TOPIC: DEPRECIATION On the basis of Fundamental Accounting Assumption of Going Concern, assets are classified as Fixed Assets and

Current Assets. Fixed assets are used in the business to drive benefits for more than one accounting period. Periodic profit is measured by charging cost against periodic revenue. Since fixed assets are used to generate periodic revenue, an appropriate portion of the cost of fixed assets, which is believed to be expired for generation of periodic revenue, needs to be charged as cost. Such an appropriate proportion of the cost of fixed assets is termed as Depreciation. Generally, the term depreciation is used to denote decrease in value but in accounting, this term is used to denote decrease in the book value of a fixed asset. Depreciation is the permanent and continuous decrease in the book value of a fixed asset due to use, effluxion of time, obsolescence, expiration of legal rights or any other cause. The characteristics of depreciation are as follows: 1. It is related to Depreciable fixed assets only. Note that Land is not a Depreciable fixed asset. 2. It is a fall in the book value of depreciable fixed asset. 3. The fall in the book value of an asset is due to the use of the asset in business operations, effluxion of time, obsolescence, expiration of legal rights or any other cause. 4. It is a permanent decrease in the book value of an asset. 5. It is a continuous decrease in the book value of an asset. Comprehensively, the term Depreciation covers Depletion, Amortization and Obsolescence. The term Depletion refers to the physical deterioration by the exhaustion of the natural resources (ore-deposits in mines, oil wells, quarries, timber stands etc.) The term Amortization refers to the economic deterioration by the expiration of intangible assets (patents, copyrights, goodwill etc.). The term Obsolescence refers to the economic deterioration by: 1. Invention of improved technique or equipment 2. Market decline due to change in taste and fashion etc. 3. Inadequacy of existing plant to meet the increased business. Causes of depreciation
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The main causes of depreciation include the following: 1. Physical wear and tear. When the fixed assets are put to use, the value of such assets may decrease. Such decrease in the value of assets is said to be due to physical wear and tear/ 2. With passage of time. When the assets are exposed to the forces of nature like weather, winds, rains, etc. the value of such assets may decrease even if they are not put to any use. 3. Changes in economic environment. The value of an asset may decrease due to decrease in the demand of the asset. The demand of the asset may decrease due to technological changes, changes in the habits of consumers etc. 4. Expiration of legal rights. When the use of an asset (e.g. patents, leases) is governed by the time bound arrangements, the value of such assets decrease with the passage of time. Need for Charging Depreciation The need for charging depreciation in accounting records arises due to any one or more of the following objectives to be achieved. 1. To ascertain true results of operations. For proper matching of costs and revenue, it is necessary to charge the depreciation (cost) against income (revenue) in each accounting period. Unless the depreciation is charged against income, the result of operations would stand overstated. As a result the Income Statement would fail to present a true and fair view of the result of operations of an accounting entity. 2. To present true and fair view of the financial position . For presenting a true and fair view of the financial position, it is necessary to charge the depreciation. If the depreciation is not charged, the unexpired cost of the asset concerned would be overstated. As a result, the Position Statement (i.e., the Balance Sheet) would not present a true and fair view of the financial position of an accounting entity. 3. To ascertain the true cost of production. For ascertaining the cost of production, it is necessary to charge depreciation as an item of cost of production. If the depreciation on fixed assets is not charged, the cost records, would not present a true and fair view of the cost of production. 4. To comply with legal requirements. In case of companies, it is compulsory to charge depreciation on fixed assets before it declares dividend [ Sec. 205(1) of The Companies Act 1956].
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5. To accumulate funds for replacement of assets . A portion of profits is set aside in the form of depreciation and accumulated each year to provide a definite amount at a certain future date for the specific purpose of replacement of the asset at the end of its useful life. Methods of Recording Depreciation There are two methods of recording depreciation as follows: 1. By charging to asset account. Under this method of recording depreciation, depreciation is directly credited to the Respective Asset Account and as a result, the Respective Asset Account appears at its book value (i.e., Original Cost less depreciation till date). Also Note, Profit = Sale Proceeds - Book Value as on date of sale, and Loss = Book Value as on date of sale Sale Proceeds. 2. By Creating Provision for Depreciation/Accumulated Depreciation Account. Under this method of recording depreciation, depreciation is credited to the Provision for Depreciation Account and as a result, the Respective Asset Account appears at its Original Cost. When the asset is sold or discarded, Asset Disposal Account is prepared to ascertain profit or loss. Asset Disposal Account is debited with the original cost of the asset disposed off and is credited with (a) the accumulated depreciation on the asset disposed off and (b) the sales proceeds of the asset disposed off. The excess of debit side total over the credit side total represents the loss on asset disposed off and is transferred to the debit of Profit and Loss Account. The excess of credit side total over the debit side total represents the profit on asset disposed off and is transferred to the credit of Profit and Loss Account. Methods of Allocating Depreciation. There are several methods of allocating depreciation over the useful lives of the assets. Those most commonly employed in industrial and commercial enterprises are the Straight Line Method (SLM) and the Written Down Method (WDV). Straight Line Method (SLM) of Depreciation. Under the SLM a fixed and equal amount in the form of depreciation , according to a fixed percentage on the original cost, is written off
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during each accounting period over the expected useful life of the asset. The rate of depreciation is calculated as follows: Original Coast less Residual value Step 1 -> Amount of depreciation = ----------------------------------------Expected Useful Life of the Asset Amount of Depreciation Step 2 -> Rate of depreciation = ------------------------------- x 100 Original Cost Written Down Method (WDV) of Depreciation. Under the WDV depreciation according to a fixed percentage calculated upon the original cost (in the first year) and written down value (in subsequent years) of an asset, is written off during each accounting period over the expected life of the asset. Under this method, the rate of depreciation remains constant year after year whereas the amount of depreciation goes on decreasing. The rate of depreciation is calculated as follows: __ / s R = [ 1 - n_ / ---- ] x 100 \/ c Where, R = Rate of Depreciation (in %), n = Useful life of the asset ( in years) s = Scrap value at the end of useful life of the asset c = Cost of the asset Illustration I: On I January 20x1, X Ltd. Purchased a machinery for Rs.12,00,000. On 1 July 20x3, a part of the machinery purchased on I January 20x1 for Rs.80,000 was sold for Rs.45,000 and a new machinery at a cost of Rs.1,58,000 was purchased and installed on the same date. The company has adopted the method of providing 10% p.a. depreciation on the original cost of the machinery. Accounts are closed on 31December each year. Required Show the necessary ledger accounts assuming that (a) Provision for Depreciation Account is not maintained, (b) Provision for Depreciation Account is maintained. Solution: Note: Straight Line Method (SLM) of Depreciation is used. (a) When Provision for Depreciation Account is not maintained. Dr. Machinery Account Cr.
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Date 1.1.x 1 1.1.x 2 1.1.x 3

