Question 2 (25 marks) In the year ending 31 December 2018, Happy Ltd bought a ne

Question

Question 2 (25 marks)

In the year ending 31 December 2018, Happy Ltd bought a new machine and made the following payments in relation to it:

$

Cost as per supplier’s list 48,000

Discount received from the supplier 4,000

Delivery charge 400

Installation charge 800

Maintenance charge 1,200

Additional component to increase capacity 1,600

Replacement parts 1,000

Required:

a Determine and justify the cost which should be used as the basis for depreciation. (7 marks)

b What is depreciation? Why is it necessary? (6 marks)

c Explain the term ‘objectivity’ as used by accountants. To what extent is depreciation objective? (5 marks)

d It is common practice in some countries to use the diminishing balance for machines in the early years of an asset’s life and then change to the straight-line method as soon as this would give a higher annual charge. What do you think of this practice? (7 marks)

Explanation / Answer

a) Basis for depreciation: Cost as per supplier's list 48000 All these costs have been incurred to put the machine to operation after purchase. Less: Discount received 4000 Add: Delivery charge 400            Installation charge 800            Additional component to increase capacity 1600 Basis for depreciation 46800 Maintenance charge is for service after the machine is put into operation for the first time and replacement parts are for future use. Hence, these costs are not capitalized. b) Depreciation is the apportioning of the cost of an asset over its useful life. It is necessary for two main reasons: 1)It allows to account for the wear and tear and obsolescence of the asset by recognizing a certain portion of its cost as depreciation expense each year. The income so determined will give the true income. 2) As the depreciation expense, is a non cash expenditure, it results in accumulating cash to that extent out of the yearly income so that funds are available when the asset requires replacement. C) The objectivity principle states that accounting statements and reporting should be such as to give a fair view of the results based on facts. Depreciation allows for expensing the capital cost of fixed assets over their life and that way provides for correct ascertaiment of income each period. It is objective, in the sense that it considers factors like life of the asset, obsolescence, likely salvage value etc., in determining the appropriate rate of depreciation. d) Maintenance charges of machines increases as the machine ages and the depreciatiion as per the diminishing balance method decreases as the machine ages. This will result in a somewhat unform total expense figure for machines (depreciation+ maintenance expense), year to year. However, some firms switch to straight line, when the straight line depreciation becomes higher in the later years.

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