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Fianancial Accounting12

ACCOUNTING CONVENTION, AN D PRACTICES

1.2. DEPRECIATION

Introduction :

A bu siness or concern h olds fixed assets for regu lar u se and not for re-sale. The capability of a

fixed asset to render service cannot be unlimited. Except land, all other fixed assets have a

limited useful life. The benefit of a fixed asset is received th rou ghou t its usefu l life. So its cost

is the pr ice paid for the Series of Services to be received or en joyed from it over a n umber of

years and it should be spread over such years,

Depreciation is the allocation of the cost of a fixed asset over the years of its working life.

Indian Accounting Standard (AS 6) states that Dep reciation is allocated so as to charge a fair

proportion of the depreciable amount in each accounting period during the expected useful

life of the asset.

Long-term fixed assets are used in the process of earning revenue. Due to regular use such

assets gradu ally lose their service potentials. Such losses are considered as expired costs w hich

have to be matched against the p eriodic revenues. The latin word depretium literally means

redu ction of value. So depreciation m eans the r edu ction in value of assets which has to be

considered for determining revenue. R. S. Anthony and J. S. Reece observed tha t the cost of

an asset tha t has a long but nevertheless limited life is systematically reduced over tha t life by

the process called dep reciation.

The cost of a fixed asset is a capital expenditure. Depreciation is allocated for every account ing

period as a cost or an expense which is matched against the revenu e of such period . Althou gh

it is a measu re of the d ecrease in the value of assets pu t to u se, it is actually a p rocess of alloca-

tion. For this reason, International Accounting Standard (IAS)-4 provides that Depreciation

is the allocation of the d epreciable am oun t of an asset over its estimated u seful life. In Ac-

counting Research Bulletin No. 22, AICPA observed that Depreciation for the year is the

portion of the total charge under such a system that is allocated to the year. Although the

allocation may prop erly take into account occuren ces du ring the year, it is not intend ed to be

the measurement of the effect of all such occurrences.

Causes of D epreciation

Itscauses are :

A. Internal

(i) Wear and tear : Plant& Machinery. Furn iture, Motor Vehicles etc. suffer from loss of

utility du e to vibration, chemical reaction, negligent hand ling, ru sting etc.

(ii) Depletion (or exhau stion) : The ut ility or resources of wasting assets (like mines etc.)

decreases with regu lar extractions.

B. External or Economic causes

(i) Obsolescence: Innovation of better substitutes, change in market demand, imposi-

tion of legal restrictions may result into d iscard ing an asset.

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13Financial Accounting

(ii) Inadequacy : Changes in th e scale of prod uction or volum e of activities may lead to

discarding an asset.

C. Time element : With the passage of time some intangible fixed assets like lease, patents.

copy-rights etc., lose their value or effectiveness, whether used or not. The word amorti-

zation is a better term to speak for the gradual fall in their values.

D. Abnormal occurrences : An Accident, fire or natural calamity can damage the service

potent ial of an asset p artly or fu lly. As a resu lt the effectiveness of the asset is affected an d

reduced.

Factors on w hich D epreciation Depends

1. Hist orical (original) cost : Which includ es money spen t for acquisition, installation. add i-

tion and improvemen t of a fixed asset. Cost of the asset, wages paid for installation. trans-portat ion costs, legal expen ses for registrat ion of lease agreements. etc. are includ ed. There

fore, historical cost refers to all expenses incurred before an asset is brough t into u se.

2 Useful life of the asset : It is the estimated p eriod over w hich the utility of an asset will

enjoyed. It dep ends up on (a) legal or contractual p rovisions regard ing lease, etc., b) level

of use of the asset, (c) degree of m aintenance and (d) technological developmen ts. Useful

life is shor ter than th e physical life of an asset.

3. Estimated residual value : It is the value expected to be realised after complete commer-

cial utilization of a fixed asset.

4. Other Relevant Factors : Some oth er relevant factors may be considered for deciding the

amoun t to be charged as dep reciation. These are

(a) Replacement cost that is the Cost that wou ld be incurred if the old asset has to be

replaced by a new asset.

(b) Provisions of the Companies Act, Income Tax Act regarding dep reciation.

(c) Costs of probable additions, alterations or improvements of the existing asset.

Objects of Charging Depreciation

Eric Kohler defined depreciation as the lost usefulness, expired utility, the diminution in

service yield. Its measu remen t and charging are n ecessary for cost recovery. It is treated as a

part of the expired cost for an asset. For determ ination of revenue, that par t or cost should be

matched against revenue. The objects or necessities of charging depreciation are :

I. Correct calculat ion of cost of product ion:Depreciation is an allocated cost of a fixed asset.

It is to be calculated and charged correctly against the revenu e of an accoun ting period . It

mu st he correctly includ ed w ithin the cost of prod uction.

