Advanced-Level
VALUATION OF ASSETS
Fixed Assets and Depreciation
A) Definition
Depreciation is the measure of the wearing out, consumption or other reduction in the useful
economic life of fixed assets whether arising from use, effluxion of time or obsolescence through
technological or market changes.
Asset - in an accounting sense, assets are economic resources devoted to business purposes
within a specific business entity. They can be said to represent a store of service potential or
prospective benefits of varying kinds, available to the future operations of the entity.
Wearing - wear and tear, through physical use, in excess of that which maintenance can restore.
Obsolescence through:
Technological change - the process of becoming increasingly out of date and, on a
comparative basis, inefficient as a result of technological advances and improvements.
Market change - the process of becoming redundant through a fall in the market demand for
the goods or services in the production of which the respective assets are used.
B) Accounting concept of depreciation
The need to depreciate fixed assets arises from the matching concept. As depreciation
represents that part of the cost of a fixed asset which is not recoverable when the asset is finally put
out of use, the amount expended must at some time be charged against profits. If the asset is one
which contributes to an enterprise's revenue over a number of accounting periods, it would be
inappropriate to charge any single period with the whole of the expenditure. Instead, the procedure
of matching periodic revenues with the cost of earning those revenues over the economic life of the
asset must be adopted. In other words, the depreciation is the process of COST ALLOCATION
under the concept of matching.
Example
`Depreciation is the part of the Cost of the Fixed Asset consumed during its period of use by
the firm' (Frank Wood, Business Accounting).
You are required to critically comment on the above definition with a brief discussion of the
objectives of providing for depreciation.
(1983 Paper II No.3 - 4 marks)
1. Depreciation is the measure of the wearing out, consumption or other reduction in the useful
economic life of fixed assets whether arising from use, effluxion of time or obsolescence
through technological or market changes.
2. Explain depreciation in relation to matching concept ~ the charging of a portion of a fixed
amount each year against the revenue earned by that assets is far accurate profit/loss
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Advanced-Level
determination.
Example
It has been said that `Depreciation is an apportionment of costs.' Explain what you understand
by this statement. (1990 Paper II No.6 - 3 marks)
1. It represents writing off of a capital expenditure over the life of a fixed asset. (Allocation of
cost)
2. It constitutes an expense to charge against the related revenues (matching)
Example
A director made the following remarks to the accountant of the company:
`I wish to show a better result for the operations of the company for the year. Can you do it by
reducing the depreciation charges in the profit and loss account.'
Comment on the above remarks.
(1990 Paper II No.6 - 9 marks)
1. Manipulation of profit by unreasonable changes in depreciation charges is against accepted
2.
3.
4.
5.
accounting concepts.
Depreciation is a cost (charge, expense). Arbitrary changes in depreciation not based on the
true state of the asset concerned are not genuine estimates of expense and are thus against
the accounting concepts of matching revenue with costs.
Inflating profit by suppressing costs is against the accounting concept of consistency.
Changing depreciation in this way is also against the accounting concept of consistency.
Manipulation of accounts is against the generally accepted principle that accounts should
reflect a true and fair view of the financial position of the company and of the operation
result of the company.
C) Misconceptions about the purpose and effects of depreciation
1)
It is sometimes thought that the net book value of an asset is equal to its net realisable
value (or market value) and that the object of charging depreciation is to reflect the fall in
value of an asset over its life. This misconception is the basis of a common, but incorrect,
argument which says that assets need not be depreciated in times when property values
are rising. As depreciation is a process of allocating the historic cost of an asset over its
useful life, not a valuation process, the written down value may not reflect the market
value of the asset.
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Advanced-Level
Example
Unless an asset declines in value, it will not be depreciated. Discuss this statement with
particular reference to the meaning of depreciation in accounting.
(1988 Paper I No.5 - 5 marks)
1. The primary meaning of ‘depreciation’ is loss of value of assets through wear and tear of
some other form of deterioration.
