Depreciation Policy Change at a Sole Trader
T. Moyo runs a delivery business. On 1 January 2024 he owned three vans: Van A bought January 2022 for P180,000, Van B bought July 2022 for P120,000 and Van C bought October 2023 for P90,000. He has always charged depreciation at 20% per annum on cost, with a full year in the year of purchase and none in the year of disposal. In March 2024 he sold Van A for P96,000. He is now considering switching to 25% reducing balance, arguing it will 'make the profit look better in early years'. He also asks whether the loss on sale should be shown separately.
1. Calculate the accumulated depreciation on Van A at the date of sale and the profit or loss on disposal under the existing policy. Show all workings.
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Existing policy: 20% of cost, full year in year of purchase, none in year of disposal.
Van A cost P180,000. Annual charge = 20% x 180,000 = P36,000. Years charged: 2022, 2023, and 2024 (year of disposal gets a full year under this policy) = 3 years. Accumulated depreciation = 3 x 36,000 = P108,000. Carrying amount at disposal = 180,000 - 108,000 = P72,000. Proceeds = P96,000. Profit on disposal = 96,000 - 72,000 = P24,000.
Note the sensitivity: if the policy charged no depreciation in the year of disposal, accumulated depreciation would be P72,000, carrying amount P108,000 and a loss of P12,000. The choice of convention flips a P24,000 profit into a P12,000 loss, so the policy must be applied consistently and disclosed. A profit on disposal does not mean the asset was a good buy; it reflects that depreciation was conservative relative to market value.
2. Evaluate Moyo's claim that reducing balance at 25% will make early-year profit look better, and advise on the accounting treatment and disclosure of the change.
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The claim is wrong in the early years. Reducing balance gives a larger charge in year one than straight line at the same or even higher rate: for a P90,000 van, 25% reducing balance gives P22,500 in year one versus 20% straight line P18,000. Profit is lower, not higher, in early years; it becomes higher only in later years as the charge falls. Total depreciation over the asset's life is the same under both methods (cost less residual value); only the timing differs. Reducing balance better matches the higher repairs and maintenance costs of older assets.
A change of method is a change in accounting estimate, not a prior-period error. It is applied prospectively from the date of change: opening carrying amounts are not restated, and the remaining carrying amount is written off over the remaining useful life at the new rate. The effect on the current year's profit must be disclosed, together with the reason for the change, so users can compare results. The change must not be made merely to improve reported profit - that would undermine faithful representation and comparability.
3. State how the disposal would appear in the statement of financial position and the statement of profit or loss, including the treatment of the P96,000 proceeds.
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In the statement of profit or loss: the profit on disposal of P24,000 is shown separately from operating profit (or within 'other income'), not netted against revenue. Depreciation for the year includes the charge on Van A up to disposal and on Vans B and C for the full year under the stated convention.
In the statement of financial position: the cost and accumulated depreciation of Van A are removed from property, plant and equipment - cost falls by P180,000 and accumulated depreciation falls by P108,000, reducing the carrying amount by P72,000. The P96,000 proceeds are not revenue; they are a capital receipt that increases cash and is reported in investing activities in a cash flow statement. Profit on disposal is not a cash inflow - the cash effect is the P96,000 proceeds, and presenting the profit as if it were cash is a common error.