2. Correct calculat ion of profits : Costs incurred for earning revenues mu st be charged prop -

erly for correct calculation of profits. The consumed cost of assets (dep reciation) has to be

prov ided for correct matching of revenues with expenses.

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3. Correct disclosure of fixed assets at reasonable value : Unless depreciation is charged .the

dep reciable asset cannot be correctly valued and presented in the Balance Sheet. Depre-ciation is charged so that the Balance Sheet exhibits a true and fair view of the affairs of the

business.

4. Provis ion of replacement cost : Depreciation is a non-cash expen se. But net p rofit is calcu-

lated after charging it. Through annual depreciation cash resources are saved and accu-

mu lated to p rovide rep lacement cost at the end of the useful life of an asset.

5. Maintenance of capital : A significant port ion of capital has to be invested for p urchasing

fixed assets. The values of such assets are gradu ally reduced d ue to their regu lar use and

passage of time. Depreciation on th e assets is treated as an expired cost and it is matched

against revenu e. It is charged against p rofits. If it is not charged the p rofits w ill remain

inflated. This will cause capital erosion.

6. Compliance w it h technical and legal requirements : Depreciation has to be charged to

comply w ith the relevant p rovisions of the Companies Act and Income Tax Act.

Problems of Measurement of Depreciation

I. Difficulty of ascertaining w orking life :It is really difficult to su mm arise the exact w ork-

ing life of an asset. Where the du ration of the benefits of the asset is time-bound , like those

of a leasehold asset, no p roblem arises. But in other cases it becomes a guess work wh ich

takes into consid eration (a) the nature of the asset; (b) the quality of the asset; (c) experts

opinions and (d) previous experience. These are all conjectures found to vary. Thus an

asset may become incapable of rendering service before its anticipated expiry da te. On theother han d, its effectiveness may remain alive much after such date.

2. Estimation of residual value :Under conservative approach, the residual value is taken

below the expected value at the end of the useful life of an asset. This, at best, helps to

avoid unforeseen losses. But residual value also depends upon market conditions, tech-

nological advancements, etc. So, its correct estimation often proves itself misleading.

3. Unw arranted happenings : Change of law, technological d evelopmen t, innovations. etc.,

may cause a d rastic reduction or w riting off of an asset. These external factors sudd enly

affect the pre-determ ined quantu m of dep reciation. On the other hand , over-use or und er-

use of an asset may also tell upon the amoun t of dep reciation.

Accounting Implications of Depreciation

I. Depreciation is a charge against profits. It is not a cash cost. It is a notional loss. The

estimated depreciation of an accounting period is matched against revenues of that pe-

riod. The profit or loss of that p eriod is calculated after charging d epreciation.

2 It is a compu lsory charge. It is not an approp riation of profits. Unless it is considered, the

process of matching costs with revenues become d efective.

3. Depreciation. as already p ointed ou t, helps to arrive at correct profit or loss. Final ac-

counts can be correctly prep ared only wh en depreciation has been correctly charged.

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4. Depreciation is necessary to value fixed assets at the end of each accounting period. Un-

less it is charged . the assets become overstated.

5. Due to inflation, effective capital of a business is eroded continuou sly. It means, more

amount of capital becomes needed to replenish the same amount of assets consumed or

utilized every year in the process of production. By charging adequate depreciation, a

prop er balance of real capital is maintained .

6. Old order change yielding place to new. This age-old belief obviates the charging of

depreciation. Old may be gold but that cannot be expected to last for ever. Decay and

senility have to be accepted for which the concept of dep reciation has to be ap plied as a

yard stick of measurem ent, of such d ecay.

7. Depreciation Accounting paves the way for replacement of assets. When the effective andworking life of an asset comes to an en d, it is replaced by a new asset. Depreciation, being

a notional cost, helps to set aside a fund every year. Such fun d is utilized to acquire the net

asset. Thus the requ irement of add itional capital or loan can be avoided .

8. As per section 205 of the Comp anies Act of India, a compan y has to provide for adequate

dep reciation before declaring d ividend s. There arc p rovisions of the Income Tax Act of

India regard ing the adequ acy of depreciation. So charging of depreciation is a legal com-

pliance which a bu siness has to observe.

Characteristics of Depreciation

The Characteristics of Depreciation are :

1. It is a charge against profit.

2. It ind icates diminution in service potential.

3. It is an estimated loss of the value of an asset. It is not an actual loss.

4. It depends upon d ifferent assumptions, like effective life and residu al value of an asset.

5. It is a process of allocation and not of valuation.

6. It ar ises mainly from an internal cause like wear and tear or d epletion of an asset. But it is

treated as any expense charged against profit like rent, salary, etc., which arise due to rn

external transaction .