2. In accounting, ‘depreciation’ is a process of allocation not of valuation.
3. It is process for the gradual conversion of fixed assets into expense – to allocate the original
cost of assets less its scrap value over its estimated useful life on a systematic basis.
4. The charge for depreciation is according to matching concept. The charge for depreciation
should be proportionate to the benefit derived.
5. A distinction must be made between actual physical wastage and provision for depreciation.
Depreciation takes place whether or not a provision is made in the books.
Example
During 1988, the company incurred a substantial loss due to adverse trading conditions. In
view of the fact that the current replacement cost of machinery was considerably higher than its net
book value, the directors proposed that no depreciation should be charged on machinery for the year.
Comment briefly on the directors' proposal.
(1989 Paper I No.6 - 4 marks)
1. Depreciation means the allocation of the cost of fixed assets to expense in the periods in
which services are received from the fixed assets in a systematic way.
2. Depreciation is charged based on matching concept to reflect the portion of the cost of the
fixed assets which has been consumed.
3. Depreciation in accounting is a process of allocation and not valuation.
4. Depreciation is not a discretionary charge for assets with limited useful life.
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Advanced-Level
Example
`There is no point in depreciating the buildings since the market must be considerably in excess of
the cost.'
(1991 Paper II No.6 - 5 marks)
1. The buildings have a limited life and should be depreciated accordingly in order to charge
an appropriate amount against distributable profits each year. If there is an increase in
market value of the building this does not extend the life and does not obviate the need to
charge depreciation. The revaluation may be brought into the accounts and the depreciation
subsequently calculated on that amount.
2)
Another misconception is that depreciation is provided so that an asset can be replaced
at the end of its useful life. This is not the case:
-
If there is no intention of replacing the asset, it could then be argued that there is no
need to provide for any depreciation at all.
-
Provision of depreciation can only restrict the funds from being distributed, however,
it cannot guarantee there are enough liquid funds available for replacement at the
proposed time.
-
If price are rising, the replacement cost of the asset will exceed the amount of
depreciation provided.
Example
The latest balance sheet of a company shows the following items:
Machinery, at cost
5 000 000
Provision for depreciation of machinery
4 500 000
The following conversation took place between the production manager and the accountant:
Production Manager:
`The company's machines are old and out of date, I want to replace a number of them.
The total cost is about $4 000 000. Can your confirm that you have the money to buy the new
machines?'
Accountant:
`I am afraid that we do not have the money.'
Production Manager:
`What? The company's balance sheet clearly indicates that you have made a provision of
four and a half million dollars. Where has the money gone?'
You are required to suggest a reply to the production manager's query and suggest a way
to ensure that money is available to replace assets at the end of their service life.
(1990 Paper II No.6 - 8 marks)
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Advanced-Level
1. Depreciation is an apportionment of cost because it represents the writing off a capital
expenditure over a number of years and constitutes an expense of the year.
2. Provision of depreciation is only a means of writing off an asset over its useful life and is
not a means of reserving cash to replace the asset when necessary. Profits is reduced by
depreciation but cash may be used to acquire trading stock or other forms of asset.
3. A scheme can be adopted whereby cash equal to the amount of depreciation is taken out to
acquire guilt-edge security or invest in way which is safe and readily realisable, so that when
a replacement is needed the investment can be realised to obtain cash to replace the assets.
D) Factors in the measurement of depreciation
1)
Identifying the cost of the asset
The distinction between capital and revenue expenditures is important as only the capital
expenditures are included in the cost. Capital expenditure is an expenditure spent by a firm to
add to the value of an existing asset. Revenue expenditure is an expenditure which is not
concerned with adding to the value of fixed assets, but represents the costs of running the
business on a day-to-day basis. (For details, see previous notes.)
2)
Ascertaining the expected useful economic life
The expected useful economic life is the period over which the present owner will derive
economic benefits from its use. It may be:
Pre-determined, as in leaseholds;
Directly governed by extraction or consumption;
Dependent on the extent of use;
Reduce by obsolescence or physical deterioration.
