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DEPRECIATION ACCOUNTING PRACTICES AND PROFITABILITY OF
SELECTED SME IN PORTHARCOURT
DEPRECIATION ACCOUNTING PRACTICES AND PROFITABILITY OF
SELECTED SME IN PORTHARCOURT
CHAPTER TWO
LITERATURE REVIEW
2.0 INTRODUCTION
This section will consist of two major sections which are conceptual
framework and the review of relevant literature. Basic concepts related to
depreciation accounting practices and its influence on profitability. The
review of relevant literature will consist of issues that has been discussed on
the research topic by historians and scholars.
2.1 CONCEPTUAL
FRAMEWORK
2.1.1 CONCEPT OF
DEPRECIATION ACCOUNTING
One of the basic objectives of financial accounting is to
calculate the true profit of loss from the operation of the enterprise for a
particular period (Moody, 1974). As per matching principle of accountancy the
costs of the products must be matched with the revenues in each period. This
principle indicates that if any revenue is earned and recorded then all costs
whether paid or outstanding must also be recorded in books of account so that
the profit and loss account could give a true and fair view of the profits
earned or loss suffered during the period and balance sheet presents true and
fair view of a financial position of the business (Edwards, 1961).
The accounting concept of depreciation refers to the process
of allocating the initial or re-stated input valuation (cost or other basis) of
plant and equipments to their useful life and charge the amount to revenue
account as expenditure (Woods, 2007).
According to Akanni (1988) depreciation is charged on the
fixed assets or those assets which are of material value having long life and
are held to be used in business and are not primarily for resale or for
conversion into cash. Usually, with the exception of land, fixed assets have a
limited number of the years of useful life. Motor vans, machines, buildings and
fixtures, for instance do not last for ever. Even land itself may have all or
part of its usefulness exhausted after few years. Some types of lands used for
quarries, mines or land of another sort of washing nature would be examples.
When a fixed asset bought is put out of use by the firm, that part of the cost
that is not recovered on disposal is called depreciation.
The American institute of certified public accountants has
defined the depreciation as Depreciation accounting is a system of accounting
which aims to distribute the cost or other basic value of tangible capital
assets less salvage (if any), over the estimated useful life of the unit (which
may be a group of assets) in a systematic and rational manner. It is a process
of allocation, not valuation (Matheson, 1984). Depreciation for the year is the
portion of the total charge under such a system that is allocated to the year.
Although the allocation may properly take into account occurrences during the
year, it is not intended to the effect of all such occurrences (Anao, 1996).
Some definitions given by prominent authors and institutes of
accountancy are given as depreciation may be defined as the permanent and
continuous diminution in the quality, quantity or value of an asset. Also, depreciation
is diminution in the intrinsic value of asset due to use and/or the lapse of
the time. This is according to ICMA Terminology. In simple words, depreciation
can be defined as a permanent, continuing and gradual shrinkage in the book
value of a fixed asset.
From the above definitions it is clear that depreciation is
the gradual, continuing and permanent fall in the value of fixed assets. The
main causes for this fall in value are wear and tear of assets accidents,
passage of time, obsolescence, inadequacies, and depletion etc. even in the
recent edition of English language dictionaries the word “depreciation” has
been described as “decline in the value of an asset due to such causes as wear
and tear, action of elements, obsolescence and inadequacy.” Although these
traditional views are under pressure because of the recognition of the changes
in the value of naira and replacement costs, (Development of inflation
accounting and replacement value technique) even then they have their
historical significances.
2.1.2 CAUSES OF
DEPRECIATION
Following are the main causes of depreciation:
1. Physical deterioration
2. Economic factors
3. Time factor
4. Depletion
Physical deterioration: It is caused mainly from wear and
tear when the asset is in use and from erosion, rust, rot and decay from being
exposed to wind, rain, sun and other elements of nature (Okoye, 1997).
Economic factors: These may be said to be those that cause
the asset to be put out of the use even though it is in good physical
condition. These arise due to obsolescence and inadequacy. Obsolescence means
the process of becoming obsolete or out of date. Old machinery in good physical
conditions may be rendered obsolete by the introduction of new model which
produce more than the old machinery. Inadequacy refers to the termination of
the use of an asset because of growth and changes in the size of the firm. But
obsolescence and inadequacy do not necessarily mean that the asset is scrapped.
It is merely put out of use by firm. Another firm will often buy it (Jennings,
1990).
