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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