/2,000 = $3,000Year 3 $10,000 x 350/2,000 = $1,750Year 4 $10,000 x 250/2,000 = $1,250

Accounting for DepreciationAccounting TreatmentDr. Fixed AssetCr. Bank/VendorPurchase price and other capital expenditureDr. Profit and LossCr. Provision for Depreciation

ExampleIn a business with financial years ended 31 December. A machine is bought for $2,000 on 1 January Year 1. The estimated useful life is 5 years.You are to show:(a) Machinery account(b) Provision for depreciation(c) Profit and loss account for the year ended 31 Dec Year 1, 2, and 3.(d) Balance sheet as at those date(1) Using straight line method and reducing balance method, at the rate of 20%.

Straight Line MethodMachineryYear 1 $Jan 1 Bank 2,000Provision for dep. MachineryYear 1Dec 31 Bal. c/d 400$Year 1$Dec 31 P/L 400Year 1 $Dec 31 Bal c/d 2,000Year 1 (2000/5)

Profit and Loss for the year ended 31 Dec Less: Expenses Depreciation - MachineryYear 1$400Balance Sheets as at 31 Dec Fixed AssetMachinery at costLess: Provision for Dep.Year 1$2,0004001,600

Year 2Provision for dep. MachineryYear 1Dec 31 Bal. c/d 400$Year 1$Dec 31 P/L 400Year 2Year 2Jan 1 Bal. b/d 400Dec 31 P/L 400Dec 31 Bal. c/d 800800800(2000/5)

Profit and Loss for the year ended 31 DecLess: Expenses Depreciation - MachineryYear 1$Year 2$400400Balance Sheets as at 31 DecFixed AssetMachinery at costLess: Provision for Dep.Year 1$Year 2$2,0002,0004008001,6001,200

Provision for dep. MachineryYear 1Dec 31 Bal. c/d 400$Year 1$Dec 31 P/L 400Year 2Year 2Jan 1 Bal. b/d 400Dec 31 P/L 400Dec 31 Bal. c/d 800800800Year 3Jan 1 Bal. b/d 800Dec 31 P/L 400Year 3Dec 31 Bal. c/d 1,2001,2001,200Year 3

Profit and Loss for the year ended 31 DecLess: Expenses Depreciation - MachineryYear 1$Year 2$Year 3$400400400Balance Sheets as at 31 DecFixed AssetMachinery at costLess: Provision for Dep.Year 1$Year 2$Year 3$2,0002,0002,0004008001,2008001,6001,200

Reducing Balance MethodMachineryYear 1 $Jan 1 Bank 2,000Year 1 $Dec 31 Bal c/d 2,000Year 1Provision for dep. MachineryYear 1Dec 31 Bal. c/d 400$Year 1$Dec 31 P/L 400 (2000*20%)

Profit and Loss for the year ended 31 Dec Less: Expenses Depreciation - MachineryYear 1$400Balance Sheets as at 31 Dec Fixed AssetMachinery at costLess: Provision for Dep.Year 1$2,0004001,600

Provision for dep. MachineryYear 1Dec 31 Bal. c/d 400$Year 1$Dec 31 P/L 400Year 2Year 2Jan 1 Bal. b/d 400Dec 31 P/L 320Dec 31 Bal. c/d 720720720Year 2(2000-400)*20%

Profit and Loss for the year ended 31 DecLess: Expenses Depreciation - MachineryYear 1$Year 2$400320Balance Sheets as at 31 DecFixed AssetMachinery at costLess: Provision for Dep.Year 1$Year 2$2,0002,0004007201,6001,280

Provision for dep. MachineryYear 1Dec 31 Bal. c/d 400$Year 1$Dec 31 P/L 400Year 2Year 2Jan 1 Bal. b/d 400Dec 31 P/L 320Dec 31 Bal. c/d 720720720Year 3Jan 1 Bal. b/d 720Dec 31 P/L 256Year 3Dec 31 Bal. c/d 976976976Year 3(2000-720)*20%

Profit and Loss for the year ended 31 DecLess: Expenses Depreciation - MachineryYear 1$Year 2$Year 3$400320256Balance Sheets as at 31 DecFixed AssetMachinery at costLess: Provision for Dep.Year 1$Year 2$Year 3$2,0002,0002,0004007209761,0241,6001,280

Disposal AccountShould be opened whenThe asset is sold, orThe asset is disposed of due to an accident.

