Lesson Notes By Weeks and Term v3 - Senior Secondary 2
Depreciation and method of depreciation
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Depreciation and method of depreciation
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Subject: Book Keeping
Class: Senior Secondary 2
Term: 2nd Term
Week: 5
Theme: Introduction
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This topic introduces students to the concept of depreciation, an essential element in accounting for fixed assets. Understanding depreciation is crucial for Nigerian learners as it impacts the financial health and reporting of businesses, from local roadside mechanics and market traders using equipment to large manufacturing companies and transport firms. Proper accounting for depreciation ensures accurate valuation of assets, computation of profit, and compliance with tax regulations, skills highly relevant for future entrepreneurs, accountants, or business managers in Nigeria.
(₦) | Accumulated Depreciation (₦) | Closing Book Value (₦) | | :--- | :--------------------- | :---------------------- | :--------------------------- | :--------------------- | | 2023 | 15,000,000 | 2,800,000 | 2,800,000 | 12,200,000 | | 2024 | 12,200,000 | 2,800,000 | 5,600,000 | 9,400,000 | | 2025 | 9,400,000 | 2,800,000 | 8,400,000 | 6,600,000 | | 2026 | 6,600,000 | 2,800,000 | 11,200,000 | 3,800,000 | | 2027 | 3,800,000 | 2,800,000 | 14,000,000 | 1,000,000 | (
Note: Closing Book Value at the end of useful life equals Residual Value) B. Reducing Balance Method (Declining Balance Method) This method charges a higher amount of depreciation in the earlier years of an asset's life and a decreasing amount in subsequent years. This is based on the assumption that assets are more efficient and lose more value in their early years. Depreciation is calculated as a fixed percentage of the asset's opening book value each year. The residual value is ignored in the annual calculation, but the asset's book value should not fall below its estimated residual value.
Formula: Annual Depreciation = Percentage Rate × Opening Book Value (or Carrying Value)
Worked Example 2: Reducing Balance Method "G-Tech Solutions" in Abuja purchased new computer equipment for its cybercafé on January 1, 2023, costing ₦2,000,
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0. The company decides to depreciate the equipment at a rate of 20% per annum using the Reducing Balance Method. The estimated residual value is ₦200,
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0. Calculation: Year 1 (2023): Opening Book Value = ₦2,000,000 Depreciation = 20% of ₦2,000,000 = ₦400,000 Closing Book Value = ₦2,000,000 - ₦400,000 = ₦1,600,000 Year 2 (2024): Opening Book Value = ₦1,600,000 Depreciation = 20% of ₦1,600,000 = ₦320,000 Closing Book Value = ₦1,600,000 - ₦320,000 = ₦1,280,000 Year 3 (2025): Opening Book Value = ₦1,280,000 Depreciation = 20% of ₦1,280,000 = ₦256,000 Closing Book Value = ₦1,280,000 - ₦256,000 = ₦1,024,000 Table showing depreciation over three years: | Year | Opening Book Value (₦) | Annual Depreciation (₦) | Accumulated Depreciation (₦) | Closing Book Value (₦) | | :--- | :--------------------- | :---------------------- | :--------------------------- | :--------------------- | | 2023 | 2,000,000 | 400,000 | 400,000 | 1,600,000 | | 2024 | 1,600,000 | 320,000 | 720,000 | 1,280,000 | | 2025 | 1,280,000 | 256,000 | 976,000 | 1,024,000 | Note on Residual Value in Reducing Balance Method: The calculation continues until the asset's book value reaches its residual value. If, in a subsequent year, the calculated depreciation would bring the book value below the residual value, depreciation for that year is limited to the amount that brings the book value down to the residual value. For instance, if the residual value was ₦1,000,000, then in 2025, the depreciation would be ₦256,000, bringing the book value to ₦1,024,
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0. If in 2026, 20% of ₦1,024,000 (₦204,800) was calculated, the book value would be ₦819,200, which is below ₦1,000,
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0. In such a scenario, the depreciation for 2026 would be limited to ₦24,000 (₦1,024,000 - ₦1,000,000) to ensure the book value doesn't go below the residual value. 2.
5. Recording Depreciation in the Books of Accounts Depreciation is an expense, and its recording affects the Statement of Profit or Loss and the Statement of Financial Position (Balance Sheet).
