Introduction
Accounting has often been referred to as the language of business. This is because it is through accounting that the various stakeholders are able to get the information indicating how the business is doing in terms of its profitability and financial position. This paper discusses the cost allocation process of assets with specific regard to depreciation, depletion, and amortization.
Accounting reporting is based on a concept known as a double entry. This means that all transactions have a ’cause and effect’. This can be summarized into the accounting equation: Assets= Capital + Liabilities (Marcus 103). Assets are classified into two broad categories; Tangible and Intangible. Tangible assets are those assets that can be seen, touched, and located. An example of a tangible asset is a motor vehicle, a machine, or a building. Intangible assets are those assets that cannot be seen or even touched. These include Goodwill, patents, copyrights, etc.
Cost Allocation Process
Depreciation is a cost that is usually charged on assets, that are used to generate income. The rationale behind depreciation is that while an asset is being used, it undergoes wear and tear which makes it depreciate in value and have a much lower value than that of its original cost. The estimated amount by which the asset has lost its value is, therefore, the depreciation charge. For the purposes of consistency, depreciation is determined using either of these two methods; straight line or reducing balance (Wendy and Colin 78). Under a straight line, an asset’s estimated useful life is determined, the expected salvage value is determined, and then the salvage value is subtracted from the cost. The amount obtained is then divided by the number of useful years to determine the depreciation charge for the year.
The following is an illustration of a depreciation charge. on 1st January 2012, Tesco Plc. acquires 5 trucks valued at £4,500.00 each. The trucks have a useful life of ten years and the estimated salvage value is £500.00. Using the straight-line depreciation method, the annual depreciation charge for the purchased trucks will be as follows.
Using the reducing balance and a 10% annual depreciation, the depreciation will be as follows
Journal entries for the second year
Dr. Depreciation……………………………………………….£4,000.00
Cr. Accumulated depreciation…………………..£4,000.00
The effect of depreciation on an income statement is that the depreciation appears as an expense thus reducing the net income. The effect of depreciation on the balance sheet is that it reduces the assets since there is a reduction in the asset’s net book value from the depreciation charge. At the end of the year 2012, Tesco PLc. will, therefore, report a reduction of the gross income by the depreciation amount and consequently a reduction in the net book value of the trucks by the depreciation amount.
Accounting for the depletion of Natural resources
Depletion is defined as the process by which natural resources are used up over time due to mining, drilling, quarrying, or timber felling. Depletion allows the miner to recover the costs in a similar way to depreciation. The two depletion types in accounting practice are cost depletion and percentage depletion (William and MIlton 123). In the cost depletion, a company allocates a proportion of the total amount of mineral. This proportion is multiplied by the amount invested. This gives the amount to be charged for depletion costs. The percentage, method involves ascertaining a percentage for each mineral and then multiplying that percentage with the gross income during the year.
The following is an illustration of the cost depletion method. Tullow Plc. is an oil exploration company. In Year, 2010 it drilled 10,000 barrels of crude oil from Abyei in South Sudan. The company has invested £40,000 in the project. The company’s engineers estimate that the oil well will produce an additional 160,000 barrels in the foreseeable future. The depletion cost will be £40,000/(£200,000 * (40,000-30,000)). = £6,000.00.
Journal entries
Dr. Depletion account……………………………………………£6,000.00
Cr. Asset account……………………………………….£6,000.00
This charge expenses in the income statement as a cost which reduces the profit of the company and also reduces the net book value of the assets invested in the project by the same amount.
Accounting for amortization of intangible assets
Amortization is an accounting term that refers to the spreading of costs over a long period of time. There are two types of amortizations though; Loan amortization and intangible assets amortization (Peterson 202). In the amortization of intangible assets, the cost of acquisition of the asset is reduced systematically over a period of time. This is done to reflect the reduction in the values of the asset due to the passage of time or other factors such as obsolescence, expiry, etc. The treatment of amortization in the financial statements takes the form of a reduction in the carrying amount of the asset in the balance sheet and as an expense in the income statement. The following is an illustration of the amortization for Dell Company.
Journal entries
Dr. Amortization account………………………………….$ 970,000.00
Cr. Intangible asset account……………………$ 970,000.00
Accounting for depreciation where there is a change in the estimated useful life of the assets
When there is a change in the estimated useful life of an asset, accounting policies dictate that adjustments be made to reflect the change in the useful life (Subramani 254). This is because the useful life of an asset is an important determinant of the depreciation charge on an asset and therefore, an increase or decrease of the same would compel the accountant to adjust for the change.
In the former case, an increase in the useful life of an asset would indicate an overcharge in the depreciation of the asset. In such a case, the adjustment is done through debiting the asset account and crediting the Profit and Loss account. In the case where the useful life is reduced, the adjustments made are crediting the asset account and debiting the accumulated depreciation of the same asset and the P&L account.
Change in method of depreciation
One of the principles of accounting when reporting is consistency. This simply means for the purposes of comparative analysis of the financial statements, there should be consistency in reporting in order to avoid earnings management that can result in misrepresentation of the true and fair position of the financial entity. However, in cases where the management decides to change from one depreciation method to another, a full explanation should be given and the financial statements should be accompanied by notes explaining the change in the depreciation method.
When effecting a change in the depreciation method, the total depreciation and the total accumulated depreciation of the new asset is calculated using the new method. The second step is to create adjusting entries for the asset which adjusts the depreciation expenses with the accumulated depreciation account. When changing from a straight line to reducing balance, the entry would debit the depreciation expense, and post a credit entry into the assets accumulated depreciation account. If for instance, Dell corporation has a car costing £30,000 depreciates at £5,000 per year. A debit to depreciation account and a credit to the accumulated depreciation account would record the depreciation.
A change in the method that would provide for depreciation at £3,000 would necessitate the company to recalculate the depreciation using the new method and then adjust for the difference. This would mean for example if the car had stayed for two years that the new depreciation using reducing balance would have the following adjusting journal entries.
Dr. Accumulated depreciation……………………….1,200.00
Cr. Depreciation Account…………………….1,200.00
Similarities between depreciation, amortization, and depletion
The main similarity among the three methods is that they are all fixed assets costs allocations that are periodically charged to the revenue account. On the other hand, the difference between the three methods is that depreciation, amortization, and depletion costs are allocated to tangible assets, intangible assets, and natural resources respectively.
Impairment of assets
An asset is considered impaired when it is carried at more than its recoverable amount. IAS 36 provides that an entity assesses at the end of each reporting year if there is any indication of impairment and if it exists, the entity shall estimate the recoverable amount. The impairment loss is arrived at by deducting the recoverable amount of an asset from its carrying amount. The journal entries recognize impairment loss by debiting the asset impairment loss and crediting the plant account.
Conclusion
The process of cost allocation provides for recognition of depreciation, amortization, and depletion as expenses. This provides an objective mode of determining the carrying value of an asset while providing for an expense for the same in the income statement. The various cost allocation methods should be put into consideration when ascertaining the overhead costs so as to have reliable information communicated to the users of financial statements.
References
Marcus, J. M. Modern Finance for SME. London: Prentice Hall, 2006. Print.
Peterson, H. Accounting for Fixed Assets. New York: John Wiley & Sons, 2002. Print.
Subramani, R. Accounting for equities, futures and options. New York: John Wiley & Sons, 2009. Print.
Wendy, Carlin and Meyer Colin. Journal of Financial Economics. London: Elseiver, 2003. 4. Print.
William, K. and F. MIlton. Cost Accounting. Houston: Dame Publications, 1999. Print.