(a) What is depreciation of an asset? (b) List three causes of depreciation. (c) Explain the following methods of depreciation: (i) straight line; (ii) redu...

Answer Details

(a) What is depreciation of an asset?

Depreciation is the gradual and permanent reduction in the value of a fixed (non-current) asset arising from use, wear and tear, the passage of time, or obsolescence. It represents the portion of the cost of the asset that is charged against profit in each accounting period over the asset's useful life, so as to match the cost of using the asset with the revenue it helps to earn.

(b) Three causes of depreciation

1. Wear and tear through constant use of the asset in the business.
2. Passage of time (effluxion of time), especially for assets with a legal life such as a lease or patent.
3. Obsolescence, where the asset becomes out of date due to new technology or changes in demand.

(Others: depletion of natural resources; damage or accident.)

(c) Explanation of methods of depreciation

(i) Straight line (fixed instalment) method: An equal amount of depreciation is charged every year over the useful life of the asset. It is calculated as: \[ \text{Depreciation per year} = \frac{\text{Cost} - \text{Scrap value}}{\text{Estimated useful life}} \] The annual charge remains constant, and the book value falls to the scrap value at the end of the life.

(ii) Reducing (diminishing) balance method: A fixed percentage is charged each year, but on the reducing net book value rather than on the original cost. The depreciation charge is therefore highest in the early years and falls each year. For example, at 20% per annum, an asset costing N10,000 is depreciated by \(N2,000\) in year one, then \(20\% \times N8,000 = N1,600\) in year two, and so on.

(iii) Revaluation method: The asset is valued (revalued) at the end of each period, and the fall in value between the opening and closing valuations is treated as the depreciation for the period. That is: \[ \text{Depreciation} = \text{Opening value} + \text{Additions} - \text{Closing value} \] It is commonly used for loose tools, livestock, and small sundry assets that are difficult to depreciate individually.