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ASSETS DEPRECIATION ACCOUNTING PRACTICES AND PROFITABILITY OF SELECTED SMES

CHAPTER ONE

INTRODUCTION

1.1   Background of the Study

Measuring the SME’s profitability is a central task both in accounting practice and theory (Benjamine, 2002). The management of SMEs need the profitability information for their decision making both in the short and in the long run and therefore must take steps to ensure the profitability of the organization (Goldberg, 2009). However, using one or another depreciation accounting method, an additional deduction of the income tax is possible, thus increasing the net profit available for the SME for the organization development. In depreciation accounting practices, the methods used includes linear depreciation, regressive depreciation and accelerated depreciation. The bigger the expense input with the depreciation, the bigger the net profit - situation found when a faster accounting depreciation policy is used (Wood, 2007). In other words, the effect of the depreciation accounting practices appears in choosing one of the depreciation methods used. In accountancy, depreciation practices refers to two aspects of the same concept: The decrease in value of assets (fair value depreciation) and the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle).

A method of reallocating the cost of a tangible asset over its useful life span of it being in motion. Businesses depreciate long-term assets for both tax and accounting purposes. The former affects the balance sheet of a business or entity, and the latter affects the net income that they report. Generally the cost is allocated, as depreciation expense, among the periods in which the asset is expected to be used. This expense is recognized by businesses for financial reporting and tax purposes. Methods of computing depreciation, and the periods over which assets are depreciated, may vary between asset types within the same business and may vary for tax purposes (Akanni, 2008). These may be specified by law or accounting standards, which may vary by country. There are several standard methods of computing depreciation expense, including fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service. For example, a depreciation expense of 100 per year for five years may be recognized for an asset costing 500.

In determining the profits (net income) from an activity of the SMEs, the receipts from the activity must be reduced by appropriate costs. One such cost is the cost of assets used but not immediately consumed in the activity. Such cost so allocated in a given period is equal to the reduction in the value placed on the asset, which is initially equal to the amount paid for the asset and subsequently may or may not be related to the amount expected to be received upon its disposal. Depreciation is any method of allocating such net cost to those periods in which the organization is expected to benefit from use of the asset. The asset is referred to as a depreciable asset. Depreciation is technically a method of allocation, not valuation, even though it determines the value placed on the asset in the balance sheet (Samuelson, 2001).

Any business or income producing activity using tangible assets may incur costs related to those assets. If an asset is expected to produce a benefit in future periods, some of these costs must be deferred rather than treated as a current expense. The business then records depreciation expense in its financial reporting as the current period's allocation of such costs. This is usually done in a rational and systematic manner. Generally this involves four criteria which includes cost of the asset, expected salvage value also known as residual value of the assets, estimated useful life of the asset, and a method of apportioning the cost over such life.

According to Dobrota (2003), accounting depreciation acts on the organization profitability within the meaning of the operating profit/loss and implicitly of the net earnings value and the fiscal depreciation causes the reduction of the income tax to be paid. The only one which influences the self-funding capacity is the fiscal depreciation, as it leads to the reduction of the income tax to be paid. The accounting depreciation does not influence the self-funding capacity, which may be seen in the formulas that underlie the self-funding capacity of an organization. Therefore in the deductive method the depreciation is not taken into account (the income tax that is influenced by the fiscal depreciation is taken into account) and in the additional method, even if the accounting depreciation is added to the net earnings, it was initially deducted from the gross operating surplus and therefore, the net earnings were reduced with its value.

1.2      Statement of problem

Depreciation and profitability has a complex, intricate and confusing relationship in the field of accounting. As a result, depreciation accounting practices has been over used, over stressed, and over worked by the accountants and professional valuers. International Accounting Standard (IAS), qualifies assets for depreciation when assets are used for more than one accounting period, i.e. assets held by an enterprise for production or service, and has economic useful life. Whereas, under Standard Statement of Accounting Practice (SSAP), depreciation is viewed as wearing out, consumption or other loss of value of fixed asset, whether arising from use, affluxion of time or obsolescence through technology and market changes. Complexity may arise when it is viewed as a fall in price, physical deterioration, allocation of cost, fall in value, valuation technique and asset replacement. Intricate and confusion are inevitable when accountants employ various methods of providing for depreciation accounting practices on the same or similar assets of different life span. The consequential effect is either to undermine or overstate the reported profit or distributable profit in the hands of the stakeholders, hence the absurdity of the financial reports. Based on these imminent issues, this study is examining the relationship between depreciation accounting practices and profitability of some selected SMEs in Port Harcourt.

1.3      Purpose of the Study

The Purpose of this study is to assess the relationship betweenDepreciation accounting practices and profitability of selected SMEsin Port Harcourt: The following are the purpose/objectives of this study:

1.  To identify the fixed installment methodand their influence on the profitability of small and medium scale enterprise.

2.  To analyzedigit method of depreciation and its impact on the profitability of a small and medium scale enterprise.

3.  To examine whether diminishing balance method of depreciation a good depreciation method for small and medium scale enterprise.

4.  To examine whether annuity method of depreciation increase or decrease the profitability of small and medium scale enterprise.

1.4      Research Questions

1.  What are the different methods of depreciation and what influence do they have in the profitability of small and medium scale enterprise.

2.  How does sum of the digit method of depreciation impact on the profitability of a small and medium scale enterprise?

3.  Is diminishing balance method of depreciation a good depreciation method for small and medium scale enterprise?

4.  Can annuity method of depreciation increase or decrease the profitability of small and medium scale enterprise?

1.5   Research Hypotheses

HO: There is no significant relationship between the digit method of depreciation impact on the profitability of a small and medium scale enterprise.

HA: There is significant relationship between digit method of depreciation impact on the profitability of a small and medium scale enterprise.

1.5      Significance of the study

Depreciation Accounting Practices and Profitability of selected Small and medium Enterprises development has been an area of intense research both in practice and academia. This empirical investigation of SMEs is therefore a significant contribution to existing literature. Furthermore, the study would provides evidence on the extent to which Rivers state Small and Medium Enterprise are accounting accommodating in readiness for gaining strategic competitive advantages in their businesses.

The study would also provide uniqueness of small and medium scale businesses call for careful consideration in the design of accounting systems. Small and medium scale enterprises are a vast majority of businesses found in variety of primary and intermediate production of the economy.

The outcome of this study will be useful for business managers and stakeholders in accounting sector on ways by which various depreciation accounting practices can influence the profitability of a small and medium scale business.This research will be a contribution to the body of literature in the area of the effect of personality trait on student’s academic performance, thereby constituting the empirical literature for future research in the subject area.

1.7   Scope of the study

This study will cover some selected Small and medium scale enterprises in Port Harcourt. This study will also cover the depreciation accounting practices in the various selected business organizations with a view to determining their effects on the profitability of the firm.

1.8   Limitation of study

Financial constraint- Insufficient fund tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature or information and in the process of data collection (internet, questionnaire and interview).

Time constraint- The researcher will simultaneously engage in this study with other academic work. This consequently will cut down on the time devoted for the research work.

1.9   Definition of terms

Depreciation: a reduction in the value of an asset with the passage of time, due in particular to wear and tear.

Profitability: is the ability of a business to earn a profit. A profit is what is left of the revenue a business generates after it pays all expenses directly related to the generation of the revenue, such as producing a product, and other expenses related to the conduct of the business activities.

Tax: a compulsory contribution to state revenue, levied by the government on workers' income and business profits or added to the cost of some goods, services, and transactions.