CHAPTER 8CHAPTER 8

DEPRECIATION OF FIXED DEPRECIATION OF FIXED ASSETS AND ASSETS AND

CAPITAL & REVENUE CAPITAL & REVENUE EXPENDITUREEXPENDITURE

Learning ObjectivesLearning Objectives• To explain the term of depreciationTo explain the term of depreciation• To explain the need for depreciationTo explain the need for depreciation• To identify and explain the causes of depreciationTo identify and explain the causes of depreciation• To calculate depreciation expense using straight To calculate depreciation expense using straight

line @ reducing balance methodline @ reducing balance method• To account for depreciation expense in the booksTo account for depreciation expense in the books• To show the depreciation charges in the profit & To show the depreciation charges in the profit &

loss a/closs a/c• To show the accumulated depreciation charges in To show the accumulated depreciation charges in

the balance sheetthe balance sheet• Distinguish between capital & revenue expenditureDistinguish between capital & revenue expenditure• Describe the effect on final a/c mainly net profit if Describe the effect on final a/c mainly net profit if

Rev. Exp. is wrongly treated as Cap. Exp. & vise Rev. Exp. is wrongly treated as Cap. Exp. & vise versaversa

IntroductionIntroduction• Fixed Asset is acquired @ bought by a business Fixed Asset is acquired @ bought by a business

either by cash @ credit.either by cash @ credit.• The value of the fixed asset recorded will not be the The value of the fixed asset recorded will not be the

cost itself but its book value i.e. the value of fixed cost itself but its book value i.e. the value of fixed asset at the end of certain period.asset at the end of certain period.

• This is because we have to show the fact that the This is because we have to show the fact that the asset has lost its value when it is being used by the asset has lost its value when it is being used by the business in its daily operation.business in its daily operation.

• When business is using a fixed asset, it must record When business is using a fixed asset, it must record the cost of the fixed asset in the balance sheet & the cost of the fixed asset in the balance sheet & the expense related to the used of the fixed asset the expense related to the used of the fixed asset (depreciation) is shown in the profit & loss a/c.(depreciation) is shown in the profit & loss a/c.

• To determine the cost of fixed asset, the concept of To determine the cost of fixed asset, the concept of capital & revenue expenditure is applied.capital & revenue expenditure is applied.

Definition & Need of DepreciationDefinition & Need of DepreciationAs defined by the MASB 14:As defined by the MASB 14:Depreciation is =Depreciation is =“ “ The allocation of the depreciable amount of an asset The allocation of the depreciable amount of an asset

over its useful life”over its useful life”• Depreciation for the accounting period is charged to Depreciation for the accounting period is charged to

the net profit & loss a/c.the net profit & loss a/c.Reasons for charging depreciationReasons for charging depreciationa)a) To find net profit @ loss for an actg period, the revenue To find net profit @ loss for an actg period, the revenue

for the period is matched against the costs incurred in for the period is matched against the costs incurred in earning that revenue.earning that revenue.

b)b) Unless depreciation on fixed assets is charged, the Unless depreciation on fixed assets is charged, the value of these assets may be overstated in the balance value of these assets may be overstated in the balance sheet.sheet.

c)c) By charging depreciation against profits, the net profit By charging depreciation against profits, the net profit available for distribution is reduced & the results is that available for distribution is reduced & the results is that fund are retained in the business.fund are retained in the business.

Causes Of DepreciationCauses Of Depreciationa)a) Wear and Wear and

teartear- The physical using up of a fixed asset, i.e. - The physical using up of a fixed asset, i.e. corrosion, rot, rust, decay. Although repairs corrosion, rot, rust, decay. Although repairs & maintenance may extend the life of the & maintenance may extend the life of the asset, they can never keep the asset working asset, they can never keep the asset working indefinitely. indefinitely.

b)b) ObsolescenObsolescencece

- The fixed assets becoming out of date or - The fixed assets becoming out of date or obsolete because of new technological obsolete because of new technological advancements.advancements.

c)c) Physical Physical factorsfactors

- Floods, dampness or excessive heat @ cold - Floods, dampness or excessive heat @ cold may make a fixed asset lose its value.may make a fixed asset lose its value.

d)d) Defluxions Defluxions of timeof time

- Certain assets such as patents & copyrights - Certain assets such as patents & copyrights have a fixed time limit of ownership.have a fixed time limit of ownership.

e)e) DepletionDepletion - Wasting assets such as mines or quarries is - Wasting assets such as mines or quarries is being depreciated because of the decrease being depreciated because of the decrease in value.in value.

Factors In Determining DepreciationFactors In Determining Depreciation

The following costs have to be considered when The following costs have to be considered when determining depreciation:determining depreciation:

a)a) Cost of assetCost of asset

i.i. Purchase price of the assetPurchase price of the asset

ii.ii. Transportation cost to get the asset to the Transportation cost to get the asset to the purchaser’s premisespurchaser’s premises

iii.iii. Insurance on the purchase of the assetInsurance on the purchase of the asset

iv.iv. Taxes on the purchase of assetTaxes on the purchase of asset

v.v. Installation cost of assetsInstallation cost of assets

b)b) Useful life of the assetUseful life of the asset

c)c) Scrap value/salvage value @ residual value of the Scrap value/salvage value @ residual value of the asset.asset.