Time factor: There are certain assets with a fixed period of
legal life such as lease, patents and copyrights. For instance, a lease can be
entered into for any period while a patent’s legal life is for some years but
on certain grounds this can be extended. Provision for the consumption of these
assets is called amortization rather than depreciation (Adekunle, 2000).
Depletion: Some assets are of wasting characters perhaps due
to extraction of raw materials from them. These materials are then either used
by the firm to make something else or are sold in their raw state to other
firms. Natural resources such as mines, quarries and oil wells come under this
heading. To provide for the consumption of an asset of a wasting character is
called provision for depletion (Igben, 1999).
Need for providing depreciation:
1. To know the correct profits.
2. Show correct financial position.
3. Make provision for replacement of assets.
2.1.3 METHODS OF
DEPRECIATION
According to Gee (1986), different methods of calculating
provision for depreciation are mainly accounting customs which may be used by
different concerns taking into consideration the individual peculiarities. The
following are the main methods of providing depreciation.
1. Fixed Installment Method.
2. Diminishing Balance Method.
3. Sums of the Digits Method.
4. Annuity Method.
5. Depreciation Fund Method.
6. Insurance Policy Method.
7. Revaluation Method
8. Depletion Method
9. Machine Hour Rate Method
Fixed Installment Method: It is also known as fixed
percentage on original cost of straight line method. Under this method a fixed
percentage of the original value of the asset is written off the estimated life
of the asset. To ascertain the annual charge under this method that is
necessary is to divide the original value of the asset (minus its residual
value if any) by the number of years of its estimated life.
Depreciation = (cost of asset – scrap value at the end) /
life of the asset (No. of Years)
Diminishing Balance Method: This method is also known as
reducing installment method or written down value method. Under this method,
depreciation will be calculated at a certain percentage each year on the
balance of the asset which is brought forward from the previous year. Every
year the installment of depreciation will reduce as the beginning balance of
the asset in each year will reduce. It is usually adopted for plant and
machinery.
The advantages of this method are:
- It tends to give
a fairly even charge of depreciation against revenue each year. Depreciation is
generally heavy during the first few years and is counterbalanced by the
repairs being light and in the later years when repairs are heavy this is
counterbalanced by the decreasing charge for depreciation.
- As and when
additions are made to the asset, fresh calculations of depreciation are not
necessary.
- This method is
recognized by the income tax authorities in Nigeria.
- Its main
drawback is that in subsequent years, original cost of asset is altogether lost
sight of and the asset can never be reduced to zero under this method. Further
this method does not take into consideration the asset as an investment and
interest is not taken into consideration.
Sums of the Digits Method: this is a variant of the reducing
installment or diminishing balance method. Under this method depreciation is
calculated by the following formula:
Depreciation = amount to be written off X Number of years of
the remaining life of the asset including the current year / the total No. of
all the digits representing the life of the assets (in years)
Depreciation Fund method : under all the methods discussed up
till now, ready cash may not be available when the time of replacement comes
because the amount of depreciation is retained in the business itself in the
form of assets not separate from other assets which cannot be readily sold.
The method (applied to long leases etc.) implies that the
amount written off as depreciation should be kept aside and invested in readily
saleable securities. The securities accumulate and when the life of the asset
expires, the securities are sold and with the sale proceeds a new asset is
purchased. Since the securities always earn interest, it is not necessary to
provide for the full amount of depreciation, something less will do. How much
amount is to be invested every year so that a given sum is available at the end
of a given period depends on the rate of interest which is easily calculated
from Sinking Fund Tables.
Factors Influencing the Choice of a Depreciation Method
The choice of depreciation method is an important decision.
The nature of asset, tax considerations, price fluctuations, accounting
conventions, obsolescence, management policy is some of the important factors
which influence this decision. It is noteworthy to mention that selection of
depreciation method is a managerial decision.
Gradual decline in the total cost of the asset during the
course of its working life till it becomes obsolete. Depreciation = Total cost
of the asset minus scrap value. is a non-cash expense which reduces the value
of a fixed asset except Land as a result of wear and tear, age, or
obsolescence. Most assets lose their value over time (in other words, they
depreciate), and must be replaced once the end of their useful or economic life
is reached. There are several accounting methods that are used in order to
write off an asset's depreciation cost over the period of its useful life
because it is a non-cash expense, depreciation lowers the company's reported
earnings while increasing free cash flow (Omoleyinwa, 2003). In a simple word
depreciation is all about the reduction in the value of fixed assets and the
allocation of the cost of assets to periods in which the assets are used.