Accounting Treatment

Dr. DisposalCr. Fixed AssetCost price of the asset soldDr. Provision for DepreciationCr. Disposal Depreciation already charged on the assets concernedDr. Cash / VendeeCr. DisposalProceeds received / receivable on the disposalIn case of loss on the disposal (Debit side greater than credit side)Dr. Profit and LossCr. DisposalWith any loss on the disposalIn case of profit on the disposal (Credit side greater than debit side)Dr. DisposalCr. Profit and LossWith any profit on the disposal

ExampleIn a business with financial years ended 31 December. A machine is bought for $2,000 on 1 January Year 1. The estimated useful life is 5 years. In Year 4, the machinery has been sold for $1,070. Show the accounting entries:You are to show:(a) Machinery account(b) Provision for depreciation(c) Disposal account(d) Profit and loss account and Balance sheet as at 31 Dec Year 4

MachineryYear 4$Jan 1 Bal. b/d 2,000Year 4$Dec 31 Disposal 2,000Pro. For Dep.Year 4$Dec 31 Disposal 976Year 4$Jan 1 Bal. b/d 976DisposalYear 4$Dec 31 Machinery 2,000Year 4$Dec 31 Pro. For Dep. 976Dec 31 P/L gain 46Dec 31 Bank 1,070 2,0462,046

Profit and Loss for the year ended 31 Dec Year 4 $Gross profit X Less: Expenses

Add: Gains on disposal 46Loss on disposal X $DisposalYear 4$Dec 31 Machinery 2,000Year 4$Dec 31 Pro. For Dep. 976Dec 31 Bank 9002,0002,000E.g. if the machinery was sold for $ 900. Dec 31 P/L- loss on 124 disposal

Depreciation on monthly/full-year basis Fixed assets can be purchased and sold at any time during the accounting year.Depreciation on a monthly basis:Based on the fraction of the year in which the asset is held.Depreciation on a full-year basis:Full years depreciation in the year of purchase and none in the year of disposal irrespective of the period in which the asset is held.In an examination, it is necessary for the students to follow the approach required by the question. Where no indication is given, the monthly basis approach is recommended.

ExampleA company bought two motor vehicles for $2,400 each on 1 July 1996. One of the vehicles was sold for $1,500 on 1 April 1998.Depreciation is to be charged:At 20% on the straight line basis (monthly basis)At 20%, using the straight line method,and bases on assets in existence at the end of each year, ignoring items sold during the yearPrepare the following accounts:Motor vehicle account Provision for depreciation, Disposal account for the year ended 31 Dec 1996,1997 and 1998.

Motor Vehicles1996July 1 Bank 4,800$1996$Dec 31 Bal. c/d 4,800(1.)1996Dec 31 Bal. c/d 480$1996$Dec 31 P/L 480($4,800 x 20% x 6/12)Provision for dep. Motor Vehicles

Motor Vehicles1996July 1 Bank 4,800$1996$Dec 31 Bal. c/d 4,80019971997Dec 31 Bal. c/d 4,800Jan 1 Bal. b/d 4,8001996Dec 31 Bal. c/d 480$1996$Dec 31 P/L($4,800 x 20% x 6/12) 48019971997Jan 1 Bal. b/d 480Dec 31 P/L($4,800 x 20%) 960Dec 31 Bal. c/d 1,4401,4401,440Provision for dep. Motor Vehicles

Motor Vehicles$$Dec 31 Bal. c/d 4,8001997Year 2Dec 31 Bal. c/d 4,800Jan 1 Bal. b/d 4,8001998Apr 1 Disposal of MV 2,400 Dec 31 Bal. c/f 2,4001998Jan 1 Bal. b/d 4,8004,8004,8001996July 1 Bank 4,800

1996Dec 31 Bal. c/d 480$1996$Dec 31 P/L($4,800 x 20% x 6/12) 48019971997Jan 1 Bal. b/d 480Dec 31 P/L($4,800 x 20%) 960Dec 31 Bal. c/d 1,4401,4401,4401998Jan 1 Bal. b/d 1,440Dec 31 P/L ($2,400 x 20%x 3/12 + $2,400 x 20%) 6001998Dec 31 Bal. c/f 1,2002,0402,040Provision for dep. Motor VehiclesDec 31 Disposal [$2,400 x 20% x (6/12 + 1 + 3/12)] 840

Disposal of Motor Vehicle1998$Dec 31 Machinery 2,4001998$Apr 1 Pro. For Dep.[$2,400x 20% x (6/12 + 1 + 3/12)] 840Dec 31 P/L loss 60Apr 1 Bank 1,500 2,4002,400

Motor Vehicles1996July 1 Bank 4,800$1996$Dec 31 Bal. c/d 4,800(2.)1996Dec 31 Bal. c/d 480$1996$Dec 31 P/L 960($4,800 x 20% )Provision for dep. Motor Vehicles

Motor Vehicles1996July 1 Bank 4,800$1996$Dec 31 Bal. c/d 4,80019971997Dec 31 Bal. c/d 4,800Jan 1 Bal. b/d 4,8001996Dec 31 Bal. c/d 960$1996$Dec 31 P/L ($4,800 x 20%) 96019971997Jan 1 Bal. b/d 960Dec 31 P/L ($4,800 x 20%) 960Dec 31 Bal. c/d 1,9201,9201,920Provision for dep. Motor Vehicles

Motor Vehicles1996July 1 Bank 4,800$1996$Dec 31 Bal. c/d 4,8001997Year 2Dec 31 Bal. c/d 4,800Jan 1 Bal. b/d 4,8001998Apr 1 Disposal 2,400 Dec 31 Bal. c/f 2,4001998Jan 1 Bal. b/d 4,8004,8004,800(2.)

