Depreciation of Non-Current Assets Chapter 11 Part One Assets & Expenses Just like assets, expenses are necessary – necessary to help in earning revenue. A business that had no employees, no premises, no advertising and no electricity could simply not do its job. In this way, assets and expenses have something in common – they both assist in the earning of revenue – and this is reflected in the fact that the definitions of both items refer to the economic benefit they bring to the business. Definitions Asset a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow to the entity Expense a consumption or outflow (or reduction in an inflow) of an economic benefit, in the form of an decrease in assets or increase in liabilities, which results in a decrease in owner’s equity (except drawings) Note Expenses refer to economic benefits that have already been consumed (in the current Reporting period), whereas assets refer to economic benefits that are yet to be consumed (and will be consumed in future Reporting periods). Depreciable Assets Items like vehicles, office equipment and shop fittings (which are controlled by the business) will provide a future economic benefit (for more than 12 months), and so should be recorded as non-current assets when they are purchased. At the same time, just because assets like these will last for more than 12 months does not mean they will last forever; as they age, they wear out, and as their life expires, so too does their ability to earn revenue. This means they are depreciable assets – they have a finite life, and will be useful for a fixed period of time, but at some point in the future will be no longer able to earn revenue. Depreciation Every year, part of the value of the asset is consumed, until – at the end of its life – the asset’s revenue earning capacity is wholly consumed, and it is unable to earn revenue any longer. As we already know, a consumption of an economic benefit is an expense, meaning that each year part of the asset’s value is consumed, so part of its value becomes an expense. This process of calculating how much value has been consumed in each period is called Depreciation. Lane Cove Furniture The vehicle is a depreciable asset with a finite life: slowly but surely, the productive capacity of the vehicle will be consumed. This will not happen in one Reporting period, but rather over a number of Reporting periods, so only part of the asset’s value should be reported as an expense for the year ended 31 December 2010. The remainder – the part yet to be consumed – should be reported as a noncurrent asset (i.e. $32 000 less the amount consumed so far). In order to calculate the part of the cost of the vehicle consumed in the current Reporting period (the year ended 31 December 2010), it is necessary to depreciate the asset. You! Review Questions 11.1. Q’s 3, 5 & 6. Depreciation of Non-Current Assets Although the term depreciation is frequently used to describe the expense, it actually refers to the process – the accounting procedure – that creates Depreciation expense. Because a non-current asset is not consumed entirely within one Reporting period, depreciation is an attempt to work how much of the asset’s value has been consumed in the current Reporting period. It therefore spreads out or allocates the cost of the asset over the years in which it is useful for earning revenue, rather than treating all of the cost as an expense in any one year. As a result of this process, depreciation expense is created, representing that part of the cost of a noncurrent asset that has been consumed in the current Reporting period. Depreciation of Non-Current Assets Depreciation is a balance day adjustment. It is made to ensure that an accurate profit is calculated, by comparing revenues earned against expenses incurred in the current Reporting period. Depreciation does not involve any payment of cash. The cash payment relating to each non-current asset will be recorded only at the time when the asset is purchased. Depreciation affects only the Income Statement and the Balance Sheet. You! Review Questions 11.2. Q’s 3 & 4. CALCULATING DEPRECIATION EXPENSE There are a number of different ways of calculating depreciation expense, each of which makes different assumptions about the way assets are consumed. Note this course only covers the straight-line method. This method of calculating depreciation assumes that non-current assets contribute evenly to revenue, doing the same job in the last year of their life as they did in their first. As a result, it assumes that the value of a non-current asset is consumed evenly over its life, and that the depreciation expense will be the same every year. Formula HC = Historical cost: the original purchase price of the non-current asset. RV = Residual Value: the estimated value of the noncurrent asset at the end of its useful life. Life = Useful Life: the estimated period of time for which the non-current asset will be used (by the current entity) to earn revenue. (This is usually measured in years.) The basic premise is to divide the cost of the asset by the number of years for which it is used, thus determining how much of that cost is consumed per year. Big Cycles See example p. 243. In this example, depreciation calculates that the business is consuming $1400 worth of the furniture’s value each year. This amount would be recorded as an expense, and would also decrease the value at which the furniture is valued in the Balance Sheet. Note: Because each non-current depreciable asset is different in terms of its useful life and residual value, each must be depreciated individually. Residual Value ‘Residual value’ is an estimate of the value of the asset at the end of its useful life. If we plan to use the asset until it is utterly worthless, then the residual value will simply be zero. However, we may dispose of the asset while it still has some value. This amount will then not be consumed by our business, but by another entity. Thus, the residual value must be deducted from the Historical cost, because this is the amount that will not be consumed by our business. Depreciable Value The amount calculated by deducting residual value from Historical cost (in the top line of the equation) is known as the depreciable value; it is the total value of the asset to be consumed by the current owner/entity, and so must be allocated over its useful life. Do Review Questions 11.3. Q’s 4 & 5. Recording Depreciation As was noted earlier, depreciation is a balance day adjustment. As a result, it is recorded in the General Journal on balance day – at the end of the Reporting period – just like a stock loss, prepaid rent or accrued wages. Mixwell Paints See Figure 11.1 on p. 245. Remember, depreciation calculates that part of the cost of a non-current asset that has been consumed in the current Reporting period. This amount would be recorded as an expense, by debiting a new account called ‘Depreciation of van’. At the same time, depreciation also decreases the value at which the asset is valued in the Balance Sheet. (After