7. Depreciation on any particular asset is restricted to the w orking life of the asset.

8. It is ch arged on tangib le fixed assets. It is not charged on an y curren t asset. For allocating

the costs of intangible fixed assets like goodwill. etc, a certain amount of their total costs

may be charged against periodic revenues. This is know n as amortization. Depreciation

includ es amortization of intangible assets wh ose effective lives are p re-estimated . Intan-

gible assets rend er benefits but th ey d o not have any physical existence. their econom ic-

values are perceived to exist. Amortization or Writing Off such assets is made to ac-

count for the deterioration of their economic values.

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Und er depreciation, Depletion and obsolescence are also covered . Depletion means gradual

exhaustion of p hysical resources due to extraction etc, as found in m ines, quarries etc. Obso-lescence means a major deterioration in the utility of an asset due to (i) innovation of im-

proved su bstitutes or techniqu es; (ii) drastic fall in the dem and of a product arising through

change in market conditions, tastes or fashions; and (iii) usefulness lost and inability arising to

cope with increased scale of operation.

Depreciation Parameters of Different Views

The exact natu re of dep reciation is viewed by d ifferent accountants from d ifferent stand-points.

These are

1. A Process of Allocat ion : The cost of an asset is allocated over the years of its useful life. E.

S. Hend riksen observed d epreciation as a systematic and rational method of allocating

costs to periods in w hich benefits are received. Allocated portion of a capital expenditu re

attributed to any accoun ting period falling w ithin the w orking life of a fixed asset is con-

sidered as the p eriodic charge for d epreciation. The periodic flow of the service poten tial

of such asset is represented by the p eriodic charge. According to this concept, the useful

working life and the residual value of fixed assets arc considered as constant for deter-

mining periodic depreciation.

2. A Decline in Serv ice Pot ent ial :With grad ual u se and effluxion of time, the capability of a

fixed asset to rend er service is reduced. So, depreciation is the measu re of the total redu c-

tion of service potential over the years of use of a fixed asset. As this concept believes that

the consum ption of service potentials of a fixed asset follow a d ecreasing trend , dep recia-

tions for d ifferent years do not become equal.

3. A Source of Fund:Depreciation is a non-cash expense bu t it is charged against p rofits, like

rent, salaries etc. As it does not cause any outflow of cash in the period in which it is

charged, some accountants p refer to believe that its equivalent am oun t is retained in cash.

This helps to build u p a fun d w hich, in turn , helps to replace the old and useless asset by

a new and useful asset.

But this view is full of defects. Depreciation is a p ortion of the tota l out flow of cash alread y

made for acquiring an asset. It is an internal arran gement that affects the period ic revenu e and

the value of a fixed asset of a business. It does not involve any other p arty. A fun d p resum es

app ropr iation of an amou nt and its external app lication. Depreciation neither helps to create,

nor to m aintain any fund. It definitely affects periodic revenue and quantu m of tax but it does

not involve the creation or extinction of any fund.

4. A Provision for Maintenance of Capital : Some accoun tants think that dep reciation helps

to maintain Capital. They feel that d epreciation is charged as a p art ofexpired cost. So, by

the time th e fixed asset ceases to render any service, the initial capital that was invested to

acquire it, is recovered fully. The American Accounting Association (AAA) felt that d e-

preciation must be based on cur rent cost of restoring the service potential consum ed d ur -

ing the period.

For restoring service p otential consumed depreciation is needed . But cost of restoration is

more related to the replacement cost, that is, the cost that will be required at the time of re-

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(i) If the value of any asset increases on revaluation, its accumu lated d epreciation should not

be debited to Profit & Loss Accoun t. The depreciation on such revalued amou nt shou ld bead justed against revaluation reserves.

(j) Any fixed asset purchased und er hire purchase should be recorded at its Cash Price show-

ing app ropriate narra tion that its full own ership has not been received.

(k) All direct costs incurred in developing the patents should be capitalised and written off

over their legal term of validity or over their w orking life, whichever is shorter.

(l) Amoun t paid for know-how of the plants, layout or designs of buildings, machinery, etc.

should be added with the respective value of the asset. Depreciation should be prov ided

on the total value. However, if such amou nts have been paid comp ositely both for man u-

factur ing process and for assets, the management should r easonably allocate the comp os-ite cost.

(o) The following information should be disclosed in the financial statements :

(i) Gross and net book values of fixed assets at the beginning and end of an accounting

period d isclosing ad ditions, disposals, acquisitions and other m ovements;

(ii) Expend iture incurred on account of used assets in the course of acquisition or con-

struction; and

(iii) Revalued amoun ts substituted for historical costs of fixed assets and necessary par -

ticulars regard ing the process adop ted for revaluation.

Depreciation Accounting (AS 6) (Revised)

The Accoun ting Standard regard ing d epreciation w as issued at first in 1982. But it was r evised

in 1994.

The revised standard (AS 6) is now man da torily applicable to all concerns in India for accoun t-

ing p eriods comm encing on or after 1.4.1995. The importan t m atters to be n oted from (AS 6)

are

1. Depreciable Assets are the assets which : -

(a) are expected to be used for more than one accounting period; and

(b) have limited useful life; and

(c) are held by an enterprise for use in prod uction or supply of goods and services, for

rental to others or for adm inistrative pu rposes but not for sale in the ord inary course

of business.

