chapter 11

Question 1

depreciation

Answer 1

the loss of a non current asset as a result of usage, wear and tear, obsolescence of the passing of time

Question 2

how can wear and tear cause depreciation

Answer 2

assets become worn out through use

Question 3

how can obsolescence cause depreciation

Answer 3

sometimes, more efficient technology has been developed the goods that they helped to produce have been replaced, which means that they are no longer needed even though they are physically capable of being used for a number of years

Question 4

how does the passage of time cause depreciation

Answer 4

a non current asset acquired for a limited period of time loses value as time passes

Question 5

how does depletion (exhaustion) cause depreciation

Answer 5

non current assets like mines, quarries and oil wells depreciate as the minerals/resources are extracted from them

Question 6

capital expenditure

Answer 6

expenditure incurred in the purchase or improvement of a non current asset

Question 7

capitalized

Answer 7

recording an item as a non current asset and showing it in the statement of financial position. expenditure needed to get a non current asset into a state where it can be used for the first time will also be regarded as part of the original cost of the asset and will be capitalized

Question 8

revenue expenditure

Answer 8

expenditure on the day to day running costs of the business. appears as expenses in the statement of profit or loss

Question 9

warranty

Answer 9

a type of arrangement where the owner of a non current asset obtains a form of insurance that will pay out for the cost of parts or repairs if there is a problem with the asset

Question 10

how is matching principle applied while accounting for depreciation

Answer 10

if we own a non-current asset for five years and it is used to generate revenue throughout that time, the matching principle requires that we spread the total cost across the whole life of the non-current asset rather than treat the whole amount as an expense in the first year.

Question 11

what happens when matching principle is not accounted for while accounting for depreciation

Answer 11

If we did treat the whole amount as an expense in the first year, then the profit for that year would be under added and those in the next four years would be over added as there would be no expense.

Question 12

why is valuation of the current asset achieved while accounting for depreciation

Answer 12

if the non-current asset is losing value across the five years and no depreciation is applied, then the valuation shown in the statement of financial position would be over added. If the whole loss in value was applied in the first year, then the value of the non-current asset might be grossly under added. As both the statement of profit or loss and the statement of financial position are influenced by our treatment of depreciation, it is very important that we account for it properly.

Question 13

way to calculate depreciation

Answer 13

straight line method
reducing balance method
revaluation

Question 14

straight line depreciation

Answer 14

a method of applying depreciation that assumes that the loss in value will occur at a constant rate. the total amount of depreciation that an asset will incur is estimated as the difference between what it cost and the estimated amount that will be received when it is sold or scrapped at the end of its useful life-its residual value. the total depreciation is then spread evenly over the number of years of its expected life

Question 15

calculation of straight line depriciation

Answer 15

depreciation per year= (cost-residual value)/estimated useful life years

Question 16

useful life

Answer 16

the amount of time that the business expects to keep the asset - this may be significantly less than its physical life.

Question 17

residual value

Answer 17

the amount that a business will receive for the asset at the end of its useful life - used to be known as scrap value.

Question 18

accumulated depreciation

Answer 18

the cumulative total of all the depreciation that has been charged on the non-current assets.

Question 19

net book value (NBV)

Answer 19

the remaining value of the asset (cost-accumulated depreciation)

Question 20

reducing balance method

Answer 20

depreciation is calculated as a fixed percentage of the written down (or net book) value of the asset of each year

Question 21

what assumption does reducing balance depreciation make

Answer 21

the non current asset will provide more benefit in the early part of its useful life because it is more efficient or cheaper to operate
the loss in value is high in the early part of its useful life and becomes more gradual as time passes

Question 22

comparing straight line and reducing balance methods of depreciation

Answer 22

both methods are designed to achieve the same thing: to distribute the cost of the non current asset over its useful in working life and to match the depreciation charge with the revenue earned in the accounting year. if applied properly, both methods account for all of the loss in value of the non current asset, but they do this in very different ways

Question 23

why should the straight line method be used

Answer 23

should be used for non current assets that are expected to earn revenue evenly over their useful lives. it is also used where the pattern of a non current asset’s earning power is uncertain. it should always be used to amortize (write off the cost of) assets with fixed lives, such as leases

Question 24

why should reducing balance method be used

Answer 24

should be used when it is considered that a non current asset’s earning power will reduce as the asset gets older. this method is also used when used the non current asset loses more of its value in the early years of its life

Question 25

what asset should be depreciated

Answer 25

all non current assets that have a limit to their useful lives should be depreciated. therefore, depreciation should be provided on all non current assets except freehold land, which does not have such a limit. freehold buildings will eventually need to be replaced and should be depreciated.