2.1.4 IMPAIRMENT
Accounting rules also require that an impairment charge or
expense be recognized if the value of assets declines unexpectedly in
depreciation accounting (Adekunle, 2000). Such charges are usually
nonrecurring, and may relate to any type of asset. Many companies consider
write-offs of some of their long-lived assets because some property, plant, and
equipment have suffered partial obsolescence. Accountants reduce the asset's
carrying amount by its fair value. For example, if a company continues to incur
losses because prices of a particular product or service are higher than the
operating costs, companies consider write-offs of the particular asset. These
write-offs are referred to as impairments. There are events and changes in
circumstances might lead to impairment. Some examples are:
- Large amount of
decrease in fair value of an asset.
- A change of
manner in which the asset is used.
- Accumulation of
costs that are not originally expected to acquire or construct an asset.
- A projection of
incurring losses associated with the particular asset.
Events or changes in circumstances indicate that the company
may not be able recover the carrying amount of the asset. In which case,
companies use the recoverability test to determine whether impairment has
occurred. The steps to determine are:
1. Estimate the future
cash flow of asset. (from the use of the asset to disposition)
2. If the sum of the
expected cash flow is less than the carrying amount of the asset, the asset is
considered impaired.
2.1.5
ACCUMULATED DEPRECIATION
While depreciation expense is recorded on the income
statement of a business, its impact is generally recorded in a separate account
and disclosed on the balance sheet as accumulated depreciation, under fixed
assets, according to most accounting principles. Accumulated depreciation is
known as a contra account, because it separately shows a negative amount that
is directly associated with another account (Wikipedia, 2015).
Without an accumulated depreciation account on the balance
sheet, depreciation expense is usually charged against the relevant asset
directly. The values of the fixed assets stated on the balance sheet will
decline, even if the business has not invested in or disposed of any assets.
The amounts will roughly approximate fair value. Otherwise, depreciation
expense is charged against accumulated depreciation. Showing accumulated
depreciation separately on the balance sheet has the effect of preserving the
historical cost of assets on the balance sheet. If there have been no
investments or dispositions in fixed assets for the year, then the values of
the assets will be the same on the balance sheet for the current and prior year
(P/Y).
2.1.6
PROFITABILITY
Profit is an income distributed to the owner in a profitable
market production process (business). Profit is a measure of profitability
which is the owner’s major interest in income formation process of market
production. There are several profit measures in common use.
Income formation in market production is always a balance
between income generation and income distribution. The income generated is
always distributed to the stakeholders of production as economic value within
the review period. The profit is the share of income formation the owner is
able to keep to himself in the income distribution process. Profit is one of
the major sources of economic well-being of a company because it means incomes
and opportunities to develop production. The words income, profit and earnings
are substitutes in this context.
Economic well-being of a company is created in a production
process, meaning all economic activities that aim directly or indirectly to
satisfy human needs. The degree to which the needs are satisfied is often
accepted as a measure of economic well-being. In production there are two
features which explain increasing economic well-being. They are improving
quality-price-ratio of commodities and increasing incomes from growing and more
efficient market production.
2.1.7
DEPRECIATION AND PROFITABILITY
Depreciation expense does not require current outlay of cash.
However, since depreciation is an expense to the company’s account, provided
the enterprise is operating in a manner that covers its expenses (e.g.
operating at a profit) depreciation is a source of cash in a statement of cash
flows, which generally offsets the cash cost of acquiring new assets required
to continue operations when existing assets reach the end of their useful
lives.
A depreciation expense has a direct effect on the profit that
appears on a company's income statement. The larger the depreciation expense in
a given year, the lower the company's reported net income i.e. its profit.
However, because depreciation is a non-cash expense, the expense doesn't change
the company's cash flow.
When a business purchases a physical asset with a useful life
of longer than a year e.g. a building, for example, or a vehicle. it doesn't
report the full cost as an upfront expense. That's because accounting rules
require that the expense be spread over the useful life of the asset. That's
done through depreciation. Say if the company bought a new truck for N30,000
cash, and it estimates that the truck has an estimated useful life of 10 years.
Under the most common depreciation method, called the straight-line method, the
company would report no upfront expense but a depreciation expense of N3,000
each year for 10 years.
