COURSE CODE & NAME: ACT001 - FUNDAMENTALS OF ACCOUNTING

LECTURE NUMBER: 7/Unit 4 (c)

LECTURE TITLE: ADJUSTMENTS AT THE END OF AN ACCOUNING PERIOD
(CONTD.)

Welcome again to Unit 4 of our course. As we mentioned in our last lecture, we will be
covering the third section of Unit 4 in today’s class. Here’s a quick reminder of the
objectives for this unit:
 Adjust nominal accounts for amounts owing and prepaid.
 Show accruals, prepayments and revenue debtors in the balance sheet.
 Explain the need for a charge for depreciation expense.
 Explain the causes of depreciation.
 Calculate depreciation using either the straight line or reducing balance methods.
 Calculate depreciation on assets bought or sold within an accounting period.
 Make adjustments for bad and doubtful debts
 Write up Journal entries for bad debt provisions and write offs.

Recommended Reading:
Chapters 26 - F. Wood & A. Sangster (2012). Business Accounting 1, 12th edition

I. Fixed and Intangible Assets

Intangible assets are those assets with no physical form. Their value is derived from the
special rights they carry. Patents, trademarks, goodwill and copyrights are examples of
intangible assets.

Fixed Assets are the long term tangible assets a business uses to operate. This includes
land, buildings, machinery, furniture and tools.

Based on the cost principle, the asset should be presented in the balance sheet at its cost
i.e. the amount paid for the asset.

They are written off against profits over their anticipated life by charging depreciation
(with exception of land). Accumulated depreciation is shown in the face of the balance
sheet or in the notes.

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II. Depreciation

Fixed Assets, with exception of land, are allocated/written off against profits over their
anticipated life by charging depreciation. Depreciation matches the asset’s cost (expense)
against the revenue earned by the asset.

Depreciation is not a process of valuation, as businesses do not record depreciation based

on market/sales value of their plant assets. Depreciation does not mean that the business
sets aside cash to replace an asset when it is used up; it has nothing to do with a cash
fund.

All assets except land, experience physical deterioration. For some plant assets, wear and
tear causes depreciation. Computers, software and other electronic equipment may
become obsolete before they wear out and is usually depreciated over a short period such
as 2-4 years.

III. Depreciation Methods

The two main methods of depreciation are the Straight Line Method and the Reducing
Balance Method.

i. Straight Line Method

The depreciation charge is calculated by dividing the cost of the asset by the number of
estimated years of useful life. For example, if a Computer was bought for $22,000 and we
estimate that it would be kept for four years then sell it for $2,000 the yearly depreciation
charge would be:

Cost ($22,000) – Estimated disposal value ($2000) $20,000

=
Number of Expected Years of Use (4) 4

= $5,000 depreciation each year for 4 years.

If the computer did not have a disposal value after four years then the depreciation charge
would be:

Cost ($22,000) $22,000

=
Number of Expected Years of Use (4) 4

= $5,500 depreciation each year for 4 years.

ii. Reducing Balance Method

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A fixed percentage of depreciation is deducted from the cost in the first year. In the
second or later years the same percentage is taken on the reduced balance (i.e. cost less
depreciation already charged). This method is also known as the diminishing balance
method.

If a fax machine is bought for $10,000 and the depreciation is to be charged at 20% the
calculations for the first three years would be as follows:

$
Cost 10,000
1st Year: Depreciation (20%) (2,000)
8,000
2nd Year: Depreciation (20% of $8,000) (1,600)
6,400
3rd Year: Depreciation (20% of $6,400) (1,280)
Cost not yet apportioned, end of year 3 5,120

IV. Accounting for Depreciation

Accounting for depreciation involves maintaining each fixed asset at its cost in the ledger
account while operating another ledger account where the depreciation is recorded. This
account is known as the accumulated provision for depreciation account.