Particulars To Bank A/c

Rs. 12,00,000

Date 31.12.x 1 31.12.x 2 1.7.x3

________ 12,00,000 ToBalance b/d 10,80,000 ________ 10,80,000 ToBalance b/d 9,60,000 To Bank A/c 1,58,000

Particulars By Depreciation A/c By Balance c/d

Rs. 1,20,000

10,80,000 12,00,000 By Depreciation 1,20,000 A/c By Balance c/d 9,60,000 10,80,000 By Bank A/c 45,000 By Profit & Loss A/c (loss on sale) By Depreciation A/c (Mach. Sold) By Depreciation A/c By Balance c/d 15,000 4,000 1,19,900 9,34,100 11,18,000 Cr. Particulars Rs. By Profit & Loss 1,20,000 A/c By Profit & Loss 1,20,000 A/c By Profit & Loss 1,23,900 A/c _______ 1,23,900

31.12.x 3 ________ 11,18,000 Dr. Date 31.12.x 1 31.12.x 2 1.7.x3 31.12.x 3

Depreciation Account Particulars Rs. Date To Machinery A/c 1,20,00 31.12.x1 0 To Machinery A/c 1,20,00 31.12.x2 0 To Machinery A/c 4,000 To Machinery A/c 1,19,90 31.12.x3 0 ______ _ 1,23,90 0

Working notes: (i) Calculation of Profit /Loss on Sale of Machinery A. Original Cost as on 1.1.20x1 of Machine sold on 1.7.20x3 B. Less: Depreciation @ 10% p.a. for 2 years (Rs.80,000x10%x2) Depreciation @ 10% p.a. for 1/2 year (Rs.80,000x10%x1/2) C. Book value as on 1.7.20x3 (A-B) D. Less: Sale Proceeds E. Loss on Sale (C-D) Rs. 80,000 - 16,000 - 4,000 60,000 45,000 15,000

(ii) Calculation of Depreciation for 20x3 on Machine (other than sold) Rs. A. Old machine of Rs.11,20,000(12,00,000-80,000) for 1 year 1,12,000 B. On New Machine of Rs.1,58,000 for year 7,900 Total 1,19,900

(b) When Provision for Depreciation Account is maintained. Dr. Machinery Account (at Original Cost) Date Particulars Rs. Date Particulars 1.1.x1 To Bank A/c 12,00,00 31.12.x By Balance c/d 0 1 1.1.x2 To Balance b/d 12,00,00 31.12.x By Balance c/d 0 2 1.1.x3 To Balance b/d 12,00,00 1.7.x3 By Machine 0 Disposal A/c 1.7.x3 To Bank A/c 1,58,00 31.12.x By Balance c/d 0 3 13,58,00 0

Cr. Rs. 12,00,000 12,00,000 80,000 12,87,000 13,58,000

Dr. Provision for Depreciation Account Cr. Date Particulars Rs. Date Particulars Rs. 31.12.x1 To Balance c/d 1,20,000 31.12.x By Depreciation A/c 1,20,000 1 1.1.x2 By Balance b/d 1,20,000 31.12.x2 To Balance c/d 2,40,000 31.12.x By Depreciation A/c 1,20,000 2
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2,40,000 1.7.x3 To Machinery 20,000 1.1.x3 Disposal A/c 1.7.x3 31.12.x3 To Balance c/d 3,43,900 31.12.x 3 3,63,900 Dr. Date 1.7.x 3