all, the non-current asset is a future economic benefit, but by depreciating the asset we are recognising that some of this benefit has now been consumed.) This reduction in the value of an asset would normally be recorded as a credit entry, but rather than credit the asset account directly, the credit entry is made to a new account called ‘Accumulated depreciation of van’. This account is a negative asset account. General Ledger Note it is imperative to identify precisely which asset is being depreciated. I know generally I have been advising you against abbreviations. However, Depreciation is an area where intelligent abbreviations can make your life much easier! Use ‘Dep.’ for Depreciation, and ‘Acc. Dep.’ for Accumulated depreciation. See Figure 11.2. Depreciation vs. Accumulated Depreciation The key to understanding Accumulated depreciation lies in the title. Whereas Depreciation expense refers to the amount consumed in the current Reporting period, Accumulated depreciation refers to depreciation that has accumulated (or built up) over the life of the asset so far. That is, Accumulated depreciation will grow every year as the depreciation expense for each Reporting period is added to it. Depreciation vs. Accumulated Depreciation As an expense, the Depreciation of van account must be closed to the Profit and Loss Summary account at the end of each Reporting period. In fact, it will open and close on the very same day, leaving it with a zero balance at the end of the period. Accumulated depreciation of van on the other hand is an ongoing account – it will be balanced at the end of the period, with its balance carried forward to the next. Review ledger accounts on p. 246. Depreciation vs. Accumulated Depreciation Note that the entry to close the Depreciation of van account is made in the General Journal at the same time that all the expense accounts – including expenses such as Cost of sales, Wages and Advertising – are closed. That is, all the expense accounts are credited individually (to transfer the amount so that profit or loss can be calculated, and reset them to zero for the next Reporting period), but only one debit entry is made to Profit and Loss Summary. The depreciation expense account would never be closed on its own. Part Two Subsequent Periods See example on pp. 246-247. The Depreciation of van account had been closed at the end of 2015, so the depreciation expense for 2016 will be the only entry in that account until it is closed again on 31 December 2016. You! Review Questions 11.4 (all q’s). Reporting Depreciation The Income Statement. Remember that it is only the depreciation expense – the amount consumed in the current Reporting period – which is reported in the Income Statement. Accumulated depreciation is a negative asset, not an expense, and so must not be reported in the Income Statement at all. Reporting Depreciation The Balance Sheet The first effect of depreciation on the Balance Sheet is via Owner’s equity. As we have already seen, depreciation expense decreases Net profit. In terms of the Balance Sheet, this decreases owner’s equity. The second effect occurs on the asset side. Accumulated depreciation reports the value of the asset that has been consumed over its life so far. It is reported directly under the asset itself. Reporting Depreciation Mixwell Paints Balance Sheet (extract). Note historical cost, acc. dep. & carrying value (p. 250). The Rate of Depreciation Depreciation can also be expressed as a rate – a percentage of the cost. Rate of Depreciation Using the figures from the earlier example regarding the office furniture, the depreciation rate would be calculated as: Note there is residual value of $800.00 (28% X 3 = 84%). Calculating using the rate In some cases, it may be the rate of depreciation that is given rather than the Historical cost, residual value and useful life. In these cases, the depreciation expense (in dollar terms) can be calculated by simply multiplying the rate by the Historical cost. See Carlton Clothing example p. 251. The cost of a non-current asset it is quite common for a business to modify an asset, or incur costs for its installation, that must also be included in this definition of cost. After all, if these other costs will provide a future economic benefit over the life of the asset, then they should be classified as non-current assets, and depreciated. The cost of an asset is thus defined as: All costs incurred in order to bring the asset into a location and condition ready for use, that will provide a benefit for the life of the asset. The cost of a non-current asset The cost of a non-current asset may therefore include: the purchase price/supplier’s price Note GST is not part of the cost of an asset. delivery costs modification costs installation costs. Maintenance Fee Note also the maintenance fee ($1000) may also be a necessary cost, but it is a yearly fee; its benefit will be consumed within a year. This means it is not part of the value of a non-current asset, but rather a current asset – Prepaid maintenance fee. It has its own separate ledger account. (It would then be subject to a balance day adjustment at the end of the Reporting period to calculate the maintenance incurred.) Basically, any costs where the benefit does not extend for the life of the asset are not included in the cost of the asset, but rather treated separately as expenses or prepaid expenses. Recording the cash purchase of a non-current asset Remember that the payment would be recorded in the CPJ on the date it occurred (1 March 2015), but not posted to the General Ledger until totals are calculated at the end of the period (31 March 2015). See also General Ledger p. 253. Depreciating for less that a year if by the end of the Reporting period the firm has had control of the asset for less than a year, the depreciation figure will need to be applied on a pro-rata basis; if the business has had the asset for only one month, then only one month’s worth of depreciation (1/12 of a year) should be charged as an expense. Pay very careful attention to the date on which the asset is acquired – this will determine how many months worth of depreciation need to be applied. Depreciating for less that a year If the asset has been under control of the business for only three months, only three months of depreciation should be calculated. Use of estimates Because the residual value and useful life are estimates, using them in the calculation of depreciation means that the reports will not be free from bias and to some extent this will undermine the Reliability of the accounting reports. However, depreciation ensures that the Profit and Loss Statement includes all information that is useful for decision-making about profit, by showing the consumption of non-current assets in the current Reporting period (relevance). Similarly, by showing accumulated depreciation in the Balance Sheet, it ensures that assets are shown at their carrying value, which is vital for decision-making about their replacement. Now… Read Summary. Do exercises.