Question 26

freehold buildings

Answer 26

In this sense ‘freehold’ means that the business has complete ownership of the land or buildings and, subject to any government regulations, can decide freely how these non-current assets are used. This differs from leasehold land or buildings where a landlord owns the land or buildings and may restrict what it is used for.

Question 27

revaluation method of depreciation

Answer 27

used to calculate the cost of consumption in the accounting year of small non-current assets such as power tools.

Question 28

how is revaluation method of depreciation calculated

Answer 28

opening valuation + purchases made during the period - closing valuation = depreciation charge for the period

Question 29

why are non cash expenses an issue

Answer 29

depreciation is not a cash expense- the only movements of cash are when the item is bought and any proceeds if it is sold at the end of its useful life. Money is not set aside to pay for a replacement when the non-current asset reaches the end of its useful life.

Question 30

why is the end of useful life an issue

Answer 30

while many businesses might base their assessment of useful life on industrial averages, there are no guarantees that this will be accurate. It is possible that depreciation will be fully applied over say five years and the non-current asset continues to provide benefits for years 6, 7 and 8. As the business has already recorded the depreciation in its accounts, it cannot go back and change any figures. The non-current asset will be retained and will appear at its (zero) net book value until it is disposed of.

Question 31

why is the past year depreciation an issue

Answer 31

The issue is, how should depreciation be treated in the year of acquisition and in the year of disposal.

Question 32

ways in which depreciation should be treated in the year of acquisition and in the year of disposal

Answer 32

A full year’s depreciation is taken in the year of acquisition, but none in the year of disposal.
Depreciation is calculated from the date of acquisition; in the year of disposal, depreciation is calculated from the commencement of the year to the date of disposal, that is, only a proportion of the annual depreciation will be provided. This is sometimes referred to as a ‘month-by-month basis’.

Question 33

why is consistency an issue

Answer 33

the chosen method of depreciation is taken in the year of acquisition, but none in the year of disposal

Question 34

when can the method of calculating depreciation be changed

Answer 34

A change in the method of calculating depreciation should only be made if the financial results and position of the business would be stated more fairly. A change should never be made in order to manipulate profit.

Question 35

disposal

Answer 35

non current assets being sold, traded in or scrapped

Question 36

when is a non current asset disposed

Answer 36

Often this will be at the end of their useful lives although sometimes a non-current asset may be sold or traded in because the business wants to upgrade or change the way it operates

Question 37

why should disposal be recorded

Answer 37

It is essential that any record of the non-current asset being disposed of be removed. It is likely that the amount of money received from that disposal will be different from the net book value at that time despite having applied depreciation to that asset. That difference between the proceeds from the sale and the net book value is the profit or loss on disposal.

Question 38

how is disposal recorded

Answer 38

before carrying out double entry, a disposals account must be created, as we shall see, this is a temporary account that will ultimately ‘disappear’ with a zero balance
step 1
remove the cost of the non current asset from the assets at cost account
debit: disposal account
credit: assets at cost account
step 2
remove all of the depreciation that has ever been charged on the non current asset being disposed of
debit: accumulated depreciation account
credit: disposals account
it may be that the amount of depreciation has been given to you, although sometimes you may have to work it out yourself
step 3
record the proceeds from the disposal
debit: bank or trade receivables
credit: disposals account
step 4
tidy up the disposal account by transferring the balance to the statement of profit or loss. there are two likely outcomes:
a) debit: disposal account
credit: statement of profit or loss as profit on disposal
b) debit: statement of profit or loss
credit: disposals account (this will be on disposal)

Question 39

part exchange

Answer 39

a new non current asset may be acquired in part exchange for one that is being disposed of

Question 40

steps to deal with part exchanges

Answer 40

step 1-Remove the cost of the non-current asset from the assets at cost account.

step 2-Remove all of the depreciation that has ever been charged on the departing non- current asset.

step 3-Record the proceeds from the disposal - this is slightly different.
debit: asset at cost
credit: disposals account

step 4-Tidy up the disposals account by transferring the balance to the statement of profit or loss.

step 5-Record the remaining cost of the new non-current asset.
Debit: Asset at cost
Credit: Bank or payable

Question 41

how does provision for depreciation comply with matching concept

Answer 41

the cost of using non current assets to earn revenue should be matched in the statement of profit or loss to the revenue earned

Question 42

how does provision for depreciation comply with prudence concept

Answer 42

if the cost of using non current assets was not included in the statement of profit or loss, profit and the value of assets in the statement of financial position would be overadded