CHAPTER 12
DEPRECIATION OF NON – CURRENT ASSETS
- LEARNING OBJECTIVES
This chapter aims at explaining the principle of depreciation of non-current assets. Determining the cost of property, plant and equipment, explaining the nature and purpose of depreciation and the different methods of depreciation and their possible effect on income, accounting for the acquisition, disposition and depreciation of non – current assets, describing the reporting of depreciation in the financial statements, and explaining the nature of wasting assets and the different methods of accounting for their depletion are the areas covered.
- CLASSIFICATION OF NON – CURRENT ASSETS
Non – Current assets can be grouped into Real Property which includes land and anything attached to it. Personal Property which includes everything else that be owned other than real property. These are things such as plant, equipment, furniture, motor vehicles, machinery, patents and copyrights.
Non – current assets can also be grouped as tangible and intangible assets. That is those with physical form such as machinery and equipment and intangible assets being those without physical substance like patents, copyrights, leases, franchises, trademarks and goodwill. These are said to be long term because they are expected to bring future economic benefit and have legal status that allow them to be classified as property (expect for goodwill).
Long term investments such as Government bonds are shown in the balance sheet under the heading of investments.
Non – depreciable and depreciable assets: Land is non – depreciable because it does not loose its capability to serve its purpose.
Property, plant and equipment are depreciable assets because they wear and tear due to use or as time pass on.
Amortisation is the process of depreciating intangible assets such as patent. Depletion is the process of depreciating wasting assets such as mines, oil and gas wells, fisheries and timber plots.
12.2 THE COST OF NON – CURRENT ASSETS
Non – Current Assets may be purchased for cash or on account. The amount at which Non – Current Assets should be recorded in the books of accounts is the total initial outlay needed to put them in use . This includes: –
x Purchase price x Transportation charges x Installation costs x Interest charges x Any other costs incurred up to the point of placing the asset in service.
Transactions involving the purchase of non – current assets may be recorded by debiting the appropriate asset account and crediting the bank account or appropriate liability account such as Accounts payable, notes payable or mortgage payable. Improvements to property, plant and machinery add value and the total cost of such improvements should be added by debiting the asset.
- 1Depreciation of non – current assets
As is the case with all adjustments in the accounts the main task in attempting to determine net income or loss on a periodic basis is to allocate revenue to the period in which it is earned and to assign expenses to the periods that have benefited from the outlays.
Non – current assets frequently last for many years and accordingly benefit a number of periods. The process of determining and recording the depreciations of most long – term assets is carried out in an effort to assign their cost to the periods that they benefit or serve.
Depreciation is there for a process of cost allocation and not asset valuation. The net amount of an asset i.e. Cost less depreciation are simply the portions of the original costs which have not yet been allocated to expense. It does not represent current values. It is therefore important to remember that the statement of financial position does not reflect the current values of a business.
- CAUSES OF DEPRECIATION
Most non – current assets lose their usefulness over time. Depreciation is the allocation of the cost of the long – term assets over future periods expected to benefit from its use. The two major types of depreciation are: –
Physical depreciation: This refers to the loss of usefulness of an asset because of: –
- Deterioration from age and wear and tear. It is generally continuous though not necessarily uniform from period to period.
- Erosion, rust, rot and decay: Assets exposed to the elements may wear out at a fairly regular rate than those that are protected. The speed of deterioration is however related to the extent to which they are used.
Functional Depreciation: This refers to the loss of usefulness because of inadequacy or obsolescence.
- Obsolescence is the process of becoming out of date. Technological development is bringing new and better and more efficient machines and equipments replacing old ones very fast.
- Inadequacy: The growth of a business may bring about a need for bigger machines and equipments
x Time: Amortisation is based on the length of time an asset has been used
e.g. a lease is based on time, patents are also based on length of time.
x Extraction: Depletion is a result of extracting raw materials such as oil, minerals e,t,c.
Information for calculating depreciation
There many and different ways of calculating depreciation for non – current assets but in all cases the following information is essential: –
- The cost of the asset
- The estimated salvage value or scrap value.
- Estimated economic life of the asset.
- The rate of depreciation.
All the four items listed above are estimates subject to changes in environmental and personal factors. For instance the salvage value of an asset cannot be realistically estimated because of time. It may be many years to come before the asset is disposed. The economic life as is influenced by many factors such as usage, or technological developments. The rate of depreciation is dependent upon usage and the environment under which the asset is being used. To sum up therefore it is evident that all the information necessary to calculate the amount of depreciation is subjective.