The depreciation is posted directly to the accumulative provision for depreciation

account. The double entry is:

Dr: Income Statement (Depreciation Expense)

Cr: Accumulated provision for depreciation account

Income Statement ( Extract) for the year ended December 31

$
2005 DEPRECIATIO 400
N
2006 DEPRECIATIO 320
N
2007 DEPRECIATIO 256
N

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 Balance Sheet (Extracts)
$ $
As at December 31, 2005
Computer at Cost 2000
Less Accumulated Depreciation (400)
1600

As at December 31, 2006

Computer at Cost 2000
Less Accumulated Depreciation (720)
1280

As at December 31, 2007

Computer at Cost 2000
Less Accumulated Depreciation (976)
1024

Lecture Questions
Question 1

On January 1, 2004, The Welding Shop Ltd bought a Machine A, for $3,000,000. The
company estimates that the machine will have a useful life of 5 years and will value
$500,000. They decide to provide for depreciation using the Straight Line Method.

Prepare:
(a) The Journal entries recording the depreciation provisions up to December 31,
2006. ( 6 marks)
(b) The Machinery Account. ( 2 marks)
(c) The Provision for Depreciation Account up to December 31, 2006. (6 marks)
(d) The Profit and Loss Extract. ( 3 marks)
(e) The Balance Sheet Extract as December 31, 2006. ( 3 marks)

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 Self-Assessment/Practice Questions
Question 2
On January 1, 2006, Manufacturers Associates bought a Plant, for $150,000. The
company estimates that the machine will have a useful life of 4 years and will value
$50,000. They decide to provide for depreciation using the Straight Line Method.

Prepare:
(a) The Journal entries recording the depreciation provisions up to December 31,
2008. ( 6 marks)
(b) The Plant Account. ( 2 marks)
(c) The Provision for Depreciation Account up to December 31, 2008. (6 marks)
(d) The Profit and Loss Extract. ( 3 marks)
(e) The Balance Sheet Extract as December 31, 2008. ( 3 marks)

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 Glossary

Terms Meanings
Cost The dollar amount assigned to a particular asset; usually the ordinary and
necessary amount expended to get an asset in place and in condition for its
intended use.
Cost Concept Resources should be maintained in their accounts at the original cost, not
at any revised value. Adjustments to the cost, e.g. depreciation, should
therefore be shown in a separate account. The accumulative effect of these
accounts may be determined when the balance sheet is being prepared.
Depreciation  the systematic reduction in the recorded cost of a fixed asset. Examples of
fixed assets that can be depreciated are buildings, furniture, leasehold
improvements, and office equipment. The only exception is land, which is
not depreciated (since land is not depleted over time, with the exception of
natural resources)

Double an accelerated form of depreciation under which the vast majority of the
declining depreciation associated with a fixed asset is recognized during the first
balance method few years of its useful life. This approach is reasonable under either of the
following two circumstances: When the utility of an asset is being
consumed at a more rapid rate during the early part of its useful life; or
When the intent is to recognize more expense now, thereby shifting profit
recognition further into the future (which may be of use for deferring
income taxes).

Physical the loss in the physical efficiency of an asset as it ages. Efficiency in this

deterioration  context refers to the asset's ability to produce a quantity of capital services
for a given amount of inputs. It is a synonym for “wear and tear” or “
decay”.

Salvage value / The amount expected to be realized at the end of an asset's useful life.  For
residual value example, you may anticipate using a vehicle for three years and then
selling it.  The anticipated sales amount at the end of the useful life is the
salvage or residual value.

Straight line The method is designed to reflect the consumption pattern of the
depreciation underlying asset, and is used when there is no particular pattern to the
manner in which the asset is to be used over time. Use of the straight-line
method is highly recommended, since it is the easiest depreciation method
to calculate, and so results in few calculation errors.

Useful life The useful life of an asset to an enterprise, usually relating to the
anticipated period of productive use of the item.

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Other Resources:
https://www.youtube.com/watch?v=jGzW-AI8jMc
https://www.youtube.com/watch?v=3Q3dRA-4yM8

References:
https://stats.oecd.org/glossary/detail.asp?ID=2062
https://www.merriam-webster.com/dictionary/understate
http://www.businessdictionary.com/definition/opening-stock.html
http://www.accountingtools.com/questions-and-answers/what-is-interest-revenue.html