Topic 6- Profit Analysis; Depreciation

Question 1

Explain your understanding of the term ‘depreciation’

Answer 1

refers to the allocation or allotment of a portion of an assets’ initial or revised cost to each year that the asset will be of use or benefit to the business. It should, therefore, be noted that depreciation is an allocation process and not a process of evaluation as is often thought

Question 2

What are the prime causes of depreciation?

Answer 2

• physical wear and tear
• technical obsolescence due to technological advancements and
• commercial obsolescence resulting in insufficient continuing demand for the service provided by the asset.

Question 3

Distinguish prime cost depreciation from diminishing value depreciation.

Answer 3

Prime coast depreciation is where the annual value of depreciation is calculated as a fixed percentage of the initial cost of the asset (less any estimated residual value). The percentage is determined by the estimated service (useful) life of the asset to the business.
Diminishing value depreciation is where the annual value of depreciation is calculated as a fixed percentage of asset’s book value (or written down value) at the beginning of the year in question.

Question 4

List the information necessary to calculate the annual depreciation of a depreciable item.

Answer 4

• For prime cost depreciation:
- the useful life of the asset - most commonly expressed in terms of time (years)
- the initial (historical) cost or revised value of the asset and
- the estimated residual value of the asset, also expressed as the salvage or trade-in value of the asset.
• For diminishing value depreciation:
- The written down value of the asset at the commencement of the year
- The annual rate of depreciation.

Question 5

If a depreciable asset is sold part way through the year, how do you calculate the value of depreciation applicable for that item for that accounting period?

Answer 5

If a depreciable asset is sold part way through the year, the value of depreciation applicable for that item for that accounting period will be based on the proportion of the year over which the asset was held. Thus if an asset was sold in the 7th month, then the value of depreciation for that asset for that year will be 7/12 of the normal annual depreciation.

Question 6

In respect to a depreciable asset, what is meant by the term ‘written down book value’ and how do you calculate this value?

Answer 6

The term ‘written down book value‘ refers to the asset’s currently recorded value (on the books of the business) and is determined by subtracting the total depreciation to date for that item from its
initial cost. Where an item has been revalued, then its written down book value will be the revalued amount minus depreciate to date i.e. since the revaluation.

Question 7

How is the profit or loss on the sale of an asset determined?

Answer 7

The profit or loss on the sale of an asset is determined by finding the difference between the item’s sale value and its written down book value at the time of sale. If this difference is positive then a profit has been made on the sale, whereas a loss is made if the difference is negative.

Question 8

Which values in a depreciation schedule need to correspond with those accounts or financial analysis dealt with in Topics 1 to 4?

Answer 8

The values in a depreciation schedule which need to correspond with those components of the Financial Analysis dealt with in topics 1 to 4, are as follows:
• The total beginning of year value of all items on the schedule must be same as that shown in the opening balance sheet.
• The value of any sales and purchases must correspond to the values shown in the cash flow statement.