As an accounting and finance student of KNUST, I constantly undertake research to discover real facts in my field of study.
In preparing the final accounts (Trading, Profit and Loss Account and the Balance Sheet), there are some adjustments that must be made at the time of preparing the accounts, mostly at the end of the financial year.
Adjustments are corrections made on an account or further workings that are effected in the final accounts. These adjustments include prepayments, accruals, provisions for depreciation, provision for bad and doubtful debts, etc. Today, I would like to explain depreciation, how it is calculated and how to account for depreciation in the final accounts.
What is Depreciation?
Depreciation is defined by the FRS 15 as "the measure of the cost or revalued amount of the economic benefits of the tangible fixed assets that have been consumed during the period." Consumption includes wearing out or reduction in the useful economic life of the tangible fixed asset, whether rising from use, effluxion of time or obsolescence through technological advancement.
Depreciation is simply the spread of the cost of a tangible fixed asset over it's estimated useful life. It is an expense, therefore must be charged to the Profit and Loss Account whether profit is made or not.
Factors That Must Be Considered In Measuring Depreciation
1. The Cost the Asset: The cost of the fixed asset include the purchase price, installation cost, carriage cost, and any other expenditure incurred in getting the asset to its place.
2. The scrap value of the asset: This is the the price at which the asset will be sold (disposed off).
3. The estimated useful life of the asset: The period within which the asset will be effectively used by the business. It is called the economic life.
4. The method of depreciation
Purposes of Depreciation/Why Depreciation
- To spread the depreciable value of the asset over its estimated useful life.
- To prevent the overstatement and understatement of profit in the income statement.
- To match cost with revenue.
- To preserve the capital of a business.
Methods of Calculating Depreciation
1. The fixed installment or the straight line method:
Under this method, a constant amount of depreciation is charged over the economic life of the asset year after year. It is calculated by deducting the estimated scrap value from the cost of the asset and dividing the result by the estimated useful life (in years).
2. The Reducing Balance Method:
Here, depreciation is charged by applying a fixed percentage to the cost of the asset for the first year. In the subsequent years, however, the rate of depreciation is applied to the net book value at the beginning of each year. Thus, the depreciation charge reduces year after year.
3. Sum of the year's digit:
This is a modified version of the reducing balance method but this method cannot reduce the cost of the asset to zero as the depreciation charge reduces year after year by a regular amount. It calculated as:
( Estimated useful life of asset in years × Depreciable value)/Sum of the year's digit.
Other methods include:
- The revaluation method.
- The Production method ( units and hours).
Provision for Depreciation
When providing for Depreciation in the final accounts, the following are necessary:
- A statement of depreciation to ascertain the accumulated depreciation on each asset.
- Fixed Assets Account to determine the balance to be transferred to the balance sheet at the end of the period.
- Provision for Depreciation Account to determine the amount of provision to be charged against profit in the profit and loss account.
- Fixed Assets Disposal Account to ascertain the profit or loss made on disposed assets during the period.
Read Also on
- Accounting Concepts And Conventions
Accountants are governed by certain rules and customs in the preparation of financial statements, penned by various professional bodies in the field such as the IASB called Accounting Concepts And Conventions.
© 2020 Ernest Festus Awudey