Project Topics

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.

 

 

 

 

 


 

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