What counts as the cost of a fixed asset, the concept of useful life, and three ways to depreciate — straight line, declining balance and double declining balance.
Fixed assets are capable of repeated use with an expected life of more than one year. When equipment is removed from service and held for sale it ceases to be a fixed asset. The initial cost includes every expenditure needed to get the asset in place and ready for use: import duty, sales tax, transportation, insurance in transit, special foundations and installation. For land it includes the negotiated price plus broker’s commission, registration and surveying fees.
With the passage of time all fixed assets except land lose their capacity to yield services. The decline in cost is charged to expense in a systematic manner — depreciation.
Straight line — uniform usage
Straight-line depreciation
A
B
1
Cost
2
Residual value
3
Useful life (years)
4
Annual depreciation
3,600
5
Written-down value at end of year 1
16,400
6
Written-down value at end of final year
2,000
blue = input (edit me)grey = formula (click to see it)
Declining balance — heavy early use
A fixed rate is applied to the written-down value, ignoring the residual value — but depreciation should not take the book value below the expected residual. It suits assets whose productivity declines proportionately more in early years; the smaller later charges are offset by rising maintenance costs. Double declining simply uses twice the straight-line rate (40% for a 5-year life) and stops at the residual value.
Declining balance (20%)
A
B
C
D
E
1
Yr
Rate
Book value
Depreciation
End value
2
Cost
Rate
3
1
10,000
2,000
8,000
4
2
8,000
1,600
6,400
5
3
6,400
1,280
5,120
6
4
5,120
1,024
4,096
7
5
4,096
819
3,277
blue = input (edit me)grey = formula (click to see it)
Double declining balance (40%, floor at residual)
A
B
C
D
E
1
Yr
Book value
Depreciation
End value
2
Cost
Residual
3
Rate
4
1
10,000
4,000
6,000
5
2
6,000
2,400
3,600
6
3
3,600
1,440
2,160
7
4
2,160
160
2,000
8
5
2,000
0
2,000
blue = input (edit me)grey = formula (click to see it)
Worked example — Map Furniture’s delivery trucks (2004–2006)
A three-year sequence of purchase, repair, trade-in and sale. The key rules: major repairs that extend life are capitalised (13,300 added to cost); routine repairs are expensed; depreciation is recorded up to the date of disposal; the difference between book value and proceeds is the gain or loss on disposal.
Date
Event
Treatment
24 Feb 2004
Used truck bought for 124,000 cash; 26 Feb major repairs 13,300
Traded in on a new truck priced 497,000; allowance 50,000
Depreciation to date 24,956; disposal account closes with a loss of 31,150
31 Dec 2005
Depreciation on new truck (life 5 yrs, residual 80,000, DDB)
497,000 × 40% × 4/12 = 66,267
28 Aug 2006
Another new truck bought for 570,000
Delivery Equipment
29 Oct 2006
2005 truck sold for 260,000
Depreciation to date 152,413; book value 278,320 → loss 18,320
31 Dec 2006
Depreciation on remaining truck (life 4 yrs, residual 90,000, DDB)
570,000 × 50% × 4/12 = 95,000
Disposal of the 2005 truck — gain or loss
A
B
1
Cost of truck
2
Accumulated depreciation to date of sale
3
Book value
278,320
4
Cash received
5
Gain / (loss) on disposal
(18,320)
blue = input (edit me)grey = formula (click to see it)
Assignment 1 (lectures 1–4, 30 marks): download the financial statements of a Pakistani company of your choice and write a note on its treatment of depreciation, inventory valuation, cost of goods sold and disposal of fixed assets.