Profit is simply all of a company's sales revenue and any
other gains minus its expenses and any losses. A N3,000 depreciation expense,
then, has the effect of reducing profit by N3,000. It's important to note,
however, that "profit" is really just an accounting creation. With
the truck in the previous example, the business spent the money upfront. All of
the money was gone as soon as they bought the truck. But as far as the
profit-and-loss calculations are concerned, the company didn't really give up
any value. Instead, it just traded N30,000 worth of cash for N30,000 worth of
truck. As time passes and the company "use up" that value by using
the truck, it turn the cost into an expense through depreciation.
Though most companies use straight-line depreciation for
their financial accounting, many use a different method for tax purposes. (This
is perfectly legal and common.) When calculating their tax liability, they use
an accelerated schedule that moves most of the depreciation to the earliest
years of the asset's useful life. That produces a greater expense in those
years, which means lower profits and which, since businesses get taxed on their
profits, means a lower tax bill in the earlier years.
2.2 REVIEW OF
LITERATURE
Several researchers and authors has written about
depreciation and profitability in various studies and papers.
The long standing confusion about depreciation in ac-counting
practice appears to be the lack of agreement among accountants on what the word
depreciation means. It is suggested by Wood (2007) and Akanni (1988) that
though depreciation is a decline in price of any asset, it is derived from
Latin, “de” meaning from and “pretium” meaning price. Conventional accounting
practice in respect to depreciable assets, depreciation means reducing the
purchasing price to the ultimate selling price at the point of disposal.
Reference is usually made to the market value only at the beginning and at the
end of the lifetime of an asset. These assertions also got the support of
Samuelson (1979). However, Bonbright (1973) and Gee (1986) viewed depreciation
as physical deterioration of asset. Others view it as deferred maintenance.
Depreciation is defined by Mathew & Perera (1996), citing United States
Supreme Court, in the case of Lind- heimer V lllinois Bell Telephone Co. 292,
US 151, (1934), as a loss not restored by current maintenance which is due to
all factors causing the ultimate retirement of the property.
Accountants are concerned with the financial aspect and not
the physical factors. Other professionals such as Engineering have their own
depreciation concepts. It is attributed by Turpins et al (1986) that physical
factors to an engineering problem in which depreciation has special meaning
relates to wear and tear of productive plants and equipment. This concept is
supported by Matheson (1984) as he stated that depreciation is a diminution of
value by reason of wears and tears, physical deterioration of assets may not be
caused by using them in production but by other factors such as decay, rust,
corrosion and technological changes. In his writing, Anao (1996) outlined
Economists concept of value, which is cost value, exchange value, used or
utility and esteem value of relative importance is faced with considerable
difficulty in understanding the concept. Unless the value of asset is
specified, economic value is not relevant to the measurement of depreciation.
It is viewed as a provision for the replacement of durable asset (worn-out) at
the end of its useful life.
Four possibilities of assets replacement are distinguished by
Jennings (1990), thereby giving support to earlier view of Mathew & Perera
(1996) as: replacement of subjective value, replacement of original cost,
physical replacement at the end of its useful life and the replacement in some
form of market value. Depreciation is viewed as problem of allocation of
original cost to match with current revenue by Omoleyinwa (2003) but described
by Institute of Chartered Accountant in England and Wales as part of the fixed
assets which is not recoverable when asset is finally put out of use. The
provision against this loss of capital is an integral cost of conducting the
business during the effective commercial life of the asset and is not dependent
upon the amount of profit earned. However, there is considerable confusion
about the nature and significance of the concept of depreciation in current
accounting thought.
The traditional concept of depreciation is seen as a loss
suffered by physical deterioration, a loss due to external causes to asset
physical form, a provision for replacement, diminution in value, a process of
cost allocation etc. It is glaring to note that none of these traditional
concepts can provide a satisfactory interpretation to what accountants do in
recording depreciation.
Certainly, if the traditional concept of depreciation must be
adhered to, the need for objective criteria in deter- mining depreciation value
is called to question. For an asset to qualify for depreciation it may be influenced
by the under mentioned properties as opined by Institute of Chartered
Accountant in England and Wales:
1. Historical cost of
the asset: Jennings (1990) cited the assertions of Exposure Draft (ED) 37, IAS
4, and SSAP 12, suggests that fixed asset can only be depreciated on the bases
of its original cost. In determining the historical cost, other cost that is
direct to the acquisition of the machine is added up to the purchase price,
like agreement cost, installation cost, improvement cost, etc. This however
will provide more objective criteria in allocating past costs to current
revenue.