The factors to be taken into account when assessing the useful life are:
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Advanced-Level
a)
Experience with the past
It will be able to estimate the life from existing data on similar assets. Past repair
costs would also be taken into account in assessing the optimum life.
b)
Total usage
Depreciation may be chiefly a function of use rather than time for some assets. In
this case, it should be calculated based on use.
c)
Deterioration over time
Rusting, warping and other physical processes may operate over time, regardless of
the rate of use.
d)
Technical obsolescence
Expected improvement in technology may force the acceleration of depreciation
regardless of the potential life of the asset.
e)
Economic obsolescence
Falling demand for the product manufactured by the use of the fixed asset may affect
its depreciation rate.
f)
Company replacement policy
Many companies replace certain types of asset at fixed intervals.
g)
Existing accounting policy
Companies frequently assume a useful life regardless of actual asset lives, which
may be longer, Although incorrect, it may be justified on grounds of simplicity and
convenience and the effect on the financial statements is usually immaterial.
3)
Determining the expected residual value
Residual value is the realisable value of the asset at the end of its useful economic
life, based on prices prevailing at the date of acquisition or revaluation, where this has
taken place. Realisation costs should be deducted in arriving at the residual value (future
inflation is ignored).
4)
Selecting an appropriate method of depreciation
a)
Depreciation methods
No specific guidance is offered on allocation of depreciation to accounting period - it
is a matter of judgement in the light of technical, commercial and account considerations,
and required annual review. The common methods are:
i) Straight-line method
ii) Reducing balance method
iii) Sum-of-the-years-digits method
iv) Units of production method
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Advanced-Level
v)
b)
Revaluation method
(For details, see previous notes)
Revision of estimated useful life
If revision of the estimate of remaining useful life is called for because of any
significant difference between the previous estimates and the current expectations, the
unamortized cost should be written off over the revised remaining useful life. This
adjustment should not be treated as a prior year adjustment because it is not due to a
change of accounting policy or correction of fundamental errors. However, the effect of
the change should be disclosed in the period of change if it is material.
Example
Tai Fat Ltd. with an accounting year ending 31st December bought a fixed asset on 1st January
1991 at a cost of $120 000, with its estimated useful life to be 10 years.
On 1st January 1995, the estimated useful life of the asset was reviewed and the directors of
the company agreed that the remaining useful life of this asset should be eight years instead of six
years. Show the necessary adjustments with regard to this revision.
Remaining life = 6 years
91 Jan
Dep.=
$120000/10 = 12000
4 years
95 Jan
Revised = 8 years
Cost – dep. = 120000 – 48000 = 72000
Prior year adjustment:
1. Change of accounting policy
2. Fundamental prior year error
Answer:
No prior year adjustment
 Not a change of accounting policy (Still using straight line method for depreciation)
 Not a Fundamental prior year error (Incorrect estimation is not an error)
If the life of assets = 4 years + 8 years = 12 years
The depreciation charge each year should have been: 120000/12 = 10000
If it is a fundamental error instead of revision of estimated useful life
Dr. Accumulated depreciation (2000*4) 8000
Cr. Retained profit
8000
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Advanced-Level
c)
Revision of depreciation methods
Once the depreciation method is selected, it should be applied consistently from
period to period unless altered circumstances justify a change. The consistency in
adopting the depreciation method is important in order to provide comparability of the
results of operations of the business from period to period. Where there is a change from
one method of depreciation to another, the net book value of the asset should be written
down to its residual value over the remaining useful life on the new basis, commencing
with the period in which the change is made. The reason, and the effect of the change if
material, should be disclosed in the period of change. However, the change of
depreciation method does not constitute a change of accounting policy and therefore, no
prior year adjustment is needed.
