FUNDAMENTALS OF ACCOUNTING

Adjustments for the Trading, Profit and loss account

DEPRECIATION

This is a reduction in the values of fixed assets. It is that part of the fixed asset that is
consumed or used up during an accounting period. Depreciation is regarded as an expense
and is therefore charged to the profit and loss account. Some of the factors which leads to
depreciation are:

1. Physical deterioration

(a) wear and tear – consistent use of the asset will cause it to wear out and value less
(b) Erosion, rust, rot and decay – land may be eroded by water or wind, while metals in
assts such as machine vehicles may rust or corrode. Asset made of wood may even
start to rot and decay.

2. Economic Factors such as:

(a) obsolescence - the fixed asset becomes outdated

(b) Inadequacy – expansion in the size of the business has led to the replacement of fixed
assets with larger ones.

3. time factor

This refers to assets that have legal life fixed in terms of years. Example of this is a lease
agreement. As each year passes by, the agreement comes closer to an end. When the
years are finished the agreement is worth nothing.

4. Depletion

This refers to assets that have a wasting character as a result of extraction of raw material,
e.g. Bauxite.

Methods of calculating Depreciation

(A) Straight line Method (Fixed Installment Method)

The same amount is charged to the profit and loss account each year as depreciation expense.

Formula 1:
Depreciation = Cost price – Scrap value
No. of Years
A machine costs $25000. It is to be kept for 4 years and then sold for an estimated figure of
$10240.

Calculate the depreciation using the straight line method

Cost price – Scrap value

No. of Years

Depreciation = 25000 – 10240

4

= $3690

Net Book Value (NBV) refers to the value of the fixed asset to date, after all depreciation
charges have been deducted.

Net Book Value: (Yr 1) 25000 – 3690 = $21310

NBV (Yr 2) 25000 – (7380) = $17620

OR

Formula 2:
Depreciation = Cost x percentage

Examples 2

A small machine costs $25000. It is to be kept for 4 years and is to be depreciated at 20% per
annum.

Depn = 25000 x 20% = $5000

NBV Yr 1 25000 -5000

NBV Yr 2 25000 - 10000

(B) Reducing Balance Method

A reduced amount is charged to the profit and loss account each year, as depreciation expense.
Formula:
Deprecation = (cost – total previous depreciation) x percentage

A machine costs $25000. It is to be kept for 4 years and depreciated at 20% using the reducing
balance method.

Calculate depreciation for each year.

Yr 1: (25000 – 0) x 20% = $5000

NBV: 25000 – 5000 = $20000

Yr 2: (25000 – 5000) x 20% = $4000

NBV = 25000 – 9000 = $16000

Yr 3: (25000 – 9000) X 20% = $3200

NBV = 25000 – 12200 = $12800

Yr 4: (25000 – 12200) x 20% = $2560

Class Activity

Question 1

A machine cost $128000. It is to be kept for 5 years, and then sold for a scrap value of $40000

i. Calculate the depreciation using the straight line method.

(128000 – 40000) /5 = $17600

ii. Calculate the NBV for year 1 and year 4

NBV (Yr 1): $110400

NBV (Yr 4): $57600

17600 x 4
Question 2

A machine cost $10240. It is depreciated at the rate of 25% per annum on the reducing balance
method.

Calculate the depreciation and NBV for year 1

Depn (Yr 1): $2560

NBV (Yr 1): 10240 – 2560 = $7680

Calculate the NBV for year 3

This requires that you know the depreciation for years 2 and 3

PROVISION FOR DEPRECIATION (Accumulated depreciation/Total depreciation to date)

This is the total amount of depreciation that has been charged on the asset. When the
accumulated depreciation is subtracted from the cost price of the asset, the result is the Net
Book Value (NBV) of the asset. That is, the value of the asset after the value for depreciation is
taken out..

To prepare the provision for depreciation account:

Debit Profit and Loss account

Credit Provision for Depreciation account.

Task 1
The trial balance (extract) for A Smith for the year ended 31, December 2004 is as follows:

Gross Profit 7120

Salaries 3500
Rates 550
Telephone 122
Insurance 300
Shop fittings at cost 6000
Vans at cost 4000
Premises at cost 9000
Provision for Depreciation:
Shop fitting 2000
Vans 1000
Premises 2500

Adjustments:
Depreciation on shop fittings is 10% per annum, vans 20% per annum reducing balance and
premises $3100.

Prepare:
(a) the profit & Loss account
(b) Balance sheet extract showing details of fixed assets.

Task 2

The trial balance (extract) for B. Brown for the year ended 31, December 2004 is as follows:

Gross Profit 15 000

Motor expense 1 300
Wages 2 100
Rates 550
Telephone 122
Insurance 300
Motor vehicles at cost 9000
Furniture at cost 7000
Premises at cost 8 500
Provision for Depreciation:
Motor vehicle 1 000
Furniture 2 000
Premises 1 500

Adjustments:
Depreciation on Motor vehicle is 20% per annum on cost, Furniture 10% per annum reducing
balance and premises $1 800.

Prepare:
(a) the profit & Loss account
(b) Balance sheet extract showing details of fixed assets.