- METHODS OF CALCULATING DEPRECIATION
The most commonly used methods of calculating depreciation are: – 1. Straight – line method
- Declining – balance method
- Sum – of – the – years – digits method
- Units – of – output method.
Straight – Line Method
This method seeks to allocate the cost of the asset to the estimated economic life in equal amounts. Taking into consideration scrap value, dividing the cost the number of years as follows: –
COST – SCRAP VALUE
NUMBER OF YEARS
Straight – Line method is most commonly used. It is easy to calculate
Declining – balance method
This method seeks to allocate larger amounts of depreciation to early years and less as the
asset grows older. A rate is calculated using the following formula: – Rate= (1- n¥ s÷ c) x100
Where n = number of years of estimated life
s = estimated salvage value
c = original cost
This rate is applied to the declining balance of the cost over the years.
- CHOOSING A DEPRECIATION METHOD
There is no depreciation method that is better than the other. All methods have different characteristics which may be preferred by business operators. For instance: Straight – Line – Method is easy to calculate and understand. It allocates equal amounts to all years of the assets economic life.
Declining – Balance – Method is more difficult to calculate. It depreciates an asset more during its early years than later years.
Sum – of – the – digit – Method allocate more depreciation to early years.
- ACCOUNTING FOR DEPRECIATION
The aims of accounting for depreciation is to allocate and reflect the cost of a non – current asset in the general profit and determining progress in the business.
Depreciation is usually calculated at the end of an accounting period along with other necessary adjusting entries.
An expense account may be opened for each asset but it is common to have a summary of assets with related accumulated depreciation account.
In the normal course of events the only entries made in the accumulated depreciation account are those made at the end of each period to record the depreciation for the period ended.
Double Entry
Once the amount of depreciation for an asset has been established for the period the following entries are made: –
- Debit the comprehensive income statement with the amount of depreciation for the year
Credit the accumulated provision for depreciation account
- The accumulated balance in the accumulated account will then be used to reduce the book value of the asset at the end of each accounting period.
- The asset account remains unchanged unless there have been any disposals or additions. It will be closed once the asset is fully depreciated or disposed.
7TRADE – IN OR EXCHANGE OF NON – CURRENT ASSETS
If an asset is traded – in on purchase of another, a trade – in allowance may be granted. The value agreed upon by the buyer and seller is known as fair market value. The trade – in allowance may be equal to, greater, or less than the undepreciated cost of the asset. The allowance, however does not reflect fair market values of assets so that losses and gains arising from trade – in allowances may not be an accurate measurement of a situation
Types of trade – ins
(a) In a transaction which involves trading – in similar assets losses are recognized but not gains i.e following the concept of conservatism.
8 WASTING ASSETS
A wasting asset is any real property which is acquired for the purpose of removing or extracting the valuable natural resource on or in the property. Examples of wasting assets
are wood lots, mines, oil wells, or any property out of which the valuable product is expected to be eventually removed or exhausted.
Depletion
The consumption and exhaustion of wasting assets is called depletion. Information necessary for computation is: –
Cost of the asset
Estimated quantity of deposits or resources
Unit cost of the deposits
Depletion expenses would be : –
COST ÷Estimated Quantity OF Output x Unit Cost
SUMMARY OF THE CHAPTER
In this chapter, the main features of depreciation were handled. It was known that it is the process of allocating the cost of a non – current asset to unit of output; it is a measure of the wear and tear of a non – current asset through usage and passage of time; is subjective because it is influenced by changing and different conditions under which the asset may be used; and that it is a non – cash expense hence it does not provides funds for replacement of assets although it is generally referred to as a provision for depreciation.
It was also learnt that: (a) Non – current assets are recorded at cost in the books of accounts. Any changes in these amounts are reflected through an accumulated depreciation account. (b) There are many methods of depreciation but commonly used are the Straight – line method and the reducing – balance method. (c) As asset is fully depreciated when the recorded depreciation equal to the cost of the asset. Since depreciation is based on the estimated useful life, an asset may still be in use after it has been fully depreciated (d) Depreciation affects profit measurement because the annual depreciation is charged as an expense in the statement of comprehensive income. (e) At the end of its useful life the asset may be scrapped without residual value, sold or traded – in for another similar or dissimilar asset. In such cases a loss or gain on disposal may be made and charged to the Income Statement.