2. Similar to the
historical cost, is the asset that must have an economic life span. Business as
a going concern, unlike in the public sector where the whole cost of the asset
is charged in the accounting period in which it was purchased. The productive
effort of the asset in the private sector is spread over its commercial value.
Professional Valuer is expected to estimate the economic useful life of the
asset which will assist accountants in the choice of depreciation provision.
3. Salvage value is
paramount in determining the value of depreciation. It is however necessary to
recall that some assets may not have residual value at the end of its useful
life. In other words it is said to be worthless, as a result of decay,
corrosion etc.
4. Nature and type of
assets. Obviously, the methods of providing for depreciation vary from one
asset to another even in the same organization. Some equipment can be fragile or
delicate to handle and the estimated life span is dependent on the asset
maintenance. Similarly natural disaster could render assets economic life span
useless, even though those assets have different monetary value, life span, and
salvage value, etc.
5. Asset usage or
capacity. Frequency and volume of production is highly necessary in making
choice of depreciation. Some equipment can withstand the stress of continuity
in the production process while others may not. Accordingly, capacity or volume
of production may vary from one machine to another as some provision for
depreciation is made on the basis of volume or capacity.
6. Improvement and
development cost. It is similar to direct costs associated with the purchase
price of the equipment to the existing asset resulting to assets efficiency,
improvement in capacity, extension of economic life span etc.
REFERENCES
Adekunle, L. O. “Accounting for Special Business,” Ba- yus
Consults, Lagos, 2000, pp. 98-114.
Akanni, J. A. “Management: Concepts, Techniques, and Cases,”
Julab Publishers Limited, Ibadan, 1988, pp. 67-96.
Anao, A. R. “An Introduction to Financial Accounting,”
Longman Nigeria Ltd., Benin City, 1996, pp. 206-257.
Benjamine, O. “Studies in Accountancy—Text and Read- ings,”
New-Age Publishers, Enugu, 1992, pp. 46-59.
Bonbright, J. C. “The Valuation of Property, in MPB Perera,
Accounting Theory and Development,” Thomson Publishing Company, 1973, pp.
508-521.
Edwards, E. O. “Depreciation and Maintenance of Real
Capital,” Thomson Publishing Company, Peera, 1961, pp. 432-476.
Gee, P. “Book Keeping and Accounts,” Butter North Green Ltd.,
London, 1986, p. 37.
Goldberg, L. “Concept of Depreciation in MPB Perera,” Accounting
Theory, 1962, pp. 98-106.
Igben, R. O. “Financial Accounting Made Simple,” ROI
Publishers, Lagos, 1999, pp. 87-116.
Institute of Chartered Accountant in England and Wales,
“Recommendations on Accounting Principle” Deprecia- tion of Financial Assets,
London, 1945, p. 73.
Jain S.P. and Narang, K.L. (1979), Advanced Accountancy, 7th
revised edition, New Delhi, Kalyani Publishers.
Jennings, A. R. “Financial Accounting,” DP Publication Ltd.,
London, 1990, pp. 340-373.
Matheson, E. “Depreciation of Factories, Mines and Industrial
Undertaking and Their Valuation,” Publishing Company, Parera, 1984, pp.
220-267.
Mathews M. R. and Perera, M. H. B. “Accounting Theory and
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Moody, R. “Principles of Accounts,” Hulton Educational
Publications Ltd., 1974, pp. 136-145.
Okoye A. E. “Cost Accountancy—Management Opera- tional
Applications,” United City Press, Benin, 1997, pp. 79-106.
Omolehinwa, E. “Foundation of Accounting,” Pumark Nigeria
Ltd., Ikeja, 2003, pp. 107-185.
Samuelson, P. A. “Economics, International Students Edition,”
McGraw-Hill Kogakusha Ltd., Auckland, 1979, pp. 134-148.
Sharma R.K and Gupta, S.K (1996), Management Accounting ,
principles and practice, 7th revised edition, New Delhi, Kalyani Publishers.
Turpin, P. H. et al., “Financial Accounting Advanced
Techniques,” 2nd Edition, Financial Training Publication Ltd., London, 1986,
pp. 320-347.
Wason, V. (2010), Financial Accounting, 1st edition, New
Delhi, S. Chand.
Wood, F. “Business Accounting 2,” 3rd Edition, Richard Clay
Ltd., London, 2007, pp. 90-220.
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