Question 5.1: When Ira Vann commenced trading as a car hire dealer on 1 Ja...
When Ira Vann commenced trading as a car hire dealer on 1 January 20X1, he purchased business premises at a cost of $50,000.
For the purpose of accounting for depreciation, he decided the following.
(a) The land part of the business premises was worth $20,000; this would not be depreciated.
(b) The building part of the business premises was worth the remaining $30,000. This would be depreciated by the straight line method to a nil residual value over 30 years.
After five years of trading, on 1 January 20X6 Ira decides that his business premises are now worth $150,000, divided into:
| $ | |
| Land | 75,000 |
| Building | 75,000
|
| 150,000
|
He estimates that the building still has a further 25 years of useful life remaining.
Required
(a) Calculate the annual charge for depreciation for the first five years of the building’s life and the statement of financial position value of the land and building as at the end of each of the first five years.
(b) Demonstrate the impact the revaluation will have on the depreciation charge and the statement of financial position value of the land and building.
(a) Before the revaluation, the annual depreciation charge is $1,000 per annum on the building.
This charge is made in each of the first five years of the asset’s life.
The carrying amount of the asset will decline by $1,000 per annum, to:
(a) $49,000 as at 31.12.X1
(b) $48,000 as at 31.12.X2
(c) $47,000 as at 31.12.X3
(d) $46,000 as at 31.12.X4
(e) $45,000 as at 31.12.X5
(b) When the revaluation takes place, the amount of the revaluation is:
| $ | |
| New asset value (to be shown in statement of financial position) | 150,000 |
| Carrying amount as at end of 20X\left( \$20,000\quad+\quad\left(\$30,000\quad – \quad \$5,000\right) \right) | 45,000
|
| Amount of revaluation | 105,000
|
The asset will be revalued by $105,000 to $150,000. If you remember the accounting equation,that the total value of assets must be equalled by the total value of capital and liabilities, you should recognise that if assets go up in value by $105,000, capital or liabilities must also go up by the same amount. Since the increased value benefits the owners of the business, the amount of the revaluation is added to capital.
However, the gain on revaluation cannot go to the income statement, as it has not been realised. Instead it is recognised in the statement of comprehensive income, as other comprehensive income. From here, the ‘gain’ is transferred to a revaluation surplus (sometimes called a revaluation reserve), part of capital in the statement of financial position.
This treatment may surprise you at first. However remember the prudence concept, which states that a profit cannot be anticipated before it is realised. Therefore the ‘profit’ cannot be dealt with as income in the income statement. If the building were to be subsequently sold for the revalued amount, the profit would be realised and could be taken to the income statement.
After the revaluation,depreciation will be charged on the building at a new rate of:
\frac{\text{Revalued amount}}{\text{Remaining useful life}}=\frac{\$75,000}{25 years}=\$3,000 \text{per year}
The carrying amount of the property will then be reduced by $3,000 per year over the remaining useful life of 25 years.
One consequence of a revaluation is therefore a higher annual depreciation charge.