By Balance b/d By Depreciation A/c By Depreciation A/c

2,40,000 2,40,000 4,000 1,19,900 3,63,900

Machinery Disposal account Cr. Particulars Rs. Date Particulars Rs. To Machinery A/c 80,000 1.7.x3 By Provision for 20,000 Depreciation A/c By Bank A/c 45,000 By Profit & Loss 15,000 A/c (Loss on Sale) ______ (balancing figure) ______ 80,000 80,000 Depreciation Account Particulars Rs. Date To Provision for 1,20,00 31.12.x1 Depreciation A/c 0 To Provision for 1,20,00 31.12.x2 Depreciation A/c 0 To Provision for 4,000 Depreciation A/c To Provision for 1,19,90 31.12.x3 Depreciation A/c 0 ______ _ 1,23,90 0 Cr. Particulars Rs. By Profit & Loss 1,20,000 A/c By Profit & Loss 1,20,000 A/c By Profit & Loss 1,23,900 A/c _______ 1,23,900

Dr. Date 31.12.x 1 31.12.x 2 1.7.x3 31.12.x 3

Illustration II: On 1st. April 20x1, Tulsian Ltd. Purchased a second-hand machine for Rs.80,000 and spent Rs.20,000 on its cartage, repairs and installation. On 30th. September 20x3, this machine is sold for Rs.50,000. Depreciation is to

be provided @ 20% according to Written Down Value Method (WDV). Accounts are closed on 31 March each year. Required Show the necessary ledger accounts assuming that (a) Provision for Depreciation Account is not maintained, (b) Provision for Depreciation Account is maintained.

Solution: (a) When Provision for Depreciation Account is not maintained. Dr. Machinery Account Cr. Date Particulars Rs. Date Particulars Rs. 1.4.x To Bank A/c 80,000 31.3.x By Depreciation A/c 20,000 1 2 [Rs.1,00,000x20% x12/12] To Bank A/c 20,000 By Balance c/d 80,000 1,00,00 1,00,000 0 1.4.x To Balance b/d 80,000 31.3.x By Depreciation A/c 16,000 2 3 [Rs.80,000x20% x 12/12] ______ By Balance c/d 64,000 80,000 80,000 1.4.x To Balance b/d 64,000 30.9.x By Depreciation A/c 6,400 3 3 [Rs.64,000x20% x 6/12] By Bank A/c (Sale) 50,000 31.3.x By Profit & Loss A/c 7,600 _____ 4 (loss) (balancing figure) _____ 64,000 64,000 Dr. Date 31.3.x2 31.3.x3 30.9.x3 Depreciation Account Particulars Rs. Date To Machinery A/c 20,000 31.3.x2 To Machinery A/c To Machinery A/c 16,000 6,400
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Cr. Particulars Rs. By Profit & Loss 20,000 A/c By Profit & Loss 16,000 A/c By Profit & Loss 6,400

31.3.x3 31.3.x4

A/c (b) When Provision for Depreciation Account is maintained. Dr. Machinery Account (at Original Cost) Date Particulars Rs. Date Particulars 1.4.x1 To Bank A/c 80,000 31.3.x2 By Balance c/d To Bank A/c 20,000 1,00,000 1.4.x2 To Balance b/d 1,00,000 31.3.x3 By Balance c/d 1.4.x3 To Balance b/d 1,00,000 30.9.x3 By Machinery Disposal A/c Dr. Date 31.3.x2 31.3.x3 30.9.x3 Cr. Rs. 1,00,000 _______ 1,00,000 1,00,000 1,00,000

Provision for Depreciation Account Cr. Particulars Rs. Date Particulars Rs. To Balance c/d 20,000 31.3.x2 By Depreciation A/c 20,000 1.4.x2 By Balance b/d 20,000 To Balance c/d 36,000 31.3.x3 By Depreciation A/c 16,000 36,000 36,000 To Machinery 42,400 1.4.x3 By Balance b/d 36,000 Disposal A/c ______ 30.9.x3 By Depreciation A/c 6,400 42,400 42,400 Machinery Disposal account Particulars Rs. Date Particulars To Machinery 1,00,000 30.9.x3 By Provision for A/c Depreciation A/c By Bank A/c (sale) 31.3.x4 By Profit & Loss A/c (Loss on Sale) ______ (balancing figure) 1,00,000 Depreciation Account Particulars Rs. Date To Provision for 20,000 31.3.x2 Depreciation A/c To Provision for 16,000 31.3.x3
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Dr. Date 30.9.x 3

Cr. Rs. 42,400 50,000 7,600 ______ 1,00,000 Cr.

Dr. Date 31.3.x2 31.3.x3

Particulars Rs. By Profit & Loss 20,000 A/c By Profit & Loss 16,000

30.9.x3

Depreciation A/c To Provision for Depreciation A/c

6,400

31.3.x4

A/c By Profit & Loss 6,400 A/c

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