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Chapter 4

Depreciation

Depreciation is an expense

Is an expense of the business and to be charged to the profit and loss account to reduce net profit

Depreciation = cost of buying - amount received on disposal

Causes of Depreciation

Physical deterioration -- wear and tear; erosion, rust, rot and decay Economic factors obsolescence; inadequacy The time factor lease, patent, the term amortization is used instead of depreciation Depletion the wasting away of an asset as it is used up (due to the extraction of raw materials), e.g. natural resources such as mines, quarries and oil wells

Methods of Calculating Depreciation

1) Straight Line Method/Fixed Installment Method Amount of depreciation is the same for every year yearly depreciation = (cost estimated disposal value)/number of expected years of use example 1: a motor lorry was bought for RM22,000 and keep it for 4 years and then sell it for RM2,000, the depreciation to be charged would be : = (RM22,000 - RM2,000)/4 = RM5,000 depreciation each year for 4 years

2) Reducing Balance Method/Diminishing Balance Method

depreciation is at a lesser amount every following period a fixed % for depreciation is deducted from the cost in the 1st year In the 2nd or later years the same % is taken of the reduced balance (cost less depreciation already charged)

reducing balance method has a much higher charged for depreciation in the early years and lower charges in the later years

Example 2
A machine is bought for RM10,000 and depreciation is to be charged at 20%, the calculations for the first three years would be as follows:
Cost RM10,000 2,000 1st year: depreciation (20% of RM10,000) RM

RM
2nd year: depreciation (20% of RM8,000) RM RM 3rd year: depreciation (20% of RM6,400) RM

8,000
1,600 6,400 1,280

Cost not yet apportioned, end of year 3

RM

5,120

3) Sum of the Years Digits

provides for higher

depreciation to be charged early in the life of an asset with lower depreciation in later year

Example 3: An asset cost RM3,000 will be in use for 5 years, the calculations will be:
Life of asset during 1st year used 5 years 1st year depreciation (RM3,000 x 5/15) Life of asset during 2nd year used 4 years 2nd year Depreciation (RM3,000 x 4/15) RM 800 RM1,000

Life of asset during 3rd year used

3 years

3rd year Depreciation (RM3,000 x 3/15)

4th year Depreciation (RM3,000 x 2/15) 5th year Depreciation (RM3,000 x 1/15)

RM 600

Life of asset during 4th year used

2 years

RM 400

Life of asset during 5th year used

1 year

RM 200

sum of these digits

15 years

RM3,000

4) Units-of-Activity - establish the total expected units of output expected from the asset. - Is ideally suits for factory machinery : production can be measured in terms of units of output or in terms of machine hours used in operating the machinery

a)units of output method =(cost salvage value)x (periods production/total expected production)

b) machine hour method =(cost salvage value)x(periods machine hours/total expected running machine hours)

a) units of output method

b) machine hour method

example: A machine cost RM6000 example: A machine cost has an expected salvage value RM2000 has no scrap of RM1000, it is expected to value and having an be able to produce 10,000 tv expected running life set over its useful life and of 1000 hours, it was a total of 1500 tv set are operated 200 hours produced in year 1 during the first year

1st year depreciation =(RM6,000-1,000)x(1,500/10,000) = RM750

1st year depreciation = RM2000(200/1000) = RM400

Depreciation Provisions and Assets Bought or Sold

Method of calculating depreciation provision for assets bought or sold during an accounting

Ignore the dates during the year that the assets were bought or sold, merely calculating a full periods depreciation on the assets in use at the end of the period assets sold during the accounting period will have had no provision for depreciation made for that last period irrespective of how many months they were in use i.e sold June 2006, so depreciation for Jan June can be ignored. assets bought during the period will have a full period of depreciation provision calculated even though they may not have been owned throughout the whole of the period i.e bought Nov 2006, so depreciation charged from Jan Dec 2006

Double Entry Records for Depreciation

assets accounts are kept at cost price and the depreciation is credited to a provision for depreciation account. Debit the profit and loss account Credit the provision for depreciation account

Disposal of Asset

When we sell a fixed asset, we must transfer both the cost and the accumulated depreciation to a separate disposal account profit on disposal is transferred to the credit of the profit and loss account (increase net profit) loss on disposal is transferred to the debit of the profit and loss account(increase expenses)

4 steps to records disposal of asset

1.transfer the cost price of the asset sold to an asset disposal account Debit computer disposals account Credit computer account 2.transfer the depreciation already charged to the assets disposal account Debit provision for depreciation :computer Credit computer disposals account 3.for remittance received on disposal Debit cash book Credit computer disposals account 4.transfer the difference to the profit and loss account Debit computer disposals account (credit balance) Credit profit and loss account (profit on disposal) OR Debit profit and loss account (loss on disposal) Credit computer disposals account (debit balance)

Accruals, prepayments and other adjustments

Other Adjustments for Final Accounts

Adjustments are needed so that the expenses and income shown in the final accounts will equal the expenses incurred in the period and the revenue that has accrued. the balances caused by the adjustments will be shown on the B/S at the end of the period example: The rent for building is RM6000 p.a. : a) Firm A pays RM5000 in the year; b) Firm B pays RM6500 in the year

Expense and Revenue Accounts for Accruals and Prepayments

Accruals Accrued Expenses 1. an exp. which the firm has used up but has not yet been paid for 2. credit balance (current liability)
Accrued Revenues 1. revenues earned but not yet received in cash or recorded 2. debit balance (current asset)

Prepayments Prepaid Expenses 1. an expense to be used up in a following period but has been paid for in advance 2. debit balance (current asset)
Unearned Revenues 1. revenues received in advance 2. credit balance (current liability) 3. if the rent due on 31/12/X5 was received on 01/12/X5 instead of 07/01/X6, the amount received = RM550. (exercise: write up the ledger a/c, showing the transfer to the final accounts and the bal. carried down to the following year)

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