2. Useful Life of a depreciable asset may be either :

(a) the period of its expected w orking life, or

(b) the num ber of prod uction or similar units expected to be obtained from the use of the

asset by the enterpr ise.

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Methods of Charging Depreciation

There are d ifferent concepts abou t the n ature of depreciation. Moreover, the natu re of all fixed

assets cannot be th e same. As a result, different m ethods are found to exist for charging d epre-

ciation. A broad classification of the methods m ay be sum marised as follows

Capital /Source of Fund :

1. Sinking Fund M ethod

2. Ann uity Method

3. Insurance Policy Method

Time Base

1. Fixed Instalment method

2. Reducing Balance Method

3. Sum of Years Digit Method

4. Double Declining Method

Use Base

1. Working Hours method

2. Mileage Meth od

3. Deplet ion Unit method

4. Service Hours Method

Price Base

1. Revaluat ion M ethod

2. Repairs Provision Method

Methods of Charging Depreciation

I. Fixed / Equal Inst alment OR Straight Line Method

Features :

(i) A fixed p ortion of the cost of a fixed asset is allocated and charged as p eriodic deprecia-tion.

(ii) Such depreciation becomes an equal amount in each period.

Depreciation = (V-S)/ n

Where,

V= Cost of the Asset

S= Residual value or th e expected scrap value

n= estimated life of the asset.

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2. Reducing / Diminishing Balance Method OR Writ t en Dow n Value Method

Features :

(i) Depreciation is calculated at a fixed percentage on the original cost in the first year. But in

subsequent years it is calculated at the same percentage on the written dow n values gradu -

ally reducing d uring the expected w orking life of the asset.

(ii) The rate of allocation is constant (usu ally a fixed percentage) but the amou nt allocated for

every year grad ually decreases.

3. Sum of Years Digit Method

Features :

(i) It is a revised form of Reducing Balance Method.

(ii) Here also the working life of an asset has to be p re-estimated and Total Depreciation is

considered as Cost of the Asset () Residual or Scrap Value.

(iii) The amoun t of annu al depreciation goes on decreasing with the use. For calculating de-

preciation, the denominator becomes the sum of the digits repre senting the life of the

asset. Thus if an asset has a life of5 years, the denomina tor shou ld be I + 2 + 3 + 4 + 5 or 15.

Depreciation = (Remaining Life of the Asset x Depreciable Amou nt)

Sum of the Years Digit

Where,

Depreciable Am oun t= Cost of the Asset Estimated Scrap Value

Sum of the Years Digit = n(n+1)/ 2

n= estimated life of the asset

Example:

If an asset costs Rs. 50,000, it has a residual value of Rs. 5,000 and working life of 5 years the

dep reciation w ill be

1st year 5/ 15 of (50,000 5,000) or Rs. 15,000;

2nd year 4/ 15 of (50,000 5,000) or Rs. 12,000;

3rd year 3/ 15 of (50,000 5,000) or Rs. 9,000;

4th year 2/ 15 of (50,000 5,000) or Rs. 6,000;

5th year 1/ 15 of (50,000 5,000) or Rs. 3,000.

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4. Double Declining Balance Met hod :

Features :

(i) Depreciation is charged at a fixed rate and it is calculated on the written dow n value of an

asset brough t forward on th e opening date of an accoun ting year.

(ii) The Rate of Depreciation becomes the double of the rate un der fixed instalment m ethod. It

may be illust ra ted as fo llows :

Rs.

Original Cost of an Asset 2,20,000

Scrap Value (Estimated) 20,000

Working Life (Estimated) 5years

Total Dep reciation Rs. 2,20,000 Rs. 20,000 = Rs. 2,00,000

Annual Deprecia tion = Rs. 2,00,000 / 5 = Rs. 40,000

Rate of Depreciation un der Straight Line Method =Rs. 40,000 100

Rs 2,00,000,= 20%

Depreciation und er DDB Method = 2 x 20% or 40%

The dep reciation w ill be calculated as

5. Working Hours Method

Features :

The Hou rly Rate of Depreciation of an asset is calculated as

Acqu isition Cost Scrap Value

Estimated Total Working Hou rs

Rs.

1styear

Less : Opening CostDepreciation @

40% 2,20,00088,000

2nd

year

Less : Opening Value

Depreciation @

40% 1,32,000

52,800

3rd

year

Less: Opening Value

Depreciation @

40% 79,200

31,680

4th

year

Less: Opening Value

Depreciation @

40% 47,520

19,008

5th

year

Less: Opening Value

Depreciation

[Opening Value - Scrap Value

28,512 20,000]

Scrap Value

28,512

8,512

20,000

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Annual Depreciation is found out as Hourly Rate of Depreciation x actual working

hours rend ered by the asset du ring the year.