1996Dec 31 Bal. c/d 960$1996$Dec 31 P/L ($4,800 x 20%) 96019971997Jan 1 Bal. b/d 960Dec 31 P/L ($4,800 x 20%) 960Dec 31 Bal. c/d 1,9201,9201,9201998Jan 1 Bal. b/d 1,920Dec 31 P/L ($2,400 x 20%) 4801998Dec 31 Bal. c/f 1,4402,4002,400Provision for dep. Motor VehiclesApr 1 Disposal ($2,400 x 20% x 2)] 960

Disposal of Motor Vehicle1998$Dec 31 Machinery 2,4001998$Apr 1 Pro. For Dep.($2,400x 20% x 2) 960Dec 31 P/L gain 60Apr 1 Bank 1,500 2,4602,460

Trade-in-allowanceThe assets being trade in for a new assetsAccounting entries:Dr. Fixed AssetsCr. DisposalWith the trade-in value of disposed asset

ExampleA company purchased machine for $2,500 each on 1 Jan. Year 1. It is the companys policy to provide for depreciation on its machinery at a rate of 20%, with a full years depreciation made in the year in which a machine is purchased, but none in the year of sale. One machine was traded in and a new machine for $4,000 was purchased on 1 Feb. Year 2. The trade-in value of the old machine was $1,000.

MachineryYear 1Jan 1 Bank 2,500$Year 1$Dec 31 Bal. c/d 2,500Provision for dep.-MachineryYear 1Dec 31 Bal. c/d 500$Year 1$Dec 31 P/L 500(2500*20%)

Machinery$$Year 2Year 2Feb 1 Disposal 2,500Dec 31 Bal. c/d 4,000Jan 1 Bal. b/d 2,500Feb1 Disposal: trade- in-allowance 1,000Feb1 Bank 3,0006,5006,500Provision for dep.-MachineryYear 1Dec 31 Bal. c/d 500$Year 1$Dec 31 P/L 500Year 2Year 2Jan 1 Bal b/d 500Feb 1 Disposal 500DisposalYear 2Feb 1 Machinery 2,500$Year 2$Feb1 Dep. 500Feb 1 Machinery: trade-in-allowance 1,0002,5002,500

Factors Determining the Amount of Depreciation

The Carrying Amount of AssetsCostPurchase priceProduction costRevalued Value

Purchases PriceAcquisition cost of a fixed asset:Invoice price (after deducting any trade discounts)Expenditures incurred in bringing the asset to a location and condition suitable for its intended use.E.g. Import duty, freight charges, insurance, etc.Expenditures incurred in improving the asset. They increase the expected future benefit from the existing fixed asset.E.g. Additional motor for machinery, the extension of a factory, etc.

ExampleA company purchased a machine for $50,000. In addition, an import duty of $5,000, landing charges of $2,000 and installation costs of $1,000 were paid. A service contract was entered into for the life of the machine at a cost of $800 per annum. The depreciation is charged at 10% of the cost per annum.

Cost of the machine = $58,000Annual depreciation charge = $58,000 x 10% = $5,800

Expenditure itemsCapital expenditureRevenue expenditure$$Invoice price50,000Import duty5,000Landing charges2,000Installation cost1,000Service charges80058,000800

ExampleThe suppliers invoice for a machine was as follows:**The depreciation is charged at 10% of cost per annum.

$$List price200,000Less Trade discount10,000 Trade-in value50,00060,000140,000Delivery charges2,000Adaptation and testing3,000Maintenance1,500Spare components1,0007,500147,500

Cost of the machine = $195,000Annual depreciation =$195,000*10% = $1,950

Expenditure itemsCapital expenditureRevenue expenditure$$Invoice price($200,000 - $10,000)190,000Delivery charges2,000Adaptation and testing3,000Maintenance1,500Service charges1,000195,0002,500

Production costAn asset is produced by the firm itself, the following expenditures should be included in the cost of the asset:Cost of raw materialsDirect cost of production, e.g. direct labour, royalties, etc.A Reasonable proportion of factory overhead expenses / indirect production costs, e.g. indirect raw materials, indirect labour, indirect expenses and interest on borrowed capital to finance the production of the asset.

