16132 Depreciation

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Financial Accounting - 3

By: Manju Asht

LFBAALPU, Phagwara


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Depreciation- Definition

Depreciation is a measure of wearing out,consumption or other loss of value ofdepreciable asset arising from use, time or

obsolescence.Depreciation is allocated so as to charge a fair

proportion of the depreciable amount in eachaccounting period during the expected usefullife of the asset.

Depreciation includes amortization of assetswhose useful life is pre-determined.


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Meaning

Depreciation is permanent and continuous

decrease in the value of a fixed asset due to

use, passage of time, obsolescence, expiration

of legal rights or any other cause.

In accounting it denotes decrease in book value

of a fixed asset.


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Need of Charging Depreciation

1 To ascertain true results of operations

2 To present true position statements

3 To ascertain true cost of production

4 To comply with legal requirements

5 To accumulate funds for replacement of assets


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ALLOCATION OF DEPRECIATION

Frequently used terms

-Original cost of the asset

-Salvage values-Useful life

-Depreciable cost

-Written down value


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Methods of Allocating Depreciation

The different depreciation methods aim to

allocate the cost of an asset to different

accounting period in a systematic and rational

manner.

Each method produces a different pattern of

expenses over the time.


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Straight Line Method

Depreciation = Cost of the asset Residual value

Estimated economical life

Rate of Dep = Amount of Depreciation X 100

Original cost


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Suitability of SLM

Suitable for those assets in relation to which

a) Repair charges are less,

b) The possibility of obsolescence is lessc) Eg. Furniture, patents, copyrights,

trademarks, lease etc


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Written down value method

R = 1 n s

c

Where R = Rate of dep. (a fixed %).

n = No. of yrs of assets useful life.

s = Salvage Value or residual value. c = Acquisition cost of the asset


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Suitability of WDV Method

Suitable for those assets in relation to which

a) Repair and renewal charges are increasing as

the asset grows older

b) The possibility of obsolescence is more

c) Eg. Plant and machinery and building etc


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sum-of-the-years'-digits (SYD)

method

It has no logical foundation other than the fact

that it accomplishes the objective of

accelerating depreciation in a systematic

manner.

This is achieved by multiplying the depreciable

base by a fraction that declines each year and

results in depreciation that decreases by thesame amount each year.


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The denominator of the fraction remains

constant and is the sum of the digits from one

to n, where n is the number of years in theasset's service life.

For example, if there are five years in the

service life, the denominator is the sum of 1,2, 3, 4, and 5, which equals 15.

The numerator decreases each year; it begins

with the value ofn in the first year anddecreases by one each year until it equals one

in the final year of the asset's estimated

service life.


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Factors affecting choice of

method/ amount of depreciation

Historical cost of asset

Usage of asset

Nature of asset Useful life of asset

Residual value of asset

Technological changes Legal requirements

Changes in demand of the product or service


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AS 6 - Change in method of depreciation

According to revised AS 6 issued by ICAI, it is

said that the selected depreciation method

should be used consistently, for comparability

of results.

Change in method should only be done if it

provided by Statute or compliance with ASetc.


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In case of change, depreciation should be

recalculated with the new method from thedate the asset coming into use.

The deficiency or surplus arising form such

change in method should be adjusted in

accounts in the year when the method is

changed.

Such surplus or deficiency should be debited

or credited, as the case may be to the profit

and loss account.


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Sinking Fund Method

It is created to provide a definite amount at a

certain future date for a specific purpose of

replacement of asset at the end of its useful

life.


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Method

A sinking fund (Depreciation fund) isestablished for accumulating funds for

replacement of asset

An amount equal to annual depreciation ischarged against the profits every year.

Above depreciation amount is transferred to

sinking fund account. Investment is purchased for above said

amount every year, except in last year.


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Above procedure is repeated every year tilllast year.

From the second year onwards till last year,interest on sinking fund investment is receivedand reinvested.

In the last year such investments are realizedwith interest

Profit / loss on investment is transferred tosinking fund investment account.

The amount realized from sale of investmentis used for the replacement of asset.


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Journal Entries First Year

For providing depreciation on asset:1. Depreciation A/c Dr.

To Sinking Fund Account

For closure of depreciation account2. Profit and loss a/c Dr.

To Depreciation

For making investment3. Sinking Fund A/c Dr.

To Bank A/c


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Second and subsequent years

Interest on investment:

4. Bank a/c Dr.

To Interest on Sinking fund a/c Transfer of interest on investment

5. Interest on Sinking fund a/c Dr.

To Sinking fund a/c(6-8) Repeat journal entries of 1st year (1-3)


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At the end of last year

(9-12) Repeat journal entries from (4- 8)13 Bank a/c Dr

To Sinking fund investment a/c

14 For profit on sale of investments:Sinking fund investment a/c Dr.

To sinking fund a/c

For loss on sale

Sinking fund a/c Dr.

To sinking fund investment a/c


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15 For transferring the balance to asset a/c

Sinking fund a/c Dr.

To Respective asset a/c

16 For sale of asset as scrap:

Bank a/c Dr.To Respective asset a/c

17 For closing respective asset a/c

Profit and loss a/c Dr.To Respective asset a/c (If dr. balance)

In case of credit balance, reverse entry is passed.


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Meaning of Provisions

Refer to book


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Distinction Between Provisions and

Reserves

Refer to book


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Documents

16132 Depreciation