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Accounting for Fixed Asset / Depreciation / Page -1-

ACCOUNTING FOR FIXED ASSET

Q.1 Ans.

Explain what is mean by a fixed asset? Fixed assets are those assets that are acquire for long-term use within the business and not intended to be sold in near future e.g. machinery, premises, furniture, motor vehicles, etc. However, purpose of keeping these assets is very important as, e.g. for BMW-Motor Ltd motor vehicles held for business use are treated as fixed assets. Explain why fixed asset are depreciated? Depreciation is charged to allocate the cost of tangible fixed asset to expense in the periods in which services are received from assets.The cost of the asset is initially debited to an asset account because fixed assets benefit the business for a long period of time, as the services are received, the cost of the asset gradually removed from the balance sheet and allocated to expense through the process called depreciation. So the basic purpose of depreciation is to achieve the Matching principle that is to, offset the revenue of an accounting period with the costs of the goods and services being consumed in the effort to generate revenue. The factors affecting the assessment of useful life according to accounting standard. (i) (ii) (iii) (iv) (v) expected usage; expected physical wear and tear; technological obsolescence; legal or similar limits on the use of the asset,such as the expiry dates of related leases; Inadequacy of Capacity.

Q.2 Ans.

Wear & Tear


Physical deterioration is caused not only from wear & tear when the asset is in use,but also from erosion rust, not decay from being exposed to wind, rain, sun and other elements of nature.All these will reduce the value of the fixesd asset so much so that it will fetch a much lower price than its historical cost, if sold. Depreciation allows the owner or creditors to assess the estimated value of the fixed asset after years of usage.

Obsolescence (out of date)


It means the process of being out-of-date for a tangible asset because more advanced equipments have been invented. The new equipment is usually efficient and economical thus rendering the old asset to be out-of-date.

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Inadequacy of Capacity When a company starts to grow, the present fixed asset might be inadequate in terms of capacity for operation.Some would have to be replaced even though they are still in good physical condition and not obsolete.
Q.3 (i) Reasons for providing depreciation on Fixed Assets: To spread the depreciable cost ( less residual value ) over the assets useful life. The purchase of a fixed asset is the purchase of a store of service units that will be used up over successive accounting periods.Depreciation seeks to change the units consumed to an accounting period. To set aside monies for replacement.The aim of depreciation policy is to save up the money needed to replace the asset after its death. To reflect the fact that the fixed assets are of second-hand value at balance sheet date. To preserve the capital of the business by preventing the amount of the depreciation available for distribution as a dividend.This is a capital maintenance concept, i.e. the greater the amount of depreciation, the more there is preserved in the business. Use two accounting concepts to explain why a depreciation charge is made in final accounts. Matching concept and Conservatism concept are used to explain why depreciation charge is made in final accounts.Since fixed assets are bought by businesses to generate revenue the expense of using the fixed assets by way of depreciation must be matched against the same period as of revenue generation.This is based on Matching Concept.Assets and profits should be valued at the lowest possible values following the concept of Prudence ( Play Safe ).Hence depreciation is provided in the final accounts so that assets are shown at their true value. Explain factors which help determine the rate at which depreciation is calculated. (i) ( ii ) ( iii ) Cost of the asset. Estimated useful life. Estimated residual vale.

(ii) (iii) (iv)

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Q.6 Ans.

Explain why an appreciation in the value of fixed assets does not in itself exclude the need for depreciation. In the balance sheet, the original costs of the assets are deducted by the accumulated depreciation to give the net book value.Net book value does not represent market value.It represents the portion of the assets that has not been used up in the operation.That is to say, depreciation is not a process of valuation(i.e.to find the market value of the assets), but allocation of cost as expense.Consequently, a fixed assets market price may rise but this should not stop the company from depreciation its assets. Should a company abandon its conservative approach and recognise the increase in value of the fixed assets, the unrealised gain could be debited to the fixed asset, and a capital reserve for the revaluation could be credited.Then, depreciation would be provided on the revised value. S.A.Abbas 0300-2136265 Accounting for Fixed Asset / Depreciation / Page -3-

Methods of depreciation
123456Straight-line, Reducing balance, Revaluation, Depletion units / Production units, Machine hours / Working hours and Sum of year & digits.

Straight-line method
The straight-line method allocates the expense of using the asset to the several period on the basis of passage of time.Here, depreciation charges is: Annual depreciation = Cost of asset Scrap value x n ( n = number of months asset Useful life 12 used in accounting year ) Advantage: Disadvantage: It is easier to calculate and is more reliable for the assets whose efficiency or productivity remains constant over their lives. This method does not take into account the seasonal fluctuations in machinery / asset usage. In one year, the asset may be used more than another year, but the depreciation is the same for both years.

The Reducing / Declining / Diminishing - Balance Method


( also called Written Down Value Method ) This is an accelerated type of depreciation method. Here, depreciation is provided by means of periodic charges calculated as a constant proportion of the balance of the asset after deducting the amount previously provided. Annual depreciation = ( Cost Accumulated depreciation ) x rate % x n / 12 The book value is defined as the balance to appear on the balance sheet, that is the cost (asset account) less the balance of the accumulated depreciation account.Amount of depreciation is heavier in earlier years and lighter in later years. The salvage value is not relevant here because the net asset amount (Asset minus accumulated depreciation) would not be allowed to drop below the salvage value.

