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TOPIC 5:DEPRECIATION | B/KEEPING FORM 3

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Cost of a Fixed Asset
Determine the cost of a fixed asset
Depreciation
is 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).
An Asset Account
Write up an asset account
Provision for Depreciation Account
Write up a provision for depreciation account
The causes of depreciation are:
  • Wear and tear.
    Any asset will gradually break down over a certain usage period, as
    parts wear out and need to be replaced. Eventually, the asset can no
    longer be repaired, and must be disposed of. This cause is most common
    for production equipment, which typically has a manufacturer’s
    recommended life span that is based on a certain number of units
    produced. Other assets, such as buildings, can be repaired and upgraded
    for long periods of time.
  • Perish ability. Some assets have an extremely short life span. This condition is most applicable to inventory, rather than fixed assets.
  • Usage rights.
    A fixed asset may actually be a right to use something (such as
    software or a database) for a certain period of time. If so, its life
    span terminates when the usage rights expire, so depreciation must be
    completed by the end of the usage period.
  • Natural resource usage.
    If an asset is natural resources, such as an oil reservoir, the
    depletion of the resource causes depreciation (in this case, it is
    called depletion, rather than depreciation). The pace of depletion may
    change if a company subsequently alters its estimate of reserves
    remaining.
  • Inefficiency/obsolescence. Some equipment will be rendered obsolete by more efficient equipment, which reduces the usability of the original equipment.
Difference between Capital and Revenue Expenditure
Distinguish between copula and revenue expenditure
Capital
expenditures represent major investments of capital that a company
makes to maintain or, more often, to expand its business and generate
additional profits. Capital expenses are for the acquisition oflong-term
assets, such as facilities or manufacturing equipment. Because such
assets provide income-generating value for a company for a period of
years, companies are not allowed to deduct the full cost of the asset in
the year the expense is incurred; they must recover the cost through
year-by-yeardepreciationover theuseful lifeof the asset. Companies often
usedebt financingorequity financingto cover the substantial costs
involved in acquiring major assets for expanding their business.
Revenue
expenses are shorter-term expenses required to meet the ongoing
operational costs of running a business, and thus are essentially the
same as operating expenses. Unlike capital expenditures, revenue
expenses can be fully tax-deducted in the same year the expenses occur.
In relation to the major asset purchases that qualify as capital
expenditures, revenue expenditures include the ordinary repair and
maintenance costs that are necessary to keep the asset in working order
without substantially improving or extending the useful life of the
asset. Revenue expenses related to existing assets include repairs and
regular maintenance as well as repainting and renewal expenses. Revenue
expenditures can be considered to be recurring expenses in contrast to
the one-off nature of most capital expenditures.
The
purpose of capital expenditures is commonly to expand a company’s
ability to generate earnings, whereas revenue expenditures are more
commonly for the purpose of maintaining a company’s ability to operate.
Capital expenditures appear as an asseton a company’s balance sheet;
revenue expenses are listed with liabilities.
Relationship between Depreciation and the Matching Principle
Explain the relationship between depreciation and the matching principle
The
reason for using depreciation is to match a portion of the cost of a
fixed asset to the revenue that it generates; this is mandated under the
matching principle, where you record revenues with their associated
expenses in the same reporting period in order to give a complete
picture of the results of a revenue-generating transaction. The net
effect of depreciation is a gradual decline in the reported carrying
amount of fixed assets on the balance sheet. It is very difficult to
directly link a fixed asset with a revenue-generating activity, so we do
not try – instead, we incur a steady amount of depreciation over the
useful life of each fixed asset, so that the remaining cost of the asset
on the company’s records at the end of its useful life is only its
salvage value.

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