Depreciation is the cost allocated as expense which has the effects of reducing the value of a fixed asset during the period it is used by a business. It is a non-cash expense and need to be charged to the Profit & Loss account yearly which lowers the company’s profit which increasing free cash flow.
Fixed assets are long life. They are bought to assist in the operation of business but not with the main purpose of resale. They are in fact revenue-generating assets as they help to gain profit depending on their useful lives. Depreciable items include machinery, vehicles, buildings and fixtures
There are reasons why assets may depreciate:
Obsolescence: Assets are replaced because new and more efficient technology has been developed.
Depletion or Exhaustion: The values of assets such as mines, quarries and oil wells diminish due to the extraction of raw materials from them.
Passage of Time: Assets which have limited period of life in terms of years. The
term amortization instead of depreciation is often used to refer this.
Physical Deterioration: Assets become worn out after used. It becomes less cost-
effective to perform and spend more to maintain and repair.
The two most common methods used to calculate depreciation expense are:
Straight line or Fixed Installment Method
Reducing Balance or Diminishing Balance Method
Straight Line Method
An equal amount of depreciation over the estimated useful life of an asset is allocated for each year.
Original Cost : $30000
Estimated Residual Value : $6000
Estimated Useful Life : 6 Years
Annual Depreciation = Original Cost – Residual Value
Estimated Useful Life
= $ 30000 – $6000
Reducing Balance Method
Depreciation is calculated as a fixed percentage based on the book value of an asset at the beginning of the accounting year but not the cost of the asset.
Original Cost : $20000
Estimated Useful Life : 4 Years
Rate of Depreciation : 20% per annum on the reducing balance
Depreciation = Rate of Depreciation x Book Value at the Beginning of the Accounting Year
Year 1 (20% X 20000) (4000)
Year 2 (20% X 15000) (3200)
Year 3 (20% X 12800) (2560)
Year 4 (20% X 10240) (2048)
Net book value at end of Year 4 8192
Provision for Depreciation
Provision for depreciation records accumulated depreciation. It is an asset contra account, hence a credit balance as shown as a deduction from the related fixed asset in the Balance Sheet. The balance of the provision for depreciation increases with time and the book value of the fixed asset decreases with time.
Provision for depreciation account is the liability of business. By making provision for depreciation account, company’s balance sheet will reflect the current value of fixed assets.
When asset is sold, it accumulated provision for depreciation will be transfer from the credit side of provision for depreciation account. Then, we will compare it with the sale value of asset. If sale value of asset is more than the current book value of asset after adjusting from provision for depreciation, it will be profit on sale of asset.
Why do business, companies, etc. include depreciation expenses and its provision in their financial statements?
To match the earning revenue
The very first reason is to match the earning revenue. Depreciation is directly related to the matching concept. Matching concept is a concept that matches the expenses with related revenues. Under the matching concept, in a particular accounting period that the expenses are the cost of the assets used to earn the revenue, if there are no expenses there will be no revenues. Revenues can’t generate without expenses. Therefore, when the expenses are matched with the revenues generated in the same period, the results will be the net profit or loss for that period. Example, consider ABC Woodworks Company, a woodworking business that purchases its own custom woodworking machinery. When ABC Woodworks Company purchases a new custom piece of machinery, this new machine is durable enough to last for several years. In accounting terms, this means that the equipment is in use over several reporting periods, not just the one in which the machine was purchased.
Besides that, the purpose of depreciate the assets is to because of the technological obsolescence. Technological obsolescence generally occurs when a new product has been created to replace the old version. When a machine has ends its useful life, the business will need to buy another new machine to continue in order to produce goods. For an example, if the technology has been obsolete, the value of the revenue in the market will be very low. In that moment, the business will write off ( i.e. fully depreciated) the technology and the needs to buy a new and advance technology arise.
Wear and Tear
Next, the third reason of depreciation is wear and tear. What is wear and tear? It means that the asset has physically degenerated due to wear and tear in used. The more we used the assets the greater the wear and tear would be. There are many reasons of physical deteriorate of an asset example: erosion, accident, friction etc. The wear and tear is general but it is also cause of depreciation.