Methods Of DepreciationMethods Of Depreciationa)a) Straight line method:Straight line method: The amount of depreciation for each accounting The amount of depreciation for each accounting

period will be the same.period will be the same. The annual depreciation is calculated by taking The annual depreciation is calculated by taking

the depreciable amount (cost less estimated the depreciable amount (cost less estimated scrap value) divided by the estimated useful scrap value) divided by the estimated useful life; or cost multiplied by percentage.life; or cost multiplied by percentage.

b)b) Reducing Balance MethodReducing Balance Method A greater amount of depreciation is being A greater amount of depreciation is being

charged in the earlier accounting years & charged in the earlier accounting years & smaller amount in the later accounting years.smaller amount in the later accounting years.

Annual depreciation is calculated by multiplying Annual depreciation is calculated by multiplying the book value with a certain percentagethe book value with a certain percentage

Accounting Entries For Fixed Asset Accounting Entries For Fixed Asset & Depreciation Expense& Depreciation Expense

a) To record acquisition of fixed asseta) To record acquisition of fixed asset

Dr. Fixed AssetDr. Fixed Asset

Cr. Bank/CreditorCr. Bank/CreditorXXXX

XXXX

b) To record depreciation expense for the yearb) To record depreciation expense for the year

Dr. Depreciation expenseDr. Depreciation expense

Cr. Provision for depreciationCr. Provision for depreciationXXXX

XXXX

c) To close depreciation to profit and lossc) To close depreciation to profit and loss

Dr. Profit and LossDr. Profit and Loss

Cr. Depreciation expenseCr. Depreciation expenseXXXX

XXXX

Profit and Loss & Balance Sheet Profit and Loss & Balance Sheet PresentationPresentation

Profit and Loss for the year ended…..Profit and Loss for the year ended…..Expenses:

DepreciationDepreciation xxxx

Balance Sheet as at……Balance Sheet as at……

Fixed Asset:Fixed Asset:Cost xxLess: Provision for Depreciation (xx)Book Value xx_

Capital & Revenue ExpenditureCapital & Revenue ExpenditureIntroductionIntroduction

Expenditure relating to the acquisition of fixed assets is Expenditure relating to the acquisition of fixed assets is treated as capital expenditure.treated as capital expenditure.

Expenditure for the maintenance of fixed assets is Expenditure for the maintenance of fixed assets is treated as revenue expenditure.treated as revenue expenditure.

If revenue is incorrectly capitalised, expenses will be If revenue is incorrectly capitalised, expenses will be understated and assets will be overstated. understated and assets will be overstated.

Definition Definition Capital ExpendituresCapital Expenditures

Expenditures that increases the assets value because of Expenditures that increases the assets value because of the improvement on the capacity or efficiencythe improvement on the capacity or efficiency

Revenue ExpendituresRevenue Expenditures Expenditures that will not improved the asset’s value but Expenditures that will not improved the asset’s value but

they are expenses incurred running of the business they are expenses incurred running of the business operation daily. operation daily.

Capital expenditure & treatmentsCapital expenditure & treatments Increase the value of the fixed assets in the Balance Sheet, Increase the value of the fixed assets in the Balance Sheet,

thus the capital of the organization.thus the capital of the organization. It must be added to the cost of the fixed asset on the debit It must be added to the cost of the fixed asset on the debit

side of the fixed assets a/c.side of the fixed assets a/c. The capital expenditure items are:The capital expenditure items are:

a)a) Freight charges, Freight charges, b)b) sales taxes, sales taxes, c)c) legal costs, legal costs, d)d) installation installation costs, extensions or additions to buildings, costs, extensions or additions to buildings, e)e) replacing a new replacing a new motor or engine to a vehicle that would extend the vehicle’s motor or engine to a vehicle that would extend the vehicle’s useful life, useful life, f)f) cost to acquire the fixed asset, cost to acquire the fixed asset, g)g) any other cost any other cost to bring the fixed asset ready for its intended use.to bring the fixed asset ready for its intended use.

Whenever a capital expenditure is wrongly classified as Whenever a capital expenditure is wrongly classified as revenue expenditure, the effects are:revenue expenditure, the effects are:

a)a) Expense are overstated, and therefore the net profit is Expense are overstated, and therefore the net profit is understatedunderstated

b)b) The fixed asset and thus capital of organization is understatedThe fixed asset and thus capital of organization is understated

Revenue expenditure & treatmentsRevenue expenditure & treatments It will be debited to expense a/c, thus chargeable to It will be debited to expense a/c, thus chargeable to

the trading profit & loss a/c.the trading profit & loss a/c. It reduce the net profit & treated as operating It reduce the net profit & treated as operating

expenses,expenses, The revenue expenditure items are:The revenue expenditure items are:

a) a) repainting an office blockrepainting an office block, b) , b) replacing a broken replacing a broken window screenwindow screen, c) , c) motor vehicle registration & motor vehicle registration & insuranceinsurance, d) , d) fuel for motor vehiclefuel for motor vehicle

If revenue expenditures wrongly classified as capital If revenue expenditures wrongly classified as capital expenditures, the effects are:expenditures, the effects are:

a)a) Expenses are understated, & therefore the net profit Expenses are understated, & therefore the net profit is overstated.is overstated.

b)b) The fixed assets and thus capital of the organization The fixed assets and thus capital of the organization is understatedis understated