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Fixed assets are purchased for continued and long-term use in earning profit in a business. They are written off against profits over their anticipated life by charging an annual amount calculated so as to eliminate the original cost, less scrap, over that period. The life of fixed assets spans over several years. Therefore, the business needs to make long term investment in fixed assets.
Fixed assets are purchased for continued and long-term use in earning profit in a business. They are written off against profits over their anticipated life by charging an annual amount calculated so as to eliminate the original cost, less scrap, over that period. The life of fixed assets spans over several years. Therefore, the business needs to make long term investment in fixed assets.
Fixed assets are purchased for continued and long-term use in earning profit in a business. They are written off against profits over their anticipated life by charging an annual amount calculated so as to eliminate the original cost, less scrap, over that period. The life of fixed assets spans over several years. Therefore, the business needs to make long term investment in fixed assets.
Fixed Asset Every business acquires various types of fixed assets such as land & building, plant & machinery, furniture, vehicles etc. These assets are used to derive production capacity. Therefore, they are also known as earning assets. Fixed assets are purchased for continued and long-term use in earning profit in a business. They are written off against profits over their anticipated life by charging an annual amount calculated so as to eliminate the original cost, less scrap, over that period.
The life of fixed assets spans over several years. Therefore, the business needs to make long term investment in fixed assets.
Depreciation Except land, all fixed assets have a limited life. During such period, due to continuous use and/or lapse of time, the value of some assets starts decreasing. Such a gradual decrement of value of assets is called Depreciation. Hence, depreciation can be defined as a decline in the value of an asset due to constant use.
Since these assets have limited life, sooner or later they have to be replaced. At the time of replacement, the business incurs heavy cash outflow which can create liquidity problem in that year. In order to avoid such problem, a fixed amount out of profit is set aside as depreciation account. By the time the fixed asset expires, sufficient amount of fund will be accumulated in depreciation account which, then can be used to buy new asset. Hence, the process of setting aside a fixed amount as expense in depreciation account is called Depreciation.
Characteristics of Depreciation The following are some of the features of depreciation: 1. Depreciation may be physical and functional. 2. Depreciation is a gradual/permanent and continuous decrease in the utility value of a fixed asset and it continues till the end of useful life of an asset. 3. Depreciation arises due to the use of assets in productive activities. 4. The primary object of depreciation is to allocate expired cost of fixed assets against a number of accounting periods. 5. Depreciation is charged in respect of fixed assets only i.e., building, machinery, equipment and furniture etc. 6. Depreciation is a charge against profit. 7. Total depreciation of an asset can not exceed its depreciable value (cost less scrap value).
Causes of Depreciation Depreciation is a measure of reduction in the use-value of an asset. It can be physical deterioration or decrease in the market value. The primary causes of depreciation are as follows: 1. Wear and Tear: Due to constant use, assets get worn or torn out. 2. Exhaustion: Exhaustion is the depletion of some assets due to continuous use and lapse of time. In case of mines and oil wells, the continuous extraction of minerals or oil, a 2 stage comes when the mine or well gets completely exhausted an nothing is left. 3. Obsolescence: Some assets are discarded before they are completely worn out because of changed conditions. This is the case when an asset becomes usefulness because of technological advancement, new invention, change in style etc. in that asset. 4. Efflux of time: Certain assets get decreased in their value with the passage of time. This is true in case of assets like leasehold properties, patents and copyrights etc. 5. Accidents: Accidents can cause depreciation in the value of the asset.
Objectives of making provision for depreciation Depreciation accounting is a must for every business for attaining the following objectives: 1. To ascertain net profit Depreciation is the expense for the business. Hence to ascertain the net profit, it must be included in the total cost of sales.
2. To depict the true financial position of the business The balance sheet depicts true financial position of a business at a point of time. To depict the true financial position of the business the assets should be shown in balance sheet not in its original cost but at the depreciated cost. That is all fixed assets should be shown at cost less the amount of depreciation suffered by them till the date of the balance sheet.
3. To ascertain cost of production Depreciation is an expense. Hence it is necessary to charge depreciation in the total cost of production to fix true sales price of the goods and service.
4. Replacement of assets One of the primary objectives of depreciation is the provision for the replacement cost on the retirement of original assets.
5. To follow the company act According to company act, it is compulsory to charge depreciation on fixed assets.
6. To ascertain income tax If depreciation is not charged, the operation will show more profit. As a result, the taxable income will be higher. Hence, depreciation is charged for the correct ascertainment of total taxable income.
Accounting Treatment for Depreciation Since depreciation is an expense it must be charged to Profit & Loss a/c. The entire process begins with the purchase of fixed asset. In the next step, the following journal entries have to be passed for recording depreciation on assets.
