Question

Describe the nature of property, plant, and equipment (PPE) and intangibles.

Explain, calculate, and record depreciation using different methods.

Answer 1

Property, Plant and Equipment represent long term assets held in the business for the purpose of generating revenue. Property, Plant and Equipment are tangible in nature, meaning they are physical in nature or can be seen and touched. These are also referred to as company's fixed assets or plant assets.

Examples for Property plant and machinery would be furniture, machinery, land, building, etc.

Intangibles represent assets which are not physical in nature unlike property, plant and equipment, instead they could be felt. Examples of Intangibles include goodwill, patents, trademarks, copyrights, etc.

The Various methods used for the calculation of depreciation are as follows

· Straight Line Depreciation Method

· Diminishing Balance Method

· Sum of Years’ Digits Method

· Double Declining Balance Method

· Sinking Fund Method

· Annuity Method

Straight Line Depreciation Method

· It is also known as fixed instalment method.

· Under this method, an equal amount is charged for depreciation of every fixed asset in each of the accounting periods.

· This uniform amount is charged until the asset gets reduced to nil or its salvage value at the end of its estimated useful life.

· Depreciation under this method is calculated by applying the formula

o Depreciation = (Purchase Price of Asset - Salvage Value) / Estimated Useful Life of Asset

· For example, the company just purchased a machine for cost 110,000 USD. The machine is estimated to be used for five years and the residual of the machine at the year fifth would be 10,000 USD. What is the depreciation expense of the machine if we use the straight-line depreciation method?

o Now, Book value of the machine is 110,000 USD

o The depreciation rate is 20% (100%/5 years)

o Residual value 10,000 USD.

o Depreciation expenses:

§ First Year = (110,000– 10,000) X 20% = 20,000 USD

§ Second Year = (110,000 – 10,000) X 20% = 20,000 USD

§ Third Year = (110,000 – 10,000) X 20% = 20,000 USD

§ Fours Year = (110,000 – 10,000) X 20% = 20,000 USD

§ Fifth Year = (55,000 – 5,000) X 20% = 10,000 USD

Diminishing Balance Method

· Under this method, the amount of depreciation is calculated as a fixed percentage of the reducing or diminishing value of the asset standing in the books at the beginning of the year, so as to bring down the book value of the asset to its residual value.

· The amount of depreciation goes on decreasing every year. That is, the amount of depreciation charged in each period is not fixed but is a gradually decreasing sum.

· Example On 1st Jan. 2003 machinery was purchased for USD 80,000. If depreciation was to be provided at 20% on the Diminishing Balance method then

o Depreciation for 2003 will be 20% of 80,000 = 16,000 and Written Down value at the end of 2003 will be 64,000 (80000-16000)

o Depreciation for 2004 will be 20% of 64,000= 12,800 and Written down value at the end of 2004 will be 51,200(64000-12800)

o Depreciation for 2005 will be 20% of 51,200= 10,240 and Written down value at the end of 2005 will be 40,960(51200-10240)

Sum of Years’ Digits Method

· The sum of years’ digits method is a form of accelerated depreciation that is based on the assumption that the productivity of the asset decreases with the passage of time. Under this method, a fraction is computed by dividing the remaining useful life of the asset on a particular date by the sum of the year’s digits. This fraction is applied to the depreciable cost of the asset to compute the depreciation expense for the period.

Double Declining Balance Method

· The double declining balance method of depreciation, also known as the 200% declining balance method of depreciation, is a form of accelerated depreciation.

· This means that compared to the straight-line method, the depreciation expense will be faster in the early years of the asset's life but slower in the later years. However, the total amount of depreciation expense during the life of the assets will be the same.

Sinking Fund Method

· The sinking fund method is a technique for depreciating an asset while generating enough money to replace it at the end of its useful life.

· As depreciation charges are incurred to reflect the asset's falling value, a matching amount of cash is invested.

· These funds sit in a sinking fund account and generate interest

Annuity Method

· The annuity method of depreciation is a depreciation technique that focuses on achieving a constant rate of return on an asset. It is more likely to be used for more expensive fixed assets that are expected to have a long useful life.

· To employ the annuity method, follow these steps:

o Estimate the future cash flows that will be associated with an asset.

o Calculate the internal rate of return on those cash flows.

o Multiply the internal rate of return by the initial book value of the asset.

o Subtract the result from the cash flow for the current period.

o The residual value is the depreciation to charge to expense in the current period.