Bad debts are the debts that are uncollectable from the debtors / customers. This usually happens when the firm sells an item on credit to the customers. A debt that is considered that won’t be able to collect back by accountant only known as bad debt.
For example, the customer has declared bankrupt, and this is where the accountant write the debt as bad debt.
The accounting entry for bad debt is:
Bad Debt – Expense
The credit entry reduces the account receivable balance while the debit entry increases the bad debts account which is expenses.
Tom Ltd sells goods to Jerry Ltd for $ 1000 on credit. Tom Ltd then found out that Jerry Ltd has been owed few companies, therefore there is a very low possibility that they will pay for the goods.
Tom Ltd should write off the receivable from Jerry Ltd for this situation. The double entry will be recorded as:
Bad Debts – Expense
Jerry Ltd (Account Receivable)
The accounting solution is to make an allowance for bad debts, making the bad debts against sales when the bad debts accrued.
Bad debts are needed to make appropriate adjustments to accounting data.
Allowance for Doubtful Debts
Doubtful debt is an expense to the business. It is a debt which is unlikely to be able to collect before turn to be bad debt. At the end of accounting period the budget of the business must be made on those amounts of the debtors. If we do not provide this account of doubtful debts, we may not be able to present a good productivity and profits of the business. In most circumstances it is estimated by applying a percentage to its debtor’s balance, which is likely go bad, during any one accounting period. The percentage is derived from the past experience of trend. In the first accounting period, the doubtful debt estimated will be recorded in full. In the subsequent accounting period, the variance of current and past period will be recorded.
To record the increase in the doubtful debt estimation:
Profit and Loss (Expenses)
Allowance for doubtful debt
To record the decrease in the doubtful debt estimation:
Allowance for doubtful debt
Profit and Loss (Revenue)
A business started on 1 January 2010. Its accounting period ended 31 December 2010. The total amount of debtors at the end of the accounting period was $30,000. It was estimated that 2% of the debtors would eventually go bad due to certain reasons but there was no evidence whether they were bankrupt or dead.
Allowance for doubtful debt = % x Total debtors (after deducting bad debt)
Allowance for Doubtful debt = 2% x $30,000
Profit and Loss (Expenses)
Allowance for doubtful debt
Reasons for Computing Allowance for Doubtful Debts
Have a more accurate end of year account
Not all debts will be decent at the end of the year account. This may be due to many different causes which consist of your debtor going bankrupt, dying or refuses to pay. These causes could mean that your business does not get all the money that was anticipated. This is why computing allowance for doubtful debts are so important. When you make an estimation based off a certain percentage you are giving your account a much more accurate lookout to go off. This means at the end of the year you will not be in huge astonishment if one of your debtors has been incapable to pay you. This means all your purchases will be more advantageous to the business overall.
Will be capable to budget correctly
Being capable to budget correctly is an advantage to any business. It will allow you to control and estimate cash flow well and also make more well-versed purchase decisions. When you make allowances for doubtful debts you are having fewer of a turnover at the end of the year. Yet the benefit is that you will not overspend on any stock, advertising or worker costs. Keeping your costs down is helpful to any businesses attainment. This is due to the fact overspending can put your business in a bad spot and avoid you from doing what is correct for your business. This is done to avoid over-stating the assets of the business as trade debtors are reported net of doubtful debt.
These points are the main twos that you have to deliberate when making allowances. They are not the only two, but the two that can affect how you think about allowances for doubtful debts. Even if doing credit and debit accounting is not your thing it is also completely possible to outsource the entire process. This may charge you a bit of money but at the same time it will do your business a world of good and it is cheap compared to the possible risks. By keeping tracks of the amount of allowance for doubtful debt accounts, it will also mean that the bad debt expense will be stated closer to the time of sales rather than waiting for the account to be determined as uncollectable. Also, when the debtors of the company are paying well, the expense of allowance for doubtful debt may decrease. When this happens, it will be considered as revenue of the company. Thus, allowance for doubtful debt may not always be an expense to the company.