Example
On 1st January 1994, the directors of the company have decided to change the method of
depreciation for the plant and machinery to the straight-line basis. The plant and machinery was
purchased at $200 000 two years ago. The company adopted the reducing balance method of
depreciation at a rate of 10% p.a. It is estimated that the remaining useful life of the plant and
machinery to be 5 years. What will be the depreciation charge for the year 1994.
Cost= $200000
92 Jan
Useful economic life (revised) = 5 years
Straight line method
94 Jan
Year 1= $200000*10% = 20000 Year 2 = $180000*10% = 18000
Cost – Depreciation =
200000 – 38000 = 162000
1.
Revision of useful economic life to 5 years (Reducing balance unchanged)
i.
Rate: NBV = Cost * (1-r)n
1 = 162000 * (1- r)5
r = 90%
2.
Reducing balance --- Straight line + life --- 5 years
i.
3.
No Prior Year Adjustment
If it is a fundamental error in method
i.
Cost = $1000 Residual value = $64
ii.
The company proposed to use straight-line method (3 years) for motor van, but the
clerk used reducing balance method mistakenly. It was discovered not until the
beginning of year 3.
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Advanced-Level
At Jan 1 (year 3)
Reducing Balance method
1000
840
160
Cost
Less: Accumulated depreciation
Prior year adjustment in year 3
Dr. Accumulated depreciation
Cr. Retained profit
Straight line method
1000
624
376
216
216
Year End adjustment for depreciation in year 3
Dr. Profit and Loss ~ Depreciation
Cr. Accumulated Depreciation
d)
312
312
Revaluation
The increase in value of the revalued fixed asset should not be credited to the profit
and loss account in the year of revaluation because it is unrealised. It should be
transferred to the revaluation reserve. This treatment is adopted in all cases except where
the amount relates to a permanent diminution in value subsequently found to be
unnecessary. Normally, therefore, the amount credited to the revaluation reserve is the
difference between the net book amount prior to revaluation and the revalued amount.
Where there has been revaluation of the fixed assets in the company during the year, the
provision for depreciation should be based on the revalued amount and current estimate of the
remaining useful life. If the change is material, it is necessary to disclose the effect of the
revaluation in the period of change.
Example
A fixed asset with a cost of $100 and accumulated depreciation of $50 is now revalued at $110.
Show the entries for the revaluation.
Fixed Assets
Bal b/d
100 Acc. Dep.
Revaluation R
60 Balance c/d
160
Revaluation Reserve (Capital Reserve)
50
Balance c/d
60 Fixed Assets
60
110
160
Accumulated Depreciation
Fixed Assets
50 Bal b/d
50
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Advanced-Level
If the asset was sold at the date of revaluation
Disposal (Before Revaluation)
Cost
100 Acc. Dep.
Profit and Loss
60 Bank
160
Disposal (After Revaluation)
50
110
160
Cost
110 Bank
110
Profit on disposal = 0
Dr. Revaluation Reserve
60
Cr. Profit and Loss App. 60
If the asset continues using two more years
Revaluation Reserve
Yr. 3 P & L App.
30 Fixed assets
Yr. 4 P & L App.
30
No revaluation depreciation = 25
60
With revaluation depreciation = 55
The difference = 30
Transfer the difference to P & L Appropriation.
(The amount transfer may not be the same under
reducing balance method)
Why P & L app?
Devaluation
Open Market Value = $900
Fixed Assets
Balance b/d
Profit and Loss
1000 Profit and Loss 100
Loss on Revaluation
100
今年跌了$100，一定要一次過入晒去 Profit and Loss Account!!
Prudence Concept: Loss – direct charge to Profit and Loss
Prudence Concept: Gain – Can’t recognise until the profit is realise
The assets increase in value $100 before.