ExampleA company constructed a machine. The related costs are as follows:Cost of the machine = $8,000 + $12,000 + $5,000 + $2,000 + $3,000 = $30,000** Depreciation is charged at 10% of cost per annumAnnual depreciation = $30,000*10% = $3,000

$Drafting and design8,000Construction: Materials and components120,000 Assembling wages5,000 Other expenses2,000Testing and Adaptation3,000

Revalued valueWhere assets are revalued in the financial statements, the provision for depreciation should be based on the revalued amount and the current estimate of the remaining useful life.

ExampleA company purchased a machine for $1,000 on 1 January 1996. It is assumed that the useful economic life of the machine is 4 years.Depreciation has been provided at 25% per annum on cost.Balance Sheet as at 31 December 1996 (Extract)$Machinery, at cost 1,000Less Provision for Dep. 250($1,000 x 25%)1,250

E.g. The machine was revalued on 1 January 1997 at $1,500. There is no change in its estimated remaining useful life.Value of the machinery = $1,500The remaining useful economic life = 4-1 = 3 yearsDepreciation for 1997 = $1,500 3 = $500Balance Sheet as at 31 December 1997 (Extract)$Machinery, at valuation 1,500Less Provision for Dep. 5001,000

Capital and Revenue Expenditure

ExpenditureIt is the amount of economic resources given up in obtaining goods and services.

Capital ExpenditureIt is an expenditure to:Get a long-term benefit,Buy fixed assets, or Add to the value of an existing fixed asset.

ExampleAcquiring fixed asset, such as premises, equipment, fixtures and furniture, etc.Expenditure which is spent to prepare the asset for its intended use, such as freight charges, legal cost, installation cost, landing charge, import duty of buying the asset.

Revenue ExpenditureIt is an expenditure for:The acquisition of assets for resale, orFor the purpose of earning revenue income.

ExampleBuying trading stockAdministrative expenses, selling expenses, or financial expenses

Accounting TreatmentCapital ExpenditureOn acquiring assets,Dr. Asset accountsCr. Bank / Cash / CreditorsAt the year end, the balances go to the Balance SheetRevenue ExpenditureWhen there are expenses,Dr. Expenses accountsCr. Bank / Cash / CreditorsAt the year end, the balances will be debited to the Profit and Loss Account, or Trading Account.

ExampleOn acquiring premises, how do we distinguish between capital and revenue expenditures?

ExpenditureBenefitNature of ExpenditureAccounting Treatment(a) Buying a houseLong-term benefit fixed asset acquiredCapitalDr. PremisesCr. Bank/Cash/ Creditor(b) Legal cost of buying a houseLong-term benefit extending beyond current accounting periodCapitalDr. PremisesCr. Bank/Cash/ Creditor

ExpenditureBenefitNature of ExpenditureAccounting Treatment(c) Installation of partition walls and lighting system in preparing the flat for use as an officeLong-term benefit to prepare the asset for intended useCapitalDr. PremisesCr. Bank/Cash/ Creditor

ExpenditureBenefitNature of ExpenditureAccounting Treatment(d) Renting a houseShort-term benefit consumed within current accounting period RevenueDr. RentCr. Bank/Cash/ Creditor(e) Management feeShort-term benefit consumed within current accounting periodRevenueDr. Management feeCr. Bank/Cash/Creditor

Capital IncomeIt is the income from the sale of a fixed asset or asset which was not acquired for resale.ExampleProfit on disposal of machineryRealization of goodwill

Revenue IncomeIt is the income form the sale of trading stock or goods acquired for resale.ExampleSale of trading goodsRental income of a property company

Accounting TreatmentRevenue IncomeThis is normal trading income, and will be credited to Trading Account.Trading Account$Sales X

Capital IncomeThis is non-trading income, and will be credited to Profit and Loss Account.Profit and Loss Account$Gross Profit b/fXProfit on Disposal X

RevaluationA fixed asset should be recorded at cost less depreciation.The value of an asset in reality is increasing as a result of inflation, which may be significantly greater than its historical cost stated in the balance sheet.Revaluation of assets is not common in Hong Kong, because he market value of an asset is very subjective.

Revaluation ProfitWhen the market value of an asset is greater than its historical cost, the increase in value should be:It is NOT to be treated as an income in the Profit and Loss Account

Dr. Fixed AssetCr. Revaluation ReserveWith the rise in value

Revaluation LossWhen the market value is smaller than the historical cost, the decrease in value can be treated in two ways:If the asset had been revalued before, and a revaluation reserve has been established:

Dr. Revaluation ReserveCr. Fixed AssetWith the decrease in value

If the loss cannot be covered by any reserve arising from the previous revaluation of the same asset:

Dr. Profit and Loss Account

Cr. Fixed AssetWith the decrease in value