Introduction to Avoidability and Mitigation

Depreciation is the process of allocating the cost of tangible non-current asset over its estimated useful life as expense to the income statement. As we discussed in Unit 6, the costs of non-current assets are treated as capital expenditure and cannot be fully expensed in the period of their purchase because several accounting years would benefit from their use.

Consequently, each of those periods is charged with a portion of the cost of the asset by using an appropriate method of depreciation chosen by the firm. Depreciation in accounting is only a cost allocation process. However, there are a number of misconceptions about depreciation.

First, it is viewed as the reduction or wear and tear in the value of an asset as a result of usage, passage of time or obsolescence. While wear and tear likely underpins the rationale for depreciation, it does not coincide with accounting view of depreciation as a merely cost allocation process or expensing approach because what constitutes depreciation is not necessarily consistent with the amount of wear and tear associated with the usage of a non-current asset. Second, depreciation is also misconstrued as the money set aside for the replacement of a non-current asset. Depreciation usually does not involve setting aside

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money for replacing the asset. Where an entity utilises depreciation as a means to set aside money to specifically replace an asset, such process is called funding depreciation. This contrasts with depreciation which is an accounting process of recording and measuring an expense, whereas a funded depreciation is a purely financing function in which the money set aside is not available for business operation but invested in securities outside the business until such future time when it would be used to purchase a new asset.

In order for an entity to account for depreciation, it adopts one or more methods of depreciation such as straight-line, reducing balance, sum of the years’ digit, unit of production, and machine hours. Before we discuss these methods very shortly, it is important we familiarise ourselves with a number of depreciation-related concepts which are asset useful life, cost, salvage value, depreciable value, accumulated depreciation, written down value (or carrying cost).

3.2.1 Useful life

This is the period of time the non-current asset is expected to generate benefit to the entity that acquired it. It is usually an estimated period based on the accounting policy the entity adopts for the purpose of charging depreciation, which usually varies among entities as well as classes of non-current assets. Usually, building will have an estimated useful life longer than plant and machinery. However, the physical life of the asset may not necessarily coincide with the estimated useful life for the purpose of depreciation. For example, the estimated useful life of a building may be 20 years whereas the physical life of the building may extend beyond 100 years. Estimating the useful life of an asset is highly subjective but business entities consider the usage of the asset, technological changes and other factors in carrying out the estimation. Apart from relating the estimated useful life of an asset to a number of years, we can also relate it to months, units of production, or machine hours.

93 3.2.2 Cost

This is the amount incurred to purchase the non-current assets plus other incidental costs incurred for the purpose of bringing the asset to the point it can be productively engaged to generate economic benefits to the entity. For example, the cost of plant and machinery will include the purchase price, freight and its associated insurance, installation cost, legal charges (if any). If an entity purchases a building for business use, the cost will include the purchase price, legal and agency fees, alteration cost and any other costs incurred to enhance the useful life and productive capacity of the asset.

Exhibit 9.1

Look-and-See Ventures acquired a machinery with a list price of N50,000 for N40,000. Other costs incurred with respect to the asset are: installation cost N2,000, incidental legal fees N1,000, freight and freight insurance N500. The cost of the machinery will be equal to N43,500 (i.e., N40,000 it costs to buy the asset, installation cost of N2,000, legal fees of N1,000 and the freight cost of N500). The list price is immaterial as the price at which the vendor sold the asset to the entity is N40,000.

3.2.3 Salvage value

The salvage value also known as scrap value or residual value is the amount the non-current asset will realise after its estimated useful life. For example, if our machinery that costs N43,500 has a useful life of 5 years and can be sold after 5 years for N5,500, it means that the scrap value is N5,500. For the purpose of depreciation, this amount is not chargeable as part of depreciation expense neither is it recognised as an income until the asset is eventually sold after the expiration of its estimated useful life.

3.2.4 Depreciable value

Depreciable value is the difference between the cost of the non-current asset and its residual value. Mathematically, it is DV = C - S, where DV = depreciable value, C = cost and S =

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residual/scrap/salvage value. Using the example in section 3.2.3, DV = N 43,500 – N 5,500 = N38,000. Conceptually, the depreciable value represents the portion of the non-current asset that can be expensed or allocated as annual depreciation charges over the useful life of the asset irrespective of the method of depreciation adopted.

3.2.5 Accumulated depreciation

This is the cumulative amount of depreciation charge of the cost of a non-current asset. If our machinery above is allocated equally over its useful life of 5 years, the annual depreciation charge will be N7,600 (i.e., N38,000/5). The accumulated depreciation at the end of the following years will be:

Table 9.1: A schedule of accumulated depreciation Year Annual

depreciation N

Accumulated depreciation

N

1 7,600 7,600

2 7,600 15,200

3 7,600 22,800

4 7,600 30,400

5 7,600 38,000

3.2.6 Written down value

This is also known as carrying cost/value/amount or net book value. The carrying amount of a non-current asset represents the difference between its cost and accumulated depreciation.

Mathematically, this is WDV = C – Acc Dep, where WDV is carrying cost or written down value or net book value, C is cost, and Acc Dep is accumulated depreciation. The following table will derive from using our machinery example above:

95 Table 9.2: A complete depreciation schedule

Year Cost

N (a)

Annual depreciation

N (b)

Accumulated depreciation

N (c)

WDV N (a-c)

1 43,500 7,600 7,600 35,900

2 43,500 7,600 15,200 28,300

3 43,500 7,600 22,800 20,700

4 43,500 7,600 30,400 13,100

5 43,500 7,600 38,000 5,500

As you will observe from Table 9.2, the value at the end of year 5 is equal to the residual value. This is so because the residual value is not included as part of the depreciable value that is depreciated or allocated as expense over the useful life of the asset.