Essay, Research Paper: Depreciation And Sale Of Asset

Depreciation is the decline in the future economic benefits of a depreciable non-current asset through wear and tear and obsolescence. It is an allocation process. It can be calculated by two main methods, each reflecting in a distinct prospect in the way the asset is used. Depreciation is to be treated as an estimated expense that does not set aside cash for the replacement of a non-current asset. In determining the cost of acquisition of the lathes, any capital expenditure made must be added to the purchase price of the lathes. This amount will be considered as the historical cost and will be used in calculating the depreciation expense
Depreciation is the allocation of the cost of a non-current asset less its estimated disposal value against revenue over the assets useful life. A depreciable asset is an asset that will be used over more than one accounting period and will gradually contribute to revenue over its useful life. However, it will give rise to future expenses as their future economic benefits are used up or expired. Examples of depreciable assets include machinery and motor vehicles.
Generally, most non-current assets, with the exception of land, decline in their potential to provide future economic benefit. There are three factors that contribute to this decline. They are, the deterioration of a non-current asset due to the use of it, technical obsolescence, whereby certain assets become out of date due to technical innovations and improvements on a comparative basis and the final, commercial obsolescence which is the process of certain non-current assets becoming redundant as the demands fall for the goods or service previously provided by the asset
Depreciation allocates the assets cost or depreciable amount over the estimated useful life of the asset to the entity. It is not a process of asset valuation. The cost of the asset less the accumulated depreciation is not intended to give the current market value of the asset as the asset purchased is not intended for re-sale but use in the business.
There are two methods of depreciating an asset, the straight-line method, and the reducing balance method. The straight-line method of depreciation allocates the same amount of depreciation expense being charged against revenue each accounting period of the assets useful life. This method is effective for assets that give a constant contribution of revenue per period. It provides a direct relationship between the depreciation expense and the asset cost. The depreciation expense is calculated from the historical cost, less the residual value over the assets useful life. The historical cost is the purchasing price of the asset plus the costs which enable the asset to be set up ready for use and other cost of improvements that are made. The residual value is the expected net amount that is recovered from the disposal of the asset at the end of its useful life. The useful life is the estimated period of time the asset is expected to be used to provide service to the business. The reducing balance method is another method of depreciation. It applies a fixed percent rate of depreciation to the cost of the asset less the accumulated depreciation. This method results in a larger proportion of depreciation charged to the earlier years of the assets life and is applied to assets that are known to be more productive in their earlier years.
From the two methods of depreciation mentioned above, the most suitable method for depreciating the lathes would be the reducing balance method. Machinery like the lathes are more productive and efficient when first bought. However, they are prone to face technical obsolescence as they are constantly updated and improved to be even more productive and efficient. By using the reducing balance method, W.Wally would also benefit from having an accurate rate of depreciation being charged against the lathes per year.
In determining the cost of a non-current asset such as a lathe, expenditure that will provide future economic benefit, i.e. contribute to the revenue earning capacities of the business for more than one year, must be considered and added to the asset value. This expenditure is known as capital expenditure and is usually of a once-off nature. Examples of capital expenditure are, upgrading machine parts of the lathes to achieve an improvement in the quality or productivity of the output. Another type of expenditure that can be made is revenue expenditure. Revenue expenditure is expenditure on assets that contribute to the revenue earning capacity, but will be used up within an accounting period. This expenditure is not added to the asset value but deducted from the revenue to find the profit. Examples of revenue expenditure include, advertising of a manufacturing business any repairs made to non-current assets, in this case the lathes.
To calculate the cost of the acquisition of the lathes, the capital expenditures that are made, need to be added to the purchase price of the lathes. These expenditures may include importing the lathes into the country, installation expenses and any other costs that occur which will contribute to the future economic benefit of the business for more than one accounting period.
To conclude, W. Wally should use the reducing balance method to depreciate his lathes as they will contribute more in their earlier years and should therefore have more of their cost allocated in the early years. He should be aware that depreciation is a process of allocation and not asset valuation. W. Wally must also consider any capital expenses that he makes towards the lathes and add the expenditure to the purchase price to enable the calculations of the depreciation to be correct. He must understand that depreciation is an expense and will reduce the net profit but it does not involve any cash outlay.