Accounts & Finance

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Final AccountsPages 267 - 271

2Topic 3.4

(HL)

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Nothing speaks more eloquently than money

French Proverb

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Assessment Objectives:AO1Demonstrate knowledge and understanding

AO2Demonstrate application and analysis

AO3Demonstrate synthesis and evaluation

AO4Demonstrate a variety of appropriate skills

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Content Objectives:

AO2:To apply and analyse • Depreciation using the following methods:

o Straight line methodo Reducing balance method

The strengths and weaknesses of each method

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Language Objectives:LO1Reading informative texts: determine two or more central ideas of a given case study LO2Writing: write arguments to support claims using evidence from a case studyLO3Listening: build on others’ ideas and participate in discussions.LO4Speaking: make strategic use of digital media textual and other interactive elements in presentations.

Depreciation (AO2)

When businesses buy fixed assets the value of the asset will change

The increase in the value of fixed assets over time is known as appreciation

However, most fixed assets tend to decrease in their value over time and is known as depreciation

Depreciation spreads the historic cost (purchase cost) of a fixed asset over its useful lifespan

Depreciation (AO2)

There are two main reasons for depreciation:

Wear and tear: fixed assets like computers, motor vehicles, etc. will fall in value as they are used over and over. As a result, such assets become less valuable to a buyer and so the value is depreciated

Obsolete assets: with newer and better products become available, these will reduce the demand for existing fixed assets. Obsolete assets e.g. old version of computers and software will fetch little value if sold. Hence their value needs to be depreciated

Depreciation (AO2) The changes in the value of fixed assets are

shown by reassessing the value of the assets on a balance sheet.

Depreciation needs to be recorded in order to:

o calculate the value of a business more accurately ie revaluing assets that have appreciated is likely to increase the net

o realistically assess the value of fixed assets over time as historical or purchase cost of fixed assets is unlikely to be equal to its current market value

o plan for the replacement of assets in the future. Provisions are made in order to replace the cost of purchasing new fixed assets.

Depreciation (AO2)

There are two main methods of calculating depreciation:

o Straight Line

o Declining or Reducing Balance

Depreciation (AO2)

Straight Line Method: Annual depreciation = Purchase cost /

lifespan

Example: An electronic security system is bought for

$25,000 and is expected to last five years.

Annual depreciation = 25 000 / 5 = 5000

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Straight-line method:Straight line depreciation at $5,000 p.a.

Year end Depreciation

Book value ($)

0 - 25,000

1 5,000 20,000

2 5,000 15,000

3 5,000 10,000

4 5,000 5,000

5 5,000 0

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Straight-line method:

Straight line depreciation at $5,000 p.a.

Values $

Year end

30,000

25,000

20,000

15,000

10,000

5,000

0

1 2 3 4 5 6

Depreciation (AO2)

Straight Line Method: Residual value: an estimate of the scrap or

disposed value of the asset at the end of its useful life.

Annual depreciation = (Historical or Purchase cost minus Residual value) / Lifespan

Example: An electronic security system is bought for

$25,000 and is expected to last five years. It is also expected to fetch a second-hand value of $5,000 in 5 years time.

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Straight-line method:

Straight line depreciation at $4,000 p.a.

Year end Depreciation

Book value ($)

0 - 25,000

1 4,000 21,000

2 4,000 17,000

3 4,000 13,000

4 4,000 9,000

5 4,000 5,000

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Straight-line method:

Straight line depreciation at $4,000 p.a.

Values $

Year end

30,000

25,000

20,000

15,000

10,000

5,000

0

1 2 3 4 5 6

Depreciation (AO2)

Straight Line Method: Straight-line method is straightforward and

simple to understand.

Limitations: fixed assets are depreciated by an equal amount each year which is unrealistic as most assets lose a much larger percentage of their value at the beginning of their useful life eg motor vehicles, etc.

Depreciation (AO2)

Reducing Balance Method: Depreciating assets at a constant rate each

year

Net book value = Historical cost minus (less) Cumulative depreciation

Using the same example: An electronic security system is bought for $25,000 and is expected to last five years.

Thus, using the reducing balance method of depreciation to depreciate the security system, say at an annual rate of 25%, the book value at the end of each year will be:

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Reducing Balance Method

Reducing balance depreciation at an annual rate of 25%:

Year end Depreciation Book value ($)

0 - 25,000

1 6,250 18,750

2 4,687 14,063

3 3,516 10,547

4 2,637 7,910

5 1,977 5,933

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Reducing Balance Method

Reducing balance depreciation at an annual rate of 25%:

Values $

Year end

30,000

25,000

20,000

15,000

10,000

5,000

0

1 2 3 4 5 6

Depreciation (AO2)

Reducing Balance Method: This method is not easy to calculate and

deciding on the rate of annual depreciation is not always a simple task.

However, fixed assets are depreciated by a larger amount in the earlier years of its useful life which is more representative of fixed assets i.e. this method is more realistic in representing the declining market value of fixed assets.

Depreciation (AO2)

Reducing Balance Method: This method is not easy to calculate and

deciding on the rate of annual depreciation is not always a simple task.

However, fixed assets are depreciated by a larger amount in the earlier years of its useful life which is more representative of fixed assets i.e. this method is more realistic in representing the declining market value of fixed assets.

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Question 1:The manager of Collison Ltd has purchased a new piece of equipment to help speed up the production line. The equipment cost $50,000 and is expected to last for five years. At the end of this period the equipment can be traded in for the value of $4000.

Calculate the depreciation for each year on the asset using both methods. Show the net book value for the equipment at the end of each of the 5 years for each method (assume that 40% is to be used for the reducing balance method).

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Q1 Suggested Answer:

Year SL Depn SL NBV RB Depn RB NBV

1 9 200 40 800 20 000 30 000

2 9 200 31 600 12 000 18 000

3 9 200 22 400 7 200 10 800

4 9 200 13 200 4 320 6 480

5 9 200 4 000 2 592 3 888

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Question 2Fiona Palmer, a sole trader purchases a delivery van for the sum of $12,000. It has as estimated life of 6 years and a trade-in value of $3,000. Palmer is not sure whether to use the straight line or the reducing balance method when providing for deprecation on the van.

You are required to calculate the annual depreciation on the van using both methods.

Show the balance remaining - the net book value - on the van at the end of each of the 6 years for each method (assume that 20% is to be used for the reducing balance method).

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Answer 2:

Year SL Depn SL NBV RB Depn RB NBV

1 1 500 10 500 2 400 9 600

2 1 500 9 000 1 920 7 680

3 1 500 7 500 1 536 6 140

4 1 500 6 000 1 229 4 915

5 1 500 4 500 983 3 932

6 1 500 3 000 786 3 146

Depreciation (AO2)

Reducing Balance Method: Amortisation is similar to depreciation but is

used to reduce the value of intangible assets on a balance sheet.

Examples: copyrights and patents near the expiry date or IPR tends to fall in value over time.

Depreciation (AO2)

Limitations of final accounts: Using a single year’s account is of little value

Non-financial matters are not revealed such as HR, ethical objectives and location

Comparison and benchmarking with other firms in the same industry should be done

Companies may window dress their accounts

Show historical performance of a company

Exercises:

1. Open this link and answer the QUIZ questions:

http://www.accountingcoach.com/depreciation/quiz

2. When Task 1 is done, try out ‘Word Scrambles’ and finally ‘Crossword Puzzle’.