It may also he called a Machine Hour Rate where total machine hours of a machine are

estimated.

6. MileageMethod

(i) It considers the total distance in m iles or kilometeres to be run by a vehicle, like bus, car,

lorry etc.

(ii) Depreciation per mile/ km =

Cost Price Scrap Value

Total miles or km s. expected to be run by the veh icle

(iii) Annu al Depreciation = Depn. per mile or km x distance covered d uring the year

7. Depletion Unit Method

Depreciation or Dep letion per un it =

Cost of acquisition and deve lopmen t cost Residua l value

Estimated un its to be raised or extracted

Annual Depreciation = Depreciation per unit x units produced or raised or extracted

du ring the week.

8. Service Hours Method: Und er this method th e expected service hours or runn ing time~

is considered as the basis of charging depreciation. For example, a locomotive enginerend ers effective service for some d efinite runn ing hou rs. In case of aircrafts flying hou rs

are p re-calculated .

Depreciation p er Service Hou r =Total Cost Residual value

Total Run ning time or Service hours

And Annual Depreciation = Rate of dep reciation per hou r x service hours rend ered d uring the

period.

9. Sinking Fund Method

Annual depreciation is isconsidered as a source of providing the replacement cost of an asset. It becomesa means of maintaining capital.

D= Depreciation

C= Cost of the asset

i= Rate of Deprecition

n= Life of the asset

D=Ci

(1+i) -1n

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Notes:

(i) No investment is made in the last year as the investments are to be sold out.

(ii) Sinking Fund Account m ay be called Depreciation Fund Account also. It is to be shown on

the liability side of Balance Sheet.

(iii) Sinking Fun d Investments Accoun t may be called Depreciation Fund Investments Ac-

count also. It is to be shown on the Asset side of the Balance Sheet.

(iv) Annual Contribution (charged in lieu of annual dep reciation) = Original Cost x Present

Value of Re. 1 at given interest rate.

Journ al Entries und er the Sinking Fun d m ethod :

At the end of first year1. (a) Profit & Loss A/ c Dr

To Depreciation A/ c (annu al contribution)

or P/ L A/ c Dr

To Sinking Fund A/ c

(b) Depreciation A/ c Dr.

To Sinking Fund A/ c

2. Sinking Fund Investment A/ c Dr.

To Bank A/c (invested amou nt)

At the end of second/subsequent years

1. Profit & Loss A/ c ... Dr. 2. Bank A/ cDr.

To Sinking Fund A/ c (annual contribution) To Interest on Investment A/ c (annual interest)3. Interest on Investment A/ cDr. 4. Sinking Fund Investment A/ cDr.

To Sin kin g Fu nd A / c (in ter est tran sfer red ) To Ban k A/ c

[amt. invested usu ally = annu al contribution +

annu al interest]

When the w orking life of the asset end s (1), (2) & (3) same as above; (4) not mad e in the last year

5. Bank A/ c Dr. 6. Sinking Fund Investment A/ c Dr.

To Sinking Fund Investment A/ c To Sinking Fund A/ c (Profit on Sale)

(Investments sold out) OR

7. Sinking Fund A/ cDr. Sinking Fund A/ c Dr.

To Asset A/ c [Asset A/ c closed ] To Sinking Fu nd Investm ent A/ c (Loss on Sale)

Illustration: Cost of an Asset Rs.40,000 Life:4 years. Depreciation 10% p.a.Under Sinking Fund Method:

Annual Depreciation = Ci

(1+i) n -1

This amoun t shall be invested at the end of years 1,2 and 3. The amou nt of investment shall

fetch 10% interest p.a. which w ill lead to accum ulat ion of Rs.40,000 at th e end of the 4th

year.

The amou nt of Rs.8,619 shall not be invested at the end of the 4th year.

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10. Annuity Method

Cost of an asset is considered to be an investment. such investment would earn interest if invested

outside the business.

D = Ci(1+i)n / (1+i)n -1

D= Depreciation

C= Cost of the asset

i= Rate of Deprecition

n= Life of the asset

Journal entries

1. Dep reciation A/ c Dr.

To Asset A/ c

(Calculated from an nu ity table)

2. Asset A/ c Dr.

To Interest A/ c

(Calculated on d iminishing values)

3. Profit & Loss A/ c Dr. .

To Depreciation A/ c

4. Interest A/ c DrTo Profit & Loss A/ c

Under Annu ity Method:

Annu al Depreciation = Ci (1 + i)n = 40,000 x 10% x 1.4641 = 12,619

(1+i) n -1 1.4641 - 1

In case of Annuity Method , the am oun t of Rs.12,619 shall not be invested ou tside the bu si-

ness.

It shall have to be taken as an yearly appropr iation. The total amoun t to be appropriated

over a p eriod of 4 year s = Rs.12,619 x 4 = Rs.50,476.Cost of Cap ital = Total Ap propr iation - Actu al Cost of the Asset = Rs.50,476 -40,000 =

Rs.10,476.

