Back to: FINANCIAL ACCOUNTING SS2
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In today’s class, we will be talking more about the depreciation of fixed assets. Enjoy the class!
Depreciation of Fixed Assets II
- Methods of providing for depreciation
REDUCING BALANCE METHOD (or DIMINISHING BALANCE METHOD)
Under this method, a fixed percentage is written off the reducing (or diminishing) balance of the asset yearly. This method charges higher depreciation in the early years of the asset and lowers in the later years
The depreciation rate (%) to be applied is computed using the formula below:
Depreciation rate (%) = 1 – C
n = No. of years
s = Scrap value
c = Cost
A machine costing N10,000 will realize N256 in four years. Show the yearly depreciation to be charged for each of the four years using a diminishing balance method.
Depreciation Rate (%) = 1 – C
= 1 – 10,000
= 1 – 10
The depreciation charge applicable to each of the four years will be:
Year 1 Depreciation = (60% X 10,000) 6,000
REDUCED BALANCE (i.e. NBV) 4,000
Year 2 Depreciation = (60% X 4,000) 2,400
REDUCED BALANCE (i.e. NBV) 1,600
Year 3 Depreciation = (60% X 1,600) 960
REDUCED BALANCE (i.e. NBV) 640
Year 4 Depreciation = (60% X 640) 348
SCRAP VALUE (i.e. NBV) 256
ADVANTAGES OF THE DIMINISHING BALANCE METHOD
- It is widely used.
- Depreciation is more scientifically provided for.
- It recognizes the efficiency of an asset by charging higher amounts in the early years and lower amounts in the later years.
- Higher depreciation amounts and low maintenance cost in the early years even out with low depreciation amounts and higher maintenance cost in the later years
DISADVANTAGES OF THE DIMINISHING BALANCE METHOD
- Calculating the rate of depreciation may be difficult
- It is not ideal for all fixed assets. For example, it cannot be used for loose tools.
SUM OF THE YEARS DIGIT
Under this method, the years in the life of the asset are represented with digits and are added. The fraction of the asset cost is then charged to the years in reverse order.
A machine cost N10,000 and has a life span of four years after which it can be sold for N256. Calculate the yearly depreciation charge for each of the four years using the sum of the years digit method.
Amount = Cost – Scrap Value
= N10,000 – N256
No. of years = 4
Add up the years thus: 1 + 2 + 3 + 4 = 10
i.e. Sum of the four years = 10
Reverse the digit for each of the years
Calculation of depreciation charge:
Year 1 = 4 X 9,744 = N3,898
Year 2 = 3 X 9,744 = N2,923
Year 3 = 2 X 9,744 = N1,949
Year 4 = 1 X 9,744 = N974
The sum of the year’s digit is similar in some respect to the diminishing balance method as it charges higher depreciation in the early years of the asset.
Therefore the advantages and disadvantages of the sum of the years digit are the same as for the Diminishing Balance Method.
- Explain the following methods of depreciation: (a) reducing balance method (b) sum of the year’s digit
- Write short notes on the following: (a) Depreciation (b) Salvage value (c) Obsolescence
Under this method the asset is revalued each year, any difference being charged to the profit and loss account.
This method is good for assets which cannot be easily depreciated because of their nature e.g. loose tools (i.e. bolts, nuts, hammer, chisel, screws) livestock, farm crops/plantations etc. The value of the assets at the beginning and end of the year will be estimated and used in the calculation of the depreciation.
On 1st January 2005, the value of loose tools was N25,000. Purchases of loose tools during the year was N7,000. On 31st December 2005, the loose tools were revalued at N24,000
Required: Calculate the depreciation on a loose tool for the year.
Balance of loose tools 1 Jan 2005 25,000
Add: Purchases of loose tools in 2005 7,000
Less: Balance of loose tools 31 Dec 2005 24,000
Depreciation on loose tools for 2005 8,000
ADVANTAGES OF THE REVALUATION METHOD
- It is suitable (or ideal) for loose tools, livestock etc.
DISADVANTAGES OF THE REVALUATION METHOD
- It cannot be used for all classes of assets.
- Revaluation of assets on yearly basis may be cumbersome
DEPLETION UNIT METHOD (or PRODUCTION UNIT METHOD )
This method is used for wasting assets such as quarry, mine, timber, and other assets (like machines) whose useful life can be estimated in hours.
A machine costing N100,000 can work for 800 hours. If it works for 120 hours in 2005 and 200hours in 2006. Calculate the depreciation charges for each year.
Calculation of Depreciation on Machine
2005 120 X N100,000 = N15,000
2006 200 X N100,000 = N25,000
- What is depreciation
- Explain the following methods of calculating depreciation (i) straight line (ii) reducing balance (iii) sum of the years digit
- What is the difference between depreciation and amortization
- State ten uses of the general journal
- Explain the principle of the double-entry system
In our next class, we will be talking more about Depreciation of Fixed Assets. We hope you enjoyed the class.
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