Fixed Assets and Depreciation

Fixed Assets and Depreciation

In terms of realization of cash, fixed assets have a longer liquidity time period. For example, if the business has purchased land and buildings, it will take a longer time to be realized in cash. In contrast, the current assets of the company – including money receivable, inventory, etc. – have a shorter time frame to be realized in cash.

In order to reduce the burden on the business accounting bodies all over the world, the depreciation tool is used to determine the actual value of the asset and use it as a sinking fund to replace the asset in the future.

The whole process of depreciation calculation occurs at the end of the year when accounts are prepared. The calculation is a non-cash expense which is estimated or forecasted and is shown in both the profit and loss statement and the balance sheet.

The question of why fixed assets should be depreciated is a common one asked by many. The main reason for calculating depreciation is to calculate the recovery of cost that is incurred on fixed assets over their useful life. This ensures the owner’s capital is intact. By following the process, future provisions can be made for replacement costs when the present asset is retired from the business.

The true value of an asset can be ascertained if depreciation is taken into account. If depreciation is not calculated, the asset value shown in the accounting books would be higher than the actual or true value.

Moreover, depreciation is often added to the cost of production so as to find out the actual cost of production. This is because machinery and equipment used to produce the product often incurs some sort of wear and tear of the asset. This must be calculated and added to the cost of producing the product.

Thirdly, depreciation must be calculated to find out the correct profit of the year and to find out the actual position of the business through the balance sheet. Unless the depreciation value is calculated and considered like other expenses, the true profit or loss of the business cannot be ascertained.

Lastly, as per Company Act statutes, a company cannot declare dividends until it has calculated depreciation and charged it to the books.

Example: You may recall that Jim, the owner of Joint Ventures, was less than thrilled with the need to lease a plane from Hurt’s Plane Rental. So he decided to buy a used plane for $75,000.How should the payment be recorded?

Since the expenditure is very large and the plane should be useful for several years, it is not reasonable to treat the acquisition as an expense. Clearly, the plane is a fixed asset. Because the plane will help generate revenue over several periods, it is not a current period expense. This is the entry for the acquisition:

One asset account, Equipment, has increased while a second asset account, Cash, has decreased.

Example: Assume that Joint Venture’s plane will last twenty years. There is no reason to assume that this plane will physically deteriorate more rapidly in the beginning or end of its useful life, so the straight-line method is used. Dividing $75,000 by 20 years gives an annual depreciation amount $3,750 per year. The entry for recording the annual depreciation is:

Accumulated depreciation is known as a contra asset account. It is found on the left (asset) side of the balance sheet, but unlike other assets, it normally has a credit balance. The idea is to allow an asset’s acquisition price to be reflected at its original cost, offset by the amount of depreciation taken against it. The fixed asset section of Joint Ventures’ balance sheet as of 12/31/04 would look like this:

Because businesses usually have several fixed assets purchased at different times, with different useful lives and different depreciation methods, it is necessary to keep a separate schedule of these assets called a fixed asset schedule. An example of a portion of a fixed asset schedule is:

Depreciation methods for fixed assets

In most circumstances you can choose between the diminishing value and straight line methods of calculating depreciation.

You do not have to use the same depreciation method for all your assets, but you must use whatever method you choose for an asset for the full year. You can change methods for any asset from year to year.

You can elect not to depreciate an asset.

The depreciation rates for various assets are set by Inland Revenue, and are based on the cost and useful life of the asset being depreciated. The general depreciation rates both diminishing value and straight lines apply as follows:

1993-2005 asset rates: Use for assets acquired on or after 1 April 1993 and before 1 April 2005, and buildings acquired on or after 1 April 1993 and before 19 May 2005, and

2006 and future year’s asset rates: Use for assets other than buildings acquired on or after 1 April 2005 and buildings acquired on or after 19 May 2005.

1. Diminishing value depreciation

The amount of depreciation is worked out on the adjusted tax value of the asset. This value is the original cost less any depreciation already claimed in previous years. If you are registered for GST the original cost price should not include GST you have already claimed in your GST return.

Example

A car purchased in May 2005 has a depreciation rate of 30% diminishing value.

Note: For secondhand and imported used cars the 20% loading does not apply.

The cost (excluding GST) was $30,000.

 

2. Straight line depreciation

Depreciation is calculated on the original cost price of the asset, and the same amount is claimed each year. If you are registered for GST, the cost excludes any

GST you have already claimed in your GST return.

Example

If the car in the example above is depreciated using the straight line method, the rate is 21%.

The GST-exclusive cost is $30,000, so the depreciation to claim each year is $6,300

$30,000 x 21% = $6,300

3. Pooling assets

• You may use a pool system to depreciate low-value assets collectively rather than individually and depreciate them as though they were a single asset.

• You must use diminishing value depreciation rates for pooled assets.

• You can pool assets that: individually cost $2,000 or less, or have been depreciated so the adjusted tax value is $2,000 or less, and are used 100% for business, or are liable for fringe benefit tax if the business use is less than 100%.

• Each pool is depreciated using the diminishing value method, at the lowest rate applying to any asset in the pool.
Video

http://www.youtube.com/watch?v=EGfTmoXGyVM



Written by
Natasha Méndez




Sources consulted
Author: John Day
Date: november 24, 2011
http://www.investorwords.com/1416/depreciation.html