1. For purchase of fixed assets Fixed assets a/c Dr. To, Cash/Bank a/c 3 (For purchase of fixed assets) 2. For charging depreciation at the end of the year Depreciation a/c Dr. To, Fixed asset a/c (For depreciation on asset)
3. For transferring depreciation to PL a/c Profit & Loss a/c Dr. To, Depreciation a/c (For transfer of depreciation to P/L a/c)
Additional Entries 4. For sale of fixed assets Cash/Bank a/c Dr. To, Fixed asset a/c (For sale of fixed asset)
5. For gain on sale of fixed assets Fixed asset a/c Dr. To, Profit & Loss a/c (For gain on sale of fixed asset)
6. For loss on sale of fixed asset Profit & Loss a/c Dr. To, Fixed asset (For loss on sale of fixed asset)
Methods of Depreciation There are a number of different methods of providing depreciation for the assets. The method of depreciation depends on a number of factors such as type of asset, life, policy organization etc. The following are the list of methods of depreciation: 1. Fixed installment method 2. Diminishing Balance method 3. Sum of the year digits method 4. Annuity method 5. Depreciation Fund method 6. Insurance policy method 7. Revaluation method 8. Depletion method 9. Machine hour rate method 10. Double declining methods 11. MACRS (Modified Accelerated Cost Recovery System) method
As per the syllabus of BIM 4 th Semester, we will discuss following 3 methods only: 4 1. Straight Line Method 2. Written Down Method 3. Depreciation Fund Method
Straight Line Method This method is also known as Fixed Installment Method, Equal Installment Method, Original Cost Method, Simple or Historical Cost Method. Under this method, a fixed proportion of original cost of the asset is written-off annually so that by the time asset is worn out, its value in the books is reduced to zero or residual value.
The amount of depreciation to be charged each year can be found out as follows:
asset of Life value scrap estimated asset fixed of Cost Original on Depreciati Annual
Advantages 1. It is simplest to understand and easy to apply. 2. The value of asset can be reduced to zero or its scrap value.
Disadvantages 1. This method does not take in account the effective utilization of the asset. The same amount of depreciation is charged from year to year, irrespective of use of the asset. 2. With the passage of time, efficiency of asset decreases but the amount of depreciation remains the same, which does not seem to be justified.
A machine was bought on January 1, 2010 for Rs.8,000. It cost Rs.1,000 for transportation and Rs.1000 for installation. The scrap value of the machine is estimated to be Rs.1,000 at the end of its three years of working life. Prepare plant account with the help of journal entries for 3 years after charging depreciation according to Straight Line Method. Solution: Total cost of machine =Rs.8,000 +1,000 +1,000 =Rs.10,000
Estimated scrap value =Rs.1,000
asset of Life value scrap estimated machine of cost Total on Depreciati Annual
5 3 000 , 1 000 , 0 1
=Rs.3,000
Journal Entries
Date Particular LF Debit Credit Jan 1, 2010 Machine a/c Dr. To, Bank a/c (For purchase of machine) 10,000 10,000 Dec. 31, 2010 Depreciation a/c Dr. To, Machine a/c (For charging depreciation on machine) 3,000 3,000 Dec. 31, 2010 Profit & Loss a/c Dr. To, Depreciation a/c (For transfer of depreciation to P/L a/c) 3,000 3,000 Dec. 31, 2011 Depreciation a/c Dr. To, Machine a/c (For charging depreciation on machine) 3,000 3,000 Dec. 31, 2011 Profit & Loss a/c Dr. To, Depreciation a/c (For transfer of depreciation to P/L a/c) 3,000 3,000 Dec. 31, 2012 Depreciation a/c Dr. To, Machine a/c (For charging depreciation on machine) 3,000 3,000 Dec. 31, 2012 Profit & Loss a/c Dr. To, Depreciation a/c (For transfer of depreciation to P/L a/c) 3,000 3,000 Dec. 31, 2012 Cash/Bank a/c Dr. To, Machine a/c (For realization of scrap value) 1,000 1,000
Dr. Depreciation Account Cr. Date Particular LF Amount Date Particular LF Amount Dec.31, 2010 To, Machine a/c 3,000 Dec.31, 2010 By, P/L a/c 3,000 3,000 3,000 Dec.31, 2011 To, Machine a/c 3,000 Dec.31, 2011 By, P/L a/c 3,000 6 3,000 3,000 Dec.31, 2012 To, Machine a/c 3,000 Dec.31, 2012 By, P/L a/c 3,000 3,000 3,000
Dr. Machine Account Cr. Date Particular LF Amount Date Particular LF Amount Dec.31, 2010 To, Bank a/c 10,000 Dec.31, 2010 By, Dep. a/c By, Bal c/d 3,000 7,000 10,000 10,000 Dec.31, 2011 To, Bal b/d 7,000 Dec.31, 2011 By, Dep. a/c By, Bal c/d 3,000 4,000 7,000 7,000 Dec.31, 2012 To, Bal b/d 4,000 Dec.31, 2012 By, Dep. a/c By, Bank a/c 3,000 1,000 4,000 4,000
Problem A trader bought machinery on 1 st January, 2013 for Rs.1,25,000 whose useful life has been estimated 5 years. After the expiry of useful life the scrap will realize Rs.25,000. Prepare machinery account and depreciation account, charging depreciation by fixed installment method for 5 years. Also pass necessary journal entries.