Fixed Assets
Balance b/d
Revaluation Reserve
1000 Revaluation Rse 100
Fixed Assets
100 Balance b/d
100
The assets increase in value $50 before, but this year decrease in value $100
Fixed Assets
Balance b/d
1000 Revaluation Rse
Revaluation Reserve
50
Fixed Assets
50 Balance b/d
50
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Advanced-Level
Profit and Loss
Loss on
Revaluation
50
Example
Wing Fat Limited bought an asset on 1st January 1993 at a cost of $48 000 with an estimated
useful life of 8 years. Straight line method was adopted. On 1st January 1996, a revaluation of the
asset took place and the market value of which was $36 000 and the remaining useful life was 4
years. Show the entries for the revaluation and provision of depreciation for the year 1996.
Assets
1996
Jan 1
Jan 1
$ 1996
Balance b/d
Revaluation Reserve
48000 Jan 1
6000 Dec 31
$
Provision for depreciation
Balance c/d
54000
18000
36000
54000
1997
Jan 1
Balance b/d
36000
Provision for depreciation
1996
Jan 1
Dec 31
$ 1996
Assets
Balance c/d
18000 Jan 1
9000 Dec 31
$
Balance b/d
Profit and Loss a/c
27000
18000
9000
27000
1997
Jan 1
Balance b/d
9000
Revelation Reserve
1996
Dec 31
Dec 31
$ 1996
Profit and Loss App.
Balance c/d
1500 Jan 1
4500
6000
$
Assets
6000
6000
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Advanced-Level
e)
Permanent diminution in value
A fixed asset may suffer a permanent diminution in value and the net book amount
may be considered not to be recoverable in full. This may occur, for example, through
obsolescence or where there is a fall in demand for a product. The net book amount
should be written down immediately to the estimated recoverable amount, which should
then be written off over the remaining useful economic life of the asset, If, subsequently,
it is found that the reasons for making the provision cease to apply, then the company
should write back the provision to the extent that it is no longer necessary.
Example
A fixed asset cost $480 at the beginning of Year 1, has an estimated 10 years working life with
no residual value and is to be depreciated on a straight-line basis. At the beginning of Year 4 there is
a permanent diminution in value and the fixed asset is written down to its estimated recoverable
amount of $224. However, at the beginning of Year 5 it is revalued at $336. Show the ledger entries
for the five years.
At 1 Jan Year 4
At 1 Jan Year 5
Cost
480
Cost
480
Less: Depreciation
144
Less: Depreciation
288 (144+112+32)
Net Book Value
336 Difference Net Book Value
$112 Recoverable amount
224
Recoverable amount
192
336
Difference
$144
Profit and Loss = 112-16 =96
Revaluation reserve = 48
Fixed Assets
Year 1
Bank
480 Year 1
Balance c/d
480
Year 2
Balance b/d
480 Year 2
Balance c/d
480
Year 3
Balance b/d
480 Year 3
Balance c/d
480
Year 4
Balance b/d
480 Year 4
Balance c/d
480
Year 5
Year 5
Year 5
Balance b/d
Profit and Loss
Revaluation reserve
480 Year 5
96
48
624
Accumulated depreciation
Balance c/d
288
336
624
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Advanced-Level
Accumulated depreciation
Year 1
Balance c/d
48 Year 1
Profit and Loss
48
Year 2
Balance c/d
96 Year 2
Balance b/d
Profit and Loss
48
48
96
96
Year 3
Balance c/d
144 Year 3
Year 3
144
Balance b/d
Profit and Loss
96
48
144
Year 4
Balance c/d
288 Year 4
Year 4
Year 4
288
Balance b/d
Profit and Loss
Profit and Loss (224/7)
144
112
32
288
Year 5
Year 5
Fixed Assets
Balance c/d
288 Year 5
56 Year 5
344
Balance b/d
Profit and Loss (336/6)
288
56
344
Profit and Loss accounts
Year 1
Depreciation
48
Year 2
Depreciation
48
Year 3
Depreciation
48
Year 4
Year 4
Depreciation
Depreciation
Year 5
Depreciation (336/6)
112 (Diminution in value)
32
56 Year 5
Profit on revaluation
96
Fixed Assets
$
48
Revelation Reserve
Year 5
???
Profit and Loss App.
$ Year 5
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