31 March 2009

At the date of acquisition the cost of the asset of $120,000 would be capitalised. The asset should then be depreciated for the years to 31 March 2009/2010 as:

Cost – residual value = ____________________- per annum

Useful economic life 10 years

Income statement extract 2008

Depreciation $__________

Statement of financial position extract 2008

Machine ______________________

31 March 2010

Income statement extract 2010

Depreciation $______________

Statement of financial position extract 2010

Machine

______________________________

31 March 2011

As the residual value and useful economic life estimates have changed during the year ended 2011, the depreciation charge will need to be recalculated. The carrying value will now be spread according to the revised estimates.

Depreciation charge:

______________________________ per annum

5 years

Income statement extract 2011

Depreciation $___________

Statement of financial position extract 2011

Machine _____________________

Component depreciation

If an asset comprises two or more major components with different economic lives, then each component should be accounted for separately for depreciation purposes and depreciated over its own useful economic life.

Example 5

A company purchased a property with an overall cost of $100m on 1 April 2009. The property elements are made up as follows:

$000 Estimated life

Land and buildings

(Land element $20,000) 65,000 50 years

Fixtures and fittings 24,000 10 years

Lifts 11,000 20 years

100,000

Calculate the annual depreciation charge for the property for the year ended 31 March 2010

Solution

$000

Land and buildings _______________________

Fixtures and fittings ________________________

Lifts ______________________________

Total property depreciation ____________________

Depreciation

Depreciation is systematic allocation the cost of a fixed asset over its useful life. It is a way of matching the cost of a fixed asset with the revenue (or other economic benefits) it generates over its useful life. Without depreciation accounting, the entire cost of a fixed asset will be recognized in the year of purchase. This will give a misleading view of the profitability of the entity. The observation may be explained by way of an example.

Example 6

ABC LTD purchased a machine costing $1000 on 1st January 2011. It had a useful life of three years over which it generated annual sales of $800. ABC LTD's annual costs during the three years were $300.

If ABC LTD expensed the entire cost of the fixed asset in the year of purchase, its income statement would present the following picture the end of the three years:

Income Statement	2011, $	2012, $	2013, $
Sales	800	800	800
Cost of Sales	(300)	(300)	(300)
Fixed Asset Cost	(1000)	-	-
Net Profit (Loss)	(500)	500	500

As you can see, income statement of ABC LTD shows net loss in the first year even though it earned the same revenue as in the subsequent years. Conversely, no fixed asset will appear in ABC LTD's balance sheet although it had earned revenue from the machine's use through out its useful life of 3 years.

If ABC LTD, instead of charging the entire cost of fixed asset at once, depreciates the capital expenditure over its useful life, its income statement and balance sheet would present the following picture at the end of the three years:

Income Statement	2011, $	2012, $	2013, $
Sales	800	800	800
Cost of Sales	(300)	(300)	(300)
Fixed Asset Cost	(333.3)	(333.3)	(333.3)
Net Profit (Loss)	166.7	166.7	166.7

Balance Sheet (Extract)	2011, $	2012, $	2013, $
Fixed Assets	1,000	1,000	1,000
Accumulated Depreciation	(333.3)	(666.7)	(1,000)
Net Book Value	666.7	333.3	Nill

As you can see, the process of relating cost of a fixed asset to the years in which the economic benefits from its use are realized creates a more balanced view of the profitability of the company. Hence, depreciation is an application of the matching principle whereby costs are matched to the accounting periods to which they relate rather than on the basis of payment.