Journal Entries:
1. To record annual depreciation expense: Debit: Depreciation Account (This is an expense account, closed to the P&L)
Credit: Provision for Depreciation Account (or Accumulated Depreciation Account) (This is a contra-asset account, reduces the book value of the asset on the Balance Sheet)
Example: `Depreciation A/C Dr. ₦2,800,000` ` Provision for Depreciation A/C Cr. ₦2,800,000` `(Being depreciation charged on bus for the year)`
2. To close the Depreciation Account at the end of the financial year: Debit: Statement of Profit or Loss Credit: Depreciation Account
Example: `Statement of Profit or Loss A/C Dr. ₦2,800,000` ` Depreciation A/C Cr. ₦2,800,000` `(Being depreciation transferred to Statement of Profit or Loss)` Presentation in Financial Statements: Statement of Profit or Loss: Depreciation expense is shown as an operating expense.
Statement of Financial Position: Fixed Asset (e.g., Plant and Machinery) at Cost: X Less: Provision for Depreciation: (Y) on bus for the year)`
2. To close the Depreciation Account at the end of the financial year: Debit: Statement of Profit or Loss Credit: Depreciation Account
Example: `Statement of Profit or Loss A/C Dr. ₦2,800,000` ` Depreciation A/C Cr. ₦2,800,000` `(Being depreciation transferred to Statement of Profit or Loss)` Presentation in Financial Statements: Statement of Profit or Loss: Depreciation expense is shown as an operating expense.
Statement of Financial Position: Fixed Asset (e.g., Plant and Machinery) at Cost: X Less: Provision for Depreciation: (Y) * Net Book Value: (X - Y) 2.
1. Definition of Depreciation Depreciation is the systematic allocation of the cost of a tangible fixed asset over its useful life. It represents the estimated loss in value of an asset due to various factors and is charged as an expense in the Statement of Profit or Loss (Income Statement) each accounting period. It is a non-cash expense, meaning no actual cash is paid out when depreciation is recorded; it merely accounts for the use of the asset. 2.
2. Reasons for Depreciation Fixed assets lose value over time for several reasons.
These include: Wear and Tear: Physical deterioration resulting from continuous use (e.g., a commercial bus engine after many trips, a generator running daily in a shop).
Obsolescence: The asset becoming outdated or inefficient due to technological advancements or changes in demand, even if it is still physically functional (e.g., an old model computer replaced by a newer, faster one; a manufacturing machine rendered inefficient by a new, automated process).
Effluxion of Time: The passage of time reducing the value or usefulness of an asset, regardless of its usage (e.g., a leasehold property whose value diminishes as the lease term expires).
Inadequacy: The asset becoming insufficient to meet the growing demands of the business (e.g., a small delivery van that can no longer handle the volume of goods a growing business needs to transport).
Depletion: The exhaustion of natural resources (e.g., crude oil wells, mineral mines). While primarily for natural resources, the concept of value reduction applies. 2.
3. Factors Considered When Calculating Depreciation To calculate depreciation accurately, the following factors are taken into account: Cost of the Asset (Original Cost): This includes the purchase price, freight charges, installation costs, and any other costs incurred to bring the asset to its intended working condition. For example, the cost of a new grinding machine for a local mill would include its purchase price, transportation from the port or distributor, and the cost of technicians to install it.
Useful Life of the Asset (Economic Life): This is the estimated period (in years or units of production) over which the asset is expected to be productive and useful to the business. This is an estimate and is often based on experience or industry standards. For instance, a delivery van might have a useful life of 5 years, while a building might have 50 years. Residual Value (Scrap Value or Salvage Value): This is the estimated amount that the business expects to recover from selling the asset at the end of its useful life. For example, a used generator might be sold for its parts or as scrap metal after its useful life. 2.
4. Methods of Depreciation The NERDC curriculum typically focuses on the Straight-Line Method and the Reducing Balance Method for SS
2. A. Straight-Line Method This method allocates an equal amount of depreciation expense to each accounting period throughout the asset's useful life. It assumes that the asset's usefulness declines evenly over time.
Formula: Annual Depreciation = (Cost of Asset - Residual Value) / Useful Life (in years)
Worked Example 1: Straight-Line Method A small transport company, "Peace Motors," in Lagos acquired a new commercial bus for ₦15,000,000 on January 1,
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3. The estimated useful life of the bus is 5 years, and its estimated residual value is ₦1,000,
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0. The company's financial year ends on December 31st.