Addition and sale of assets during the year During the accounting period, a firm can buy and/or sale its fixed assets. The additional purchase of assets increase the amount of depreciation whereas sales of existing assets decrease the amount of depreciation at the end of the period.
Addition of asset The depreciation for the additional assets purchased during the accounting period may be provided on either of the following two basis: 1. Depreciation may be provided for a year for the additional assets irrespective of use period. That is, depreciation may be provided for a year even if assets are added in middle or near to end of accounting period. 2. Depreciation may be provided on assets added for the use period only. That is, depreciation should be provided for the period of the date of purchase to end of accounting period, i.e., for use period only.
Note: If date of addition and method of charging deprecation is given in the problem, then depreciation on additional assets should be provided for use period only.
Illustration 2 The financial year of a firm is closed on December 31, each year. It purchased the following machinery: 7 On January 1, 1996 Machine costing Rs.30,000 On July 1, 1996 Machine costing Rs.20,000 On April 1, 1997 Machine costing Rs.10,000 The machinery is to be depreciated by fixed installment method at 10% p.a. Show the machinery account for 1996 and 1997. Solution: Year Particular Machine Total Depreciation 1 2 3 1996 Cost Depreciation 30,000 3,000 20,000 1,000 - -
Note: - Depreciation for 1 st machine is provided for a year in 1996 and 1997. - Depreciation on 2 nd machine is provided only for 6 months in 1996 and for a year in 1997. - Depreciation on 3 rd machine is provided for 9 months in 1997.
Dr. Machinery Account Cr. Date Particular LF Amount Date Particular LF Amount Jan 1, 1996 July 1, 1996 To, Bank a/c
To, Bank a/c 30,000
20,000 Dec.31, 1996 By, Dep. a/c By, Bal c/d 4,000 46,000 50,000 50,000 Jan 1, 1997 April 1, 1997 To, Bal b/d
Problem On 1 st January 1999 a company purchased a plant and machinery costing Rs.1,00,000. It is estimated that the working life of the plant is 10 years after which its break up value will be zero.
Additions are made on 1 st April, 2000 to the value of Rs.50,000. Its probable life was estimated at 5 years and scrap value at the end of life is Rs.10,000.
More additions are made on 1 st July, 2001 to the value of Rs.44,000 (Break up value Rs.4,000). The working life was estimated at 4 years.
It was decided to write off depreciation by Straight Line Method. The accounts are closed on 31 st
December each year. Required: Show the plant and machinery account for the first 4 years. 8
Sale of assets During the accounting period, the firm may sell its partial or whole assets due to various reasons before the expiry of their useful life. In such a case, the depreciation should be provided on those assets up to their date of sales. The assets can be sold at book value (original cost accumulated depreciation) or at a profit or at loss. The gain or loss should be accounted accordingly.
Illustration 3 Clinton maintains his books of accounts on calendar year basis. He purchased on 1.1.94 a machine for Rs.40,000. He purchased another machine on 1 st October 1994 for Rs.20,000 and on 1 st July 1995 for Rs.10,000. On 1 st July, 1996 one fourth of the machine installed on 1 st January, 1994 became obsolete and was sold for Rs.6,800.
Show hoe the machinery account will appear in the books of Clinton for all the 3 years under fixed installment method. Depreciation is to be charged at 10% per annum. Solution:
Year Particular Machine Total Depreciation 1 2 3 1994 Cost Depreciation 40,000 4,000 20,000 500 - -
Dr. Machinery Account Cr. Date Particular LF Amount Date Particular LF Amount 1.1.94 1.10.94 To, Bank a/c To, Bank a/c 40,000 20,000 31.12.94 By, Dep. a/c By, Bal c/d 4,500 55,500 60,000 60,000 1.1.95 1.7.96 To, Bal b/d To, Bank a/c 55,500 10,000 31.12.95 By, Dep. a/c By, Bal c/d 6,500 59,000 65,500 65,500 1.1.96 To, Bal b/d
59,000 31.12.96 By, Bank a/c By, Dep. sold machine By, P/L a/c (loss) By, Dep. a/c By, Bal c/d 6,800 500
700
6,000 45,000 59,000 59,000
Problem 9 A machine was purchased for Rs.10,000 on 1 st January, 1988. It was decided to depreciate it at the rate of 10% on original cost method. On 1 st July, 1989 another machinery was purchased for Rs.20,000. On 1 st January, 2010 the machinery bought on 1 st January, 1998 was sold for Rs.8,500.
