Depreciation Policy Change at Kgosi Furnishers
Kgosi Furnishers bought a delivery van on 1 January Year 1 for P180,000. The policy was straight-line over 5 years with no residual value. On 1 January Year 3 the business sold the van for P95,000 cash. Separately, the business bought machinery on 1 July Year 3 for P60,000, depreciated at 20% per annum on cost, with a policy of charging a full year in the year of acquisition. The owner asks whether the machinery policy is 'fair' and whether the van sale produced a profit.
1. Calculate the profit or loss on disposal of the van, showing the accumulated depreciation and net book value at the date of sale.
Read the worked answer
Van: straight-line, P180,000 ÷ 5 = P36,000 per year.
Held 1 Jan Year 1 to 1 Jan Year 3 = 2 full years.
| P | |
|---|---|
| Cost | 180,000 |
| Accumulated depreciation (2 × 36,000) | (72,000) |
| Net book value at disposal | 108,000 |
| Sale proceeds | 95,000 |
| Loss on disposal | (13,000) |
Double entry for the disposal:
- Dr Disposal account P180,000; Cr Van (cost) P180,000
- Dr Accumulated depreciation P72,000; Cr Disposal P72,000
- Dr Bank P95,000; Cr Disposal P95,000
- Balance on disposal account: P13,000 debit → loss, transferred to income statement.
Key reasoning: the profit or loss compares proceeds with net book value, not original cost. Comparing P95,000 with P180,000 would wrongly suggest a P85,000 loss. Depreciation is an allocation of cost, not a fund of cash, so the accumulated depreciation must be removed on disposal.
2. Evaluate the machinery depreciation policy (20% on cost, full year in year of acquisition) and calculate the Year 3 charge and Year 4 charge. Explain one consequence of the policy for reported profit.
Read the worked answer
Year 3 charge: P60,000 × 20% = P12,000 (full year, despite purchase on 1 July). Year 4 charge: P12,000.
Evaluation of the policy:
- Consistency is satisfied - the same method and rate each year, which is a qualitative characteristic of useful information.
- Full-year convention is simple and avoids pro-rating, but it is not faithful to the matching principle: the machine was used for only six months in Year 3, yet a full year's charge is made. Year 3 profit is understated by P6,000 relative to a strict time-apportioned charge.
- It is prudent - charging early rather than late - but prudence must not be used to deliberately distort.
- A reducing-balance method might better reflect the machine's falling service potential, but straight-line is acceptable if it reflects even use.
Consequence: Year 3 profit is reduced by P12,000 rather than P6,000; the net book value at 31 Dec Year 3 is P48,000. The policy is defensible only if disclosed and applied consistently; the owner should be told the convention, not just the rate.