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11. Insurance Policy Method

(i) It has a close similarity with the Sinking Fund Method. But, here money is not used for

investment in securities It is used to p ay premium on an Insurance Policy which assures

fund s necessary for rep lacement. It may also be called Depreciation Fund Policy Method.

(ii) An insurance policy for an assets is taken on the basis of (a) the specific nu mber of years

over wh ich the asset will he used , and (b) the amoun t that w ill he required as the rep lace-

men t cost of the asset.

(iii) At the end of the specific working life of the asset, the policy matures and the Insurance

Company pays the amou nt includ ing bonus, if any.

(iv) Depreciation is substituted by the ann ual premium on the policy.

Journal Entries : 1st year and subsequen t years

1. Profit & Loss A/ c Dr.

To Depreciation Fund A/ c

[amt. of dep reciation]

2. Insu rance Policy A/ c Dr.

To Bank A/ c

[Premium p aid at the beginning of the yr.]

At the end of working life of the asset(1) and (2) same as above

3. Bank A/ c Dr.

To Insurance Policy A/ c

[amt. received on matu rity of policy]

4. Insurance Policy A/ c Dr.

To Depreciation Fund A/ c

[Profit or Bonu s received]

5. Depreciation Fund A/ c Dr.

To Asset A/ c [for closing th ese accoun ts]

6. If the asset is sold ou t

Bank A/ c Dr.

To Asset A/ c

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If Depreciation i s based on the Market Price of asset

1. Revaluation Method

Annual Depreciation is considered to be the reduction in the value of an asset during a

year, or Annual Dep reciation is the shortfall in th e closing value of an asset from its open-

ing value.

2. Repairs Provision Method

(i) This method compu tes depreciation on an asset on the basis of (a) the cost of the asset and

(b) the estimated total cost of repairs to be needed th rough out th e working life of the asset.

(ii) The expenses for repairs and renewals do not become the same every year. Rather the

amoun ts spent in different years should be d ifferent.

The total cost of repairs for an asset through out its w orking life is estimated first.

(iii) With total estimated dep reciation this total estimated cost of repairs is add ed.

(iv) The result is d ivided by the w orking life of the asset to find ou t annual d epreciation.

Thus, Annua l Depreciation = (Depreciation + Repairs Cost) / Working Life of the Asset

[*Estimated Total Depreciation = Cost of Acquisition Scrap Value]

(v) Whatever may be the actual cost of repairs paid in a year, the Annual Depreciation amoun t

as calculated above is debited to Profit & Loss Accoun t and credited to Prov ision for De-

preciation and Repairs Account.

The actual amount paid for repairs is debited to Provision for Depreciation and Repairs ac-count.

(vi) After the expiry of the working life of the asset, the balance of the above mentioned Prov i-

sion Accoun t is transferred to the Asset Account.

(vii) Some concerns create Provision for Repairs & Renew als Accoun t separa tely with out in-

cluding depreciation.

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EXERCISE

1. Why depreciation is charged ?

2. Why Depreciation is called Notional Cost ?

Problem 1.

Special Points : (a) Depreciation under Fixed Instalment Method; (b) Assets purchased on different

dates, (C) Sale of A sset, (d) Loss on Sale

B. Co. Purchased machinery as follows :

Date of Purchase Cost of Machine (Rs.)

1.4.86 60,000

1.10.86 40,000

1.7.87 20,000

On 1.1.88 one-third of the machinery which was purchased on 1.4.86 became obsolete and

was sold for Rs. 6,000. The m achinery w as to be d epreciated by Fixed Instalmen t Method at

10% p a.

Show how the Machinery Account w ould ap pear in the ledger of the Company for the years

1986. 1987 and 1988. Assum e that th e accounting year of the Company ends on 31st December

every year.

(Ans: Loss on sale Rs. 10,500; Annual Depreciations 1986 Rs. 5,500: 1987 Rs. 11,000; 1968 Rs.

10,000. Balance atMachinery Account on 31. 2.1988 Rs. 77,000)

(Hints : Dep reciations 1986 = Rs. 5,000, 1987 = Rs. 11,000, 1988 = Rs. 10,000)

Problem 2.

Special Points : (a) Use of Provision for Depreciation A ccount , (b) Journal Entries, (c) Sale and Profit on

sale.

After Rs. 5,000 was prov ided for dep reciation in the current year. the accum ulated provision

for dep reciation w ent u p to Re. 50,000. The Machine concerned wh ose original cost had beenRs. 55,000 was then sold as scrap for Rs. 20,000 (cash) and replaced thereafter by a new ma-

chine costing Rs. 75,000. Give Journal en tries to record the above tr ansactions.

(Ans.: Profit on sale of scrap Rs.15000]

Problem 3.

