Depreciation, Disposal and a Covenant Pressure
Ridgeway Engineering has a 31 December year end. On 1 July 2022 it bought a computer-controlled lathe for $48,000. The owner estimated a residual value of $6,000 and a useful life of six years, and has charged depreciation straight-line with monthly apportionment from the month of purchase. On 1 October 2024 the business bought a second lathe for $30,000, with an estimated residual value of $3,000 and a five-year life. On 31 December 2024 the first lathe was sold for $26,000. The owner is surprised that a machine bought for $48,000 and sold for $26,000 produces a loss, and asks whether switching to reducing-balance depreciation at 25% would make the accounts 'more realistic'. The bank covenant requires profit before tax above $60,000; draft profit before depreciation and disposal is $71,000.
1. Calculate the depreciation charge for 2024, the profit or loss on disposal of the first lathe, and the total effect on 2024 profit.
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First lathe: annual straight-line charge is ($48,000 - $6,000) / 6 = $7,000. Depreciation to 31 December 2023 was $3,500 for 2022 (six months) plus $7,000 for 2023 = $10,500. The 2024 charge is a full $7,000 because the lathe was sold on 31 December. Accumulated depreciation at disposal is $17,500, so net book value is $48,000 - $17,500 = $30,500. Proceeds are $26,000, giving a loss on disposal of $4,500.
Second lathe: annual charge is ($30,000 - $3,000) / 5 = $5,400. From 1 October to 31 December is three months, so the 2024 charge is $5,400 x 3/12 = $1,350.
Total 2024 depreciation = $7,000 + $1,350 = $8,350. Total effect on profit = depreciation $8,350 plus disposal loss $4,500 = $12,850. Profit becomes $71,000 - $12,850 = $58,150. The lathe did not 'lose' $22,000 in value; $17,500 of the cost had already been charged as depreciation before the sale.
2. Evaluate the owner's proposal to switch to 25% reducing balance. Include the covenant calculation and whether the change is acceptable.
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Under 25% reducing balance: first lathe 2022 charge = $48,000 x 25% x 6/12 = $6,000; 2023 charge = ($48,000 - $6,000) x 25% = $10,500; 2024 charge = ($48,000 - $16,500) x 25% = $7,875. Net book value at disposal = $48,000 - $6,000 - $10,500 - $7,875 = $23,625. Sale proceeds $26,000 give a gain of $2,375. Second lathe 2024 charge = $30,000 x 25% x 3/12 = $1,875. Total depreciation = $9,750. Profit = $71,000 - $9,750 + $2,375 = $63,625, which meets the $60,000 covenant.
However, the change would be unacceptable if made simply to satisfy the covenant. Depreciation method must reflect the pattern of economic benefits consumed and be applied consistently. A switch from straight-line to reducing balance is a change in accounting policy, not a free choice each year; it would require justification, disclosure and, under IFRS, retrospective application. Reducing balance may be defensible if the lathe loses value faster early on, but the owner's stated reason is covenant management. The auditor would challenge the timing, and a gain on disposal created largely by a policy switch is not a real improvement in performance.
3. Suppose the residual value of the first lathe had been revised to $2,000 on 1 January 2024. Explain how this affects the 2024 charge and the disposal, ignoring tax.
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A revision of residual value is a change in accounting estimate, applied prospectively. At 1 January 2024 the lathe's net book value is $48,000 - $10,500 = $37,500. Remaining useful life is 4.5 years, because 1.5 years of the original six-year life have elapsed. The new depreciable amount is $37,500 - $2,000 = $35,500, spread over 4.5 years, giving a 2024 charge of $35,500 / 4.5 = $7,888.89, say $7,889.
Net book value at 31 December 2024 is $37,500 - $7,889 = $29,611. Proceeds of $26,000 give a loss on disposal of $3,611. The loss is smaller than the original $4,500, but the depreciation charge is larger by $889. The total profit effect is the same: $7,889 + $3,611 = $11,500, compared with $7,000 + $4,500 = $11,500. The revision reallocates the cost between depreciation and disposal; it does not change the total expense over the asset's life. No prior-year adjustment is made.