Calculation: Annual Depreciation = (₦15,000,000 - ₦1,000,000) / 5 years Annual Depreciation = ₦14,000,000 / 5 Annual Depreciation = ₦2,800,000 per year Table showing depreciation over its useful life: | Year | Opening Book Value (₦) | Annual Depreciation (₦) | Accumulated Depreciation (₦) | Closing Book Value (₦) | | :--- | :--------------------- | :---------------------- | :--------------------------- | :--------------------- | | 2023 | 15,000,000 | 2,800,000 | 2,800,000 | 12,200,000 | | 2024 | 12,200,000 | 2,800,000 | 5,600,000 | 9,400,000 | | 2025 | 9,400,000 | 2,800,000 | 8,400,000 | 6,600,000 | | 2026 | 6,600,000 | 2,800,000 | 11,200,000 | 3,800,000 | | 2027 | 3,800,000 | 2,800,000 | 14,000,000 | 1,000,000 | (
Note: Closing Book Value at the end of useful life equals Residual Value) *
B. Reducing 3.
1. Teacher Activities Introduction (10 minutes): Begin by asking students to recall what fixed assets are and provide examples of fixed assets used in typical Nigerian businesses (e.g., vehicles, buildings, generators, machinery).
Pose a question: "Do these assets last forever without losing value? What happens to their value over time?" Facilitate a brief discussion to lead into the concept of depreciation. Introduce the topic "Depreciation and Method of Depreciation" and state the learning objectives clearly.
Concept Explanation (20 minutes): Define depreciation using simple, relatable language. Explain the reasons for depreciation with practical Nigerian examples (e.g., a taxi wearing out, an old phone model becoming obsolete, a rented building's value decreasing as lease expires). Discuss the factors (Cost, Useful Life, Residual Value) influencing depreciation calculations, using examples.
Method Demonstration (30 minutes): Explain the Straight-Line Method, writing the formula on the board. Work through Worked Example 1 (Peace Motors bus) step-by-step, involving students in calculations. Explain the Reducing Balance Method, writing the formula on the board. Emphasize the difference in calculation basis (cost vs. book value). Work through Worked Example 2 (G-Tech Solutions computer equipment) step-by-step, engaging students. Briefly explain and demonstrate the basic journal entries for recording depreciation.
Activity Facilitation (15 minutes): Divide students into small groups (e.g., 4-5 students per group). Provide a short practice scenario (see Guided Practice below) for each group to discuss and calculate, applying both methods. Circulate among groups, providing guidance, clarifying misconceptions, and ensuring active participation.
Review and Consolidation (5 minutes): Call on groups to present their findings or solutions. Address common errors or misunderstandings. Summarize key takeaways of the lesson. 3.
2. Student Activities Participate in the introductory discussion, offering examples of fixed assets and their value changes. Take notes on definitions, reasons, factors, and formulas for depreciation methods. Actively participate in the step-by-step calculations during teacher demonstrations. Engage in group discussions and collaborative problem-solving for guided practice questions. Ask clarifying questions when concepts or calculations are unclear. Present group solutions to the class.
Business Profitability and Taxation (SMEs and Corporations): Depreciation directly impacts a business's reported profit. In Nigeria, many Small and Medium-sized Enterprises (SMEs), such as local manufacturing plants (e.g., plastic recycling, food processing), commercial transport operators (e.g., luxurious bus companies, 'Keke Napep' fleets), and even large corporations, use depreciation to reduce their taxable income. Understanding depreciation allows businesses to accurately assess their profitability and plan for tax payments. For example, a transport company can calculate how much the value of its fleet reduces each year, which impacts its profits and subsequently, the company income tax payable to the Federal Inland Revenue Service (FIRS). Asset Management and Replacement Decisions (Government & Private Sector): Depreciation provides a realistic picture of the remaining value of assets. This is vital for state-owned enterprises (e.g., PHCN distribution companies, Nigerian Railway Corporation) and large private companies in Nigeria. By tracking the book value of assets (e.g., power turbines, railway coaches, hospital equipment), management can plan for their eventual replacement. For instance, the Nigerian National Petroleum Corporation (NNPC) uses depreciation to account for its oil exploration and refining equipment, informing decisions on when to upgrade or replace critical machinery to maintain efficiency and avoid costly breakdowns. Investment Decisions and Asset Valuation (Entrepreneurs & Investors): For individuals looking to invest in a business or purchase used assets, understanding depreciation is key to assessing fair value. An entrepreneur considering buying a used printing press or a second-hand generator for their business in Nigeria would not only look at the physical condition but also understand its depreciated value in accounting terms. This helps them gauge the asset's remaining economic life and make an informed investment decision, preventing overpayment for assets nearing the end of their useful life.