Special Points (a) Depreciation under diminishing balance method, (b) Purchase of A ssets on different

dates, (c) Sale and profit or loss on sale.

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Q Ltd , pu rchased on 1st Janu ary, 1988 a machine for Rs. 10,000. On 1.7.88 it again pu rchased

another machine for Rs. 5,000. On 1.7.89 the machine purchased on 1.1.1988 was sold for Rs.4,000. On 1.7.1990 a new machine w as purchased for Rs. 12,000. On the same date the machine

pu rchased on 1.7.88 was sold for Rs. 4,200.

Depreciation was provided at 10% p.a. on the written down value every year. Show the Ma-

chinery Accoun t .

(Ans.: Loss on sale in 1989= Rs.. 4,550 Profit on sale in 1990 =Rs. 139)

(Hints : Depreciation in

1988 = 10000 100

10

+ 5,000 x100

10

12 =Rs. 1250; 1989 = 9,000 100

10

12

6

+ 4,750 100

10

Rs. 925;

1990 = 12,000 100

1012

6+ 4,275

100

1012

6=Rs.. 814)

Problem 4

Special Points : (a) Change in method of depreciation with prospective effect; (b) Sale of Asset.

ABC Ltd. purchased on 1.1.90 a second hand plant for Rs. 30,000 and spent Rs. 20,000 for

overh auling it. On 1.7.90 additional machinery costing Rs. 25,000 was pu rchased. On 1.7.92 the

plant pu rchased on 1.1.90 became obsolete and was sold for Rs. 10,000. On that da te a new

machine w as pu rchased at a cost of Rs. 60,000.

Depreciation w as prov ided annually on 31st December @ 10% per annu m on the original cost.

In1993. however the company changed this method of providing depreciation and adopted

the method of providing off 15% on the dim inishing value.

Show the Machinery Account for the years 1990 to 1994.

(Hints and Ans:

1990 Cost of Machines purchased = 50,000(1.1.90) + 25,000 (1.7.90) = Rs. 75,000

Depreciation: 10% 0f 50,000 + 10% of 25,000 lot yr Rs. 6,250.

Balan ce of Machinery Rs. 68,750 on 31. 12.1990

1991 Dep recia tion: 10% of (50,000 + 25,000) : Rs. 7,500;

Balan ce of Machinery on 31.12.91 = Rs. 61,250.

1992 Depreciation of machine sold : 10% of50,000 lot 6 months = Rs. 2,500:

1993 Loss on sale = Rs. 27,500.

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Dep reciation on other m achin es 10% of 25,000 + 10% of 60,000 lot yr - Rs. 5,500.

Balan ce of Machinery on 31.12.92 = Rs. 75,750.

1993 Depreciation = 15% of W.D.V = 15% of 75,750 = Rs. 11,362.50 or Rs. 11,363;

Balance on 31.12.93 Rs. 64,367.

1994Depreciation 15% of Rs, 64,387 = Rs. 9,658; Balan ce of m achinery on 31.12.94 = Rs. 54.729}

Problem 5.

Change of M ethod Prospective Effect

A firm pu rchased on 1st January. 1996. certain machinery for Rs. 19,40,000 and spen t Rs. 60,000on its erection. On 1st July in the same year additional machinery costing Rs. 10,00,000 was

acquired . On 1st July. 1998. the m achinery pu rchased on 1st Janu ary 1996 hav ing become obso-

lete was au ctioned for Rs. 8,00,000 and on the same d ate fresh machine w as pu rchased at a cost

of Rs. 15,00,000.

Depreciation w as provided for annu ally on 31st December at th e rate of 10% per annu m on the

original cost of the asset. In 1999, how ever, the firm changed this method of providing d epre-

ciation and ad opted the method of wr iting off 20% on the wr itten dow n value.

Give the Machinery Account as itwould stand at the end of each year from 1996 to 2000.

Problem 6.

Special Point: Change from diminishing balance to st raight line method w it h retrospective

effect..

Messrs M & W commenced business on 1.1.1990 when they purchased plant and equipment

for Rs. 70,000. They adop ted a p olicy of (i) charging dep reciation at 15% per annum on d imin-

ishing ba1ance basis and (ii) charging full years depreciation on additions. Over the years,

their p urchases of plant h ave been 1.4.91Rs. 1,50,000; 30.9.94Rs. 2,00,000

On 1.1.94 it was d ecided to change the meth od and rate of dep reciation to 10% on straight line

basis with retrospective effect from 1.1.90, the ad justm ent being made in the accoun ts for the

year end ing 31st December 1994. Calculate th e d ifference in d epreciation to be ad justed in the

plant an d Equip men t Accoun t on 1.1.94 and show the Ledger A/ c for the year 1994.

Problem 7.

