Depreciation
The Cost of an asset that is consumed by that financial period by the business
OR
The Allocation of Cost of an Asset over its useful working life
Discuss the possible ways of funding for the purchase of an additional non current asset
1. Bank Loan
2. Partner's Loan
3. Sale of surplus non current asset
4. Hire purchase
5. Partner introduces more capital
6. Admit a new partner
Why a Company Calculates Depreciation?
1. To comply with the prudence concept by avoiding overstating non current assets and profit by recording the depreciation charge as an expense
2. To comply with Matching Concept by matching the loss in value of the asset with the income generated from using it
3. Ensure the financial Statements show a true and fair view
4. To match the loss in value with wear and tear and obsolescence etc
State Causes of Depreciation
1. Time or Passage of Time
2. Obsolescence
3. Technology Advances
4. Economic Factors
5. Wear & Tear
6. Depletion
State an example for each cause of depreciation
Passage of time - Leasing a building
Obsolescence & Technology Advances - Machinery & Office Equipment
Wear & Tear - Fixtures & Fittings
Depletion - Quarry, oil wells and mines
Economic Factors - Such as inflation and deflation of market value
State four factors to consider when calculating depreciation charge
1. Type of Asset
2. Depreciation Method
3. Cost of the Asset
4. Length of Owneship
5. Usage
6. Residual Value
Why different Assets have different Rates of Depreciations
This is because different assets decrease in value at different values compared to other assets. For example, Machinery has a heavier fall in value in the early stages and it decreases with time as the usage decreases. So reducing balance method is the most suitable.
For Fixtures and fittings, the decrease in value will be even as the usage will be even so straight line method is the best option
Why you shouldn't change the depreciation Method...
The business should not change the depreciation method as it violates the consistency concept and makes comparison between years of very little benefit
There is only one reason for change. Only if the business is able to prove the change will improve the true and fair view of the business. However, changes must be done to the previous years due to this
Why change from reducing balance to straight line method?
1. Easier to calculate and faster
2. Less error prone
3. More appropriate for items that have an even charge
Why change from Straight line to Reducing Balance Method
1. Even though it is harder to calculate and more error prone it is very accurate and reliable
2. Used with assets that have a higher fall in value in the earlier stages such as machinery so it reflects prudence and matching more accurately
3. Also as the charge decreases the maintainance cost increase thus resulting in an even charge whereas for straight line the charge increases as maintainance cost increases
The Main Reason for using Reducing Balance for Machinery & Equipment
Plant and Machinery has a larger fall in value at the earlier years. Also the maintainance cost increases and thus maintains an even charge
Accounting Treatment for Loose tools
1. If the cost is material / significant then we must use the revalution method... Matching Concept
2. If the cost is not significant then charge the full amount to that year... Materiality Concept
Accounting Concepts related to Depreciation
You will need to memorise these:
The same depreciation method must be used every year to allow meaningful comparisons
To avoid overstating the non current assets and profit by charging depreciation as an expense
To charge the cost of the asset against the revenue generated from using it for that financial period