Depreciation of Fixed Assets

Back to: FINANCIAL ACCOUNTING SS2

 

Welcome to class! 

In today’s class, we will be talking about the depreciation of fixed assets. Enjoy the class!

Depreciation of Fixed Assets

CONTENT

• Causes of Depreciation
• Reasons for charging depreciation
• Factors to be considered in the computation of depreciation
• Methods of providing for depreciation

DEPRECIATION

It may be defined as the permanent and continuing diminution (or lessening) in the quality, quantity or value of an asset.

CAUSES OF DEPRECIATION

1. Physical factors – Assets may depreciate as a result of physical factors like humidity (or dampness), heat, erosion, evaporation of liquids, rust, rot and decay etc.
2. Wear and Tear – An asset may depreciate as a result of constant usage.
3. Passage of Time – or Effluxion of Time; Assets like patents, copyrights, leaseholds etc. have a fixed period of legal life. They, therefore, depreciate as a result of the passage of time. The depreciation of these intangible assets is known as AMORTISATION
4. Obsolescence – Assets may be rendered out of use as a result of new technology or invention or change in fashion. The value of such obsolete assets (e.g. Black and White TV) will reduce drastically over a short period of time.
5. Inadequacy or Superfluity – Assets may be out of use because of the increase in the output of a firm. In such a situation, assets will be replaced with new and bigger ones.
6. Depletion – Some natural resources like gold, crude oil, iron ore deposits, quarries etc. reduce in value as they are being exploited or mined. These assets are known as WASTING ASSETS. The more they are extracted, the less the reserve that remains.

REASONS OR ADVANTAGES OF CHARGING DEPRECIATION

1. Since it reduces net profit, the tax to be paid will be reduced
2. The business will have a fund to replace the asset at the end of the useful life
3. The value of the assets will not be overstated in the Balance Sheet
4. Rather than charging the cost of an asset to the profits in the year of purchase, the cost of an asset is spread over its useful life – this is a demonstration of the matching concept in accounting.
5. To ascertain the profit or loss on the disposal of assets.

FACTORS TO BE CONSIDERED IN THE COMPUTATION OF DEPRECIATION

1. The historical (or original) cost of the asset
2. The estimated useful life of the asset
3. The estimated scrap value (or salvage) value of the asset
4. The method of depreciation to be used e.g. straight line, reducing balance, revaluation method etc.
5. The internal causes of depreciation
6. The external causes of depreciation.

METHODS OF PROVIDING FOR DEPRECIATION

1. Straight-line Method
2. Reducing Balance Method (or Diminishing Balance Method)
3. Sum of the year’s digit
4. Revaluation Method
5. Depletion Unit Method

Other less common methods include:

1. Sinking Fund Method
2. Insurance Policy Method
3. Annuity Method etc.

STRAIGHT LINE METHOD

Under this method, an equal amount is charged for depreciation yearly throughout the usage of an asset.

Formula =     Cost – Scrap Value

No. of years

Illustration:

The cost of a machine is N50,000. The residual value is N8,000 and is expected to last for 7 years. Calculate the depreciation charge for each of the seven-year.

Solution

Depreciation   =    Cost – Scrap Value

Estimated Useful life

=    50,000 – 8,000

7

=    42,000

7

=  N6,000

N.B.      The N6,000 is debited to Profit and Loss Account and credited to the Provision for Depreciation on Machine Account

ADVANTAGES OF THE STRAIGHT LINE METHOD

1. It is simple (or easy) to calculate
2. It is widely used
3. It is time-oriented
4. It is judicially recommended – Edwards v. Sauntons Hotels

DISADVANTAGES OF THE STRAIGHT LINE METHOD

1. It is not suitable (or ideal) for all type of fixed assets. For example, it cannot be used for loose tools
2. It is not scientific – as it does not take the efficiency of the asset into consideration
3. The assumption of equal depreciation per year is unrealistic

GENERAL EVALUATION

1. State six characteristics of depreciable assets
2. Explain three differences between a trial balance and a balance sheet
3. List seven errors that will affect the agreement of the trial balance
4. Explain the following : (i) real account (ii) nominal account (iii) personal account
5. List eight items that cause disagreement between Cash Book and bank statement balance

 

In our next class, we will be talking more about Depreciation of Fixed Assets.  We hope you enjoyed the class.

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