Change of Method w it h retrospective effect

Chartered Planes Ltd w hich dep reciates its machinery at 10% on Diminishing Balance Method

had on 1st

Janu ary 1995, Rs. 9,72,000 to the debit of Machinery Accoun t. During the year 1995 a pa rt of the

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machinery purchased on 1st July, 1993 for Rs. 80,000 was sold for Rs. 45,000 on 1st July, 1995

and a new machinery at a cost of Rs. 1,50,000 was purchased and installed on the same date.installation charges being Rs. 8,000. The comp any wanted to change its method of dep recia-

tion from Diminishing Balance Method to Straight Line Method with effect from 1st Janu ary,

1993 and adjust the d ifference in the accounts for 1991. The ra te of depreciation r emained the

same as before.

Show the Machinery Account and entries in the Profit & Loss Accoun t as regard s dep reciation

and obsolescence loss in 1995. .

[Ans : Balance ofMachinery A ccount on 31.12.95 Rs, 2,34,100 A dditional Depreciation to be provided

for changing the method Rs. 12,000; Depreciation in 1995 (a) on machinery sold Rs. 4,000 (b) Rs.

1,19,900 on remaining assets; loss on sale Rs. 15,000]

[Hints Balance on 1.1.95 = 9,72,000 :. Balance on 1.1.94 =10

000,72,9 9=10,80,000

Balan ce on 1.1.93 =10

000,80,10 9 = 12,00,000.

W. D. Value on 1.1.95 under S.LM= 12,00,000 -.10% x 2 of 12,00,000 = Rs. 9,60,000)

Problem 8.

(a) Change of method, w it h retrospect iv e effect (b) use of prov ision for Depreciat ion Account

and Asset Disposal Account

On 1.1.91 a new plan t was pu rchased by Mrs. Kalyani Basu for Rs. 1,00,000 and a furth er sum

of Rs. 5,000 was spent on its installation. On 1.6.92 another plan t w as acqu ired for Rs. 65,000.

On 2.10.93 the first plant w as totally destroyed and an amou nt of Rs. 2,500 only w as realised by

selling the scraps. It w as not insu red.

On 20.10.93, a second han d plan t was pu rchased for Rs. 75,000 and a further su m of Rs. 7,500

was spent on its rep airs and Rs. 2,500 on its erection. It came in to u se on 15.11.93. Depreciation

has been p rovided at 10% on the original cost ann ually on 31st December. It w as the p ractice to

provid e dep reciation for full year on all acquisitions mad e at any time du ring any year and to

ignore dep reciation on an y item sold d uring the year. The accounts are closed an nu ally on 31stDecember.

In December, 1993, it w as decided to change the method of depreciation and to follow the rate

of 15% on d iminishing balance method of depreciation w ith retrospective effect in respect of

the existing items of plant and to m ake necessary ad justm ents on 31:12.93.

Show the Plant Accoun t, Plant Disposal Account an d Provision for Depreciation Account for 3

years.

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[Ans:Balance of Plant Account on 31.12.93 Rs. 1,50,000 Loss on sale as per Plant Disposal Ac-

count Rs. 81,500 Balan ce Of Prov. for Depreciation A/ c on 31.12.93Rs. 30,788.)

Problem 9.

Machinery Account of R. C. Ltd. showed a debit balance of Rs. 32,400 on 1st January 1995.

dep reciation being p rovided at 10%. On 1st July 1995 a par t of the m achinery pu rchased for Rs.

10,000 on 1st Janu ary 1993 was sold for Rs. 7,000 and on th e same d ate a new machinery which

cost Rs. 20,000 was purchased .

On 31st December. 1995, the company decided to change the method of depreciation from

written dow n value method to straight line method with effect from 1st Janu ary. 1993, dep re-

ciation rem aining at 10% pa.

Show the Machinery Accoun t.

[Ans :Balance of Machinery A /c on 31. 12.95 Rs. 40,000; Loss on Sale of M achinery Rs. 695; Further

depreciation to be charged due to change of method Rs. 300 under Straight Line Method Depreciation on

Machinery Sold Rs. 405 on other machinery Rs. 4,000)

[Hints : For converting to straight line m ethod original cost on 1.1.93 to be found out.

W.D. Value on l.1.95=Rs.32,400 :. Value on l.1.94 =32,400 9

10= Rs. 36,000;

Value on 1.1.93 =36,0009

10= Rs. 40,000

(a) Cost of Machinery on 1,1.93 Rs. 40,000

Less : Cost of Machine sold on 1.7.95 Rs. 10,000

Rs 30,000

Add: Purchase on 1.7.95 Rs. 20,000

Cost Price on Machinery in hand Rs. 50,000

(b) Depreciation on 30,000 @ 10% 3.000Und er S.L.M. on 20,000 10% for 6 m onths 1,000

[1.7. to 31.12.95] 4,000

(c) Difference of Depreciation

Under S. L M. Under W. D. V. M. Difference

1993 3,000 3,000 -

1994 3,000 2,700 300

To be charged 300

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Study Note 1.2,Page 12 32