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Advantage:

Useful for machines / vehicles used in production or delivery as these are mostly efficient in the earlier years of their life.So the cost of depreciation should be more in those years. Since the amount of depreciation is heavier in earlier years and lighter in later years, this affects the costs of production since costs appeal to decrease in later years.

Disadvantage:

Revaluation Method
Annual depreciation = Beginning balance + Addition During Closing balance of fixed assets the Year of fixed assets

Machine Hours Method


Annual depreciation = ( Cost of asset Salvage value ) x No.of hours machine used in a year Life of machine in hours Advantage: Disadvantage: It is easy and simple to use.Its relates to actual use of asset. Accounting to this method, if asset is not used, there will be no depreciation charge.However, physical deterioration and obsolescence will still take place despite the asset not being used at all.Problems of excessive use, which may necessitate a more than normal rate of depreciation.

Depletion units / Production units Method


Annual depreciation = ( Cost of asset Salvage value ) x No.of units extracts machine in a year Life of machine in units

Sum of Year & Digits Method


Annual depreciation = ( Cost of asset Salvage value ) x Life ; where D = N ( N+1 ) ;N = Life D 2

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Q.7

Depreciation has been described as a process of allocation, not of valuation. Consider and comment upon the above statement. How is depreciation affected by inflation,and to what extent should the annual charge of depreciation be amended to take account of the effects of inflation?

Ans.

Depreciation in respect of fixed assets is the allocation of the cost over their estimated useful lives.The reason being that fixed as so is to do contribute a part in the generation of revenue.Under the principle of matching,these costs need to be realized and matched. Depreciation results in the reduction of the cost in the balance sheet (net book value). This reduction,on the other hand,represents the physical deterioration,obsolescence and inadequacy of the assets. The process of depreciation is to measure the value of the service the assets have provided during any given accounting period.Consequently,net book value represents that portion of the original costs that have not been used up in the generation of revenue.It does not represent market price. For example, a freehold building which has a net book value of $500,000 could be sold for $1million.The latter being the market price of the building. Determination of market price involves consideration and many issues like inflation, present value,future contribution,and so on,through net book value should be a suitable basis.But this should not be taken as saying depreciation is a process of valuation. The main purpose of depreciation is cost allocation. During a period of inflation, it may be necessary to revalue the fixed asset to reflect the market value.Depreciation in this case, will be based on the revised current value. However, it is difficult to obtain the current value (actual value) as the issue is truly complicated.Consequently, this concept is not widely used and depreciation based on historical cost continues.

Q.8 (i)

Given below are five different methods of valuing a companys land and buildings. Comment on the suitability(or unsuitability) of each method of valuation for the purpose of showing the land and buildings in the annual accounts, explaining the advantages and disadvantage association with each method. At the current selling price of the land plus the original cost of the buildings. Generally the purchase of a building is made with the land.It is not correct to value in the accounts the building at cost and the land at selling price; the doctrine of consistency will be revoked. Advantage: The availability of the current price of the land is useful for decision making. Disadvantage: Information might be misleading as current cost and historical cost are mixed together. S.A.Abbas 0300-2136265

(a) Ans.

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(b) Ans.

At the current selling price of the land and buildings. Land and building are acquired as fixed asset and for resale in the ordinary course of business. Consequently, the selling price is not suitable for valuation and recording in the books. Another point of contention is that the selling price normally fluctuates from time to time. Advantage: Both land and building are of current cost which is useful for decision making. Disadvantage: Current cost is difficult to ascertain and very subjective. At the original cost of the land and buildings. While land is not subject to to wear and tear .Provision for depreciation must be made on buildings.Consequently to report land and buildings at their original cost are not adequate. Advantage: The valuation is objective and easy. Disadvantage: The information is not adequate for decision makers. At the original cost of the land plus a proportion of the cost of the buildings, after taking account of their wearing out. In line with the comments in the previous paragraph, the method of valuing land and buildings at the original cost less the wear and tear provision for buildings would be suitable for reporting. It is consistent with the historical cost concept if accounting. Advantage: The value of the asset is objective. Disadvantage: The information is not adequate. At the amount of that would be needed to buy similar land and buildings. It is difficult to obtain the amount to buy similar land and buildings as no two plots of land and as well as of two buildings could be identical in term of location advantages and disadvantages age condition furnishing and so on. Advantage: It will be of great use to users of annual accounts. Disadvantage: The value arrived is at highly subjective. Which of the above methods is widely used in accounting and why? Generally, most companies would record the original purchase cost of land and buildings less provision for depreciation on buildings in the accounts. However, the market values of the assets are also shown as notes to the accounts to enhance the usefulness of the information. This method of reporting is in line with historical cost accounting. How do accountants take account of increase in the value of land and buildings and how are such changes reflected in the account? As mentioned earlier, even if market value of the land and buildings is higher than cost , the company can still conservatively keep in the books the assets as cost less provision for depreciation on buildings. The market values is then disclosed as a note to the accounts .However ,should the company find appropriate to book the increased value , then the difference between the market value and cost would be debited o land and building accounts and credited to a capital reserve accounts. S.A.Abbas 0300-2136265

(c) Ans.

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