Purchase of Non-Current Depreciable Assets Financed by a Loan

1. Non-Current Assets (NCAs)

• Definition: Economic resources controlled by a business that are not held for resale but are used for a number of years (more than 12 months) to generate economic benefits.
• Examples: Buildings, equipment, vehicles, furniture, land.

KEY TAKEAWAY: NCAs are long-term assets used in the operation of a business.

2. Depreciable Assets

• Definition: NCAs that have a finite life and are expected to decline in value over time due to wear and tear, obsolescence, or usage.
• Characteristics:
  • Expected to be used for more than one accounting period.
  • A limited (finite) useful life.
  • Expected to decline in value.
• Examples: Equipment, vehicles, buildings (excluding land).
• Non-Depreciable Assets: Land (generally appreciates in value).

VCAA FOCUS: VCAA loves to test the understanding of why land is not depreciated.

3. Depreciation

• Definition: The systematic allocation of the depreciable value of an asset over its useful life. It is not a process of valuation.
• Depreciable Value: The cost of the asset less its residual value.
  • Formula: Depreciable Value = Cost - Residual Value
• Residual Value (RV): The estimated amount the business expects to receive when the asset is sold or disposed of at the end of its useful life.
• Useful Life (Life): The estimated period over which the asset is expected to be used by the business.

KEY TAKEAWAY: Depreciation is an allocation of cost, not a valuation of the asset.

4. Accounting Assumptions and Qualitative Characteristics

• Accrual Basis Assumption: Depreciation recognizes that the benefit of an asset is consumed over its useful life, and the expense should be matched with the revenue it helps generate in each accounting period.
• Historical Cost (HC): Assets are initially recorded at their original purchase price. Depreciation is based on this cost.
• Relevance: Depreciation provides a more accurate picture of a business’s financial performance by recognizing the expense associated with using an asset over time.

EXAM TIP: Relate depreciation to accounting assumptions like Accrual Basis and HC, and qualitative characteristics like relevance.

5. Methods of Calculating Depreciation

• Straight-Line Method: Allocates an equal amount of depreciation expense each year over the asset’s useful life.
  • Formula: Depreciation Expense = (Cost - Residual Value) / Useful Life
  • Example:
    • Cost: \$50,000
    • Residual Value: \$10,000
    • Useful Life: 5 years
    • Depreciation Expense = (\$50,000 - \$10,000) / 5 = \$8,000 per year

REMEMBER: Straight-Line is the simplest method; Depreciation Expense is constant each year.

6. Recording the Purchase of a Non-Current Asset Financed by a Loan

6.1 General Journal Entries

• Purchase of the Asset:

  Date	Account	Debit	Credit
  [Date]	[Asset Name]	\$[Cost]
  	Bank		\$[Down Payment]
  	Loan Payable		\$[Loan Amount]
  	Being purchase of [Asset] with loan

• Example: Purchase of equipment for \$40,000, paid \$10,000 cash and took out a loan for \$30,000.

  Date	Account	Debit	Credit
  [Date]	Equipment	\$40,000
  	Bank		\$10,000
  	Loan Payable		\$30,000
  	Being purchase of equipment with loan

6.2 General Ledger Entries

• Post the journal entries to the respective General Ledger accounts:
  • Asset Account (e.g., Equipment): Debit
  • Bank Account: Credit
  • Loan Payable Account: Credit

7. Depreciation Expense

7.1 General Journal Entry

• Recording Depreciation:

  Date	Account	Debit	Credit
  [Date]	Depreciation Expense	\$[Depreciation]
  	Accumulated Depreciation – [Asset]		\$[Depreciation]
  	Being depreciation expense for [Asset]

• Example: Depreciation expense for the equipment is \$8,000.

  Date	Account	Debit	Credit
  [Date]	Depreciation Expense	\$8,000
  	Accumulated Depreciation – Equipment		\$8,000
  	Being depreciation expense for equipment

7.2 General Ledger Entries

• Post the journal entry to the respective General Ledger accounts:
  • Depreciation Expense Account: Debit
  • Accumulated Depreciation Account: Credit

STUDY HINT: Practice journal entries and ledger postings until they become second nature.

8. Reporting Depreciation in Financial Statements

8.1 Income Statement

• Depreciation Expense is reported as an expense, reducing the business’s profit.

8.2 Balance Sheet

• The asset is reported at its carrying amount (book value).
  • Formula: Carrying Amount = Cost - Accumulated Depreciation
• Accumulated Depreciation: A contra-asset account that reduces the value of the asset.
• Loan Payable: Reported as a liability (current or non-current, depending on the repayment terms).

8.3 Cash Flow Statement

• Depreciation is a non-cash expense. It is added back to net profit in the operating activities section when using the indirect method.
• The cash outflow for the purchase of the asset is reported in the investing activities section.
• The cash inflow from the loan is not reported in the Cash Flow Statement as it is financing, not operating, investing, or financing activity.

COMMON MISTAKE: Forgetting to add back depreciation when calculating cash flow from operations using the indirect method.

9. Example: Comprehensive Illustration

Scenario:

On July 1, 2024, ABC Co. purchased a machine for \$60,000. They paid \$20,000 in cash and took out a loan for the remaining \$40,000. The machine has an estimated useful life of 5 years and a residual value of \$10,000. ABC Co. uses the straight-line method for depreciation.

Required:

1. Prepare the journal entries for the purchase of the machine.
2. Calculate the annual depreciation expense and prepare the journal entry.
3. Show how the machine and depreciation would be reported on the financial statements for the year ended June 30, 2025.

Solution:

1. Journal Entries for Purchase:

2. Depreciation Calculation and Journal Entry:

• Depreciable Value = \$60,000 - \$10,000 = \$50,000
• Depreciation Expense = \$50,000 / 5 = \$10,000 per year

3. Financial Statement Presentation (Year Ended June 30, 2025):

• Income Statement:

  • Depreciation Expense: \$10,000

• Balance Sheet:

  • Assets:
    • Machine: \$60,000
    • Less: Accumulated Depreciation: (\$10,000)
    • Carrying Amount: \$50,000
  • Liabilities:
    • Loan Payable: \$40,000 (Assuming no principal repayment)

• Cash Flow Statement (Indirect Method - Partial):

  • Operating Activities:
    • Net Profit (before depreciation)
    • Add: Depreciation \$10,000
  • Investing Activities:
    • Purchase of Machine (\$20,000)
  • Financing Activities
    • Proceeds from Loan \$40,000

APPLICATION: Understanding the full cycle – purchase, depreciation, and financial statement reporting – is crucial for analyzing a business’s NCA management.

10. Ethical Considerations

• Accurate Depreciation: Businesses must accurately estimate useful life and residual value to ensure that depreciation expense reflects the true economic consumption of the asset.
• Impact on Profit: Manipulating depreciation (e.g., extending useful life) can artificially inflate profits in the short term, which is unethical.
• Transparency: Disclose depreciation methods and assumptions in the notes to the financial statements to provide transparency to stakeholders.

VCAA FOCUS: Be prepared to discuss the ethical implications of depreciation choices.