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# A CRITICAL REVIEW OF DEPRECIATION

critical

A CRITICAL REVIEW OF DEPRECIATION

A CRITICAL REVIEW OF DEPRECIATION

CHAPTER ONE: GENERAL INTRODUCTION.

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1.1 Background of the study

Depreciation is one of the important areas that need special attention in accounting, because it affects the determination of the net profit of any organisation. Depreciation is the term used to describe the portion of cost of fixed assets which is deducted from revenue for the relative portion of assets services in the operation. It has been observed that most Nigerian firms do not care so much about the treatment of depreciation, and if they do, they adhere mostly to the traditional methods of charging depreciation on a Straight Line or Fixed Instalment basis and at times use the Reducing or Diminishing Balance Method at the expense of other methods irrespective of whether it is the appropriate method or not. There are however, other various methods for estimating the scrap values and annual depreciation of assets that are allowed to be used in respect of the Generally Accepted Accounting Principle (GAAP). These methods require different information and calculations and they also result in varying estimates, which may have different effects on profit determination. Apart from the effects that they may have on profit, they may also affect key financial indicators such as operating income and working capital, hence, it has become imperative to investigate the variability of the situation empirically.

1.2 Statement of the problem

Depreciation is considered to be caused as a result of a number of factors. According to Barreca (1999), it is caused due to physical deterioration, functional and economic obsolescence. Other factors are changes in the market supply and demand for the asset. The fact that depreciation is caused by different factors, it is vital that the method used to depreciate a fixed asset has bearing to the factors which caused the asset to lose value. According to Baum (1991), there exists variety of depreciation methods that are used in allocating depreciable amount in respect of an asset over its useful life. These methods include straight-line method (SLM), sum of the years’ digits method (SOYDM), diminishing balance method (DBM), and Units-of-Production Method (UPM) among others.

1.3 Objectives of the Study

The major objective of this study is to investigate critically the different depreciation methodology in accounting. Specifically the study will:

• Examine the various ways of charging depreciation.
• Applicability and significance of depreciation to firms.
• Evaluate the effect of the estimates on profit determination of the company.

1.4 Research Questions

• What are the various ways of charging depreciation?
• What is the applicability and significance of depreciation to firms?
• What are the effects of the estimates on profit determination of firms?

1.5 Research Hypotheses

The main research hypotheses will be as follows:

H0:       There exist no significant variations on estimates provided by different depreciation methods used by firms in Nigeria.

H1:       Estimates provided by different depreciation methods have significant variation’s effects on profits determination.

1.6 Significance of the Study

The rationale behind conducting the study is to serve as a pioneering effort in filling a gap that past studies researchers have not developed interests to address. Previous studies on depreciation admit that different depreciation methods yield different estimates, but they failed to go further to established whether the variations are of significant effect or not and especially on profit determination. Depreciation concept in the context of this study is viewed from the accounting perspective.

1.7 Scope of the Study

Depreciation ensures that organizations allocate costs associated with their assets in financial reports, particularly in the statement of profit and loss. It also enables managements of organizations through the knowledge of annual rate of depreciation and salvage values of assets to come up with more rational decisions on selection issues, financial planning, income tax management, and optimal asset replacement.

1.8 Definition of Terms

(a) Depreciation:

Depreciation is defined as a reduction in the value of an asset over time, due in particular to wear and tear.

(b) Methodology:

Methodology can be defined as a system of methods used in a particular area of study.

(c) Salvage value:

Salvage value is the net realizable value of an asset at the end of its useful life.

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