Prepare machinery account for 3 years, assuming that the books are closed on 31 st December each year.
(Ans: Profit on sale of machinery Rs.500; Balance on machinery account on 31 st Dec, 2010, Rs.17,000).
Written Down Method This method is also known as Diminishing Balance method, Reducing Balance method. Under this method, a fixed percentage of depreciation is charged on the reducing balance of asset (cost - depreciation) till the amount is reduced to scrap value. Since a constant percentage rate is being applied to the written down value, the amount of depreciation charged every year decreases over the life of the asset. This method assumes that an asset should be depreciated more in earlier years of use than later years because the maximum loss of an asset occurs in the early years of use.
The fixed percentage rate, to be applied to the allocation of net cost as depreciation, can be obtained by following formula n asset of cost e Depreciabl Value Scrap - 1 on Depreciati of Rate Where, n =Estimated useful life of the asset
Example The cost of asset is Rs.2,16,000 and salvage value at the end of useful life is Rs.27,000. The estimated useful life of asset is three years. It is decided to depreciate the asset under written down value method. Required: Rate of Depreciation
Solution: n asset of cost e Depreciabl Value Scrap - 1 on Depreciati of Rate
3 2,16,000 27,000 - 1 on Depreciati of Rate =50%
Advantages 1. The amount of depreciation decreases continuously with the gradual decrease in the service potential of asset. 10 2. When additions are made to the asset, fresh calculation of depreciation is not required. 3. Under this method larger amount of depreciation is provided in earlier years and thus method minimizes the impact of obsolescence.
Disadvantages 1. Amount of depreciation expenses decreases even if the efficiency of asset is maintained by way of repairs and maintenance. 2. Heavy depreciation expenses will be charged to profit and loss account in earlier years. 3. Even after becoming obsolete, the book value of asset can never be zero.
Illustration An asset was purchased for Rs.50,000 on 1 st January, 1998. Assuming annual depreciation to be 10%, show the asset account for 3 years under written down value method. Solution:
Calculating depreciation for 3 years Year Balance of asset Depreciation 1 50,000 5,000 2 45,000 4,500 3 40,500 4,050
Asset Account Date Particular LF Amount Date Particular LF Amount 1.1.1998 To, Bank a/c 50,000 31.12.98 By, Dep. a/c By, Bal c/d 5,000 45,00 50,000 50,000 1.1.98 To, Bal b/d 45,000 31.12.98 By, Dep. a/c By, Bal c/d 4,500 40,500 45,000 45,000 1.1.98 To, Bal b/d 40,500 31.12.98 By, Dep. a/c By, Bal c/d 4,050 36,450 40,500 40,500
Dr. Depreciation Account Cr. Date Particular LF Amount Date Particular LF Amount 31.12.98 To, Asset 5,000 31.12.98 By, P/L a/c 5,000 5,000 5,000 31.12.98 To, Asset 5,000 31.12.98 By, P/L a/c 5,000 5,000 5,000 31.12.98 To, Asset 5,000 31.12.98 By, P/L a/c 5,000 5,000 5,000
Problem A firm purchased plant and machinery on 1 st April 2013 for Rs.50,000. Depreciation is written- 11 off at the rate of 10% per annum. Show 5 years plant and machinery account and depreciation account under reducing balance method. The firm closes its books on 31 st December each year. [Ans: Balance 30,344]
Purchases of asset Illustration A machine was bought for Rs.40,000 with an estimated life of 10 years. Write off 10% depreciation each on diminishing balance system and show the ledger account for the first five years. At the commencement of third year a new machine worth Rs.5,000 was added. Solution:
Journal Entries
Date Particular LF Debit Credit 1 st year Machine a/c Dr. To, bank a/c (Being purchase of machine) 40,000 40,000 At the end of 1 st year Depreciation a/c Dr. To, Machine a/c (Being depreciation charged at 10%) 4,000 4,000 Profit & Loss a/c Dr. To, Dep. a/c (Being transfer of depreciation to P/L a/c) 4,000 4,000 At the end of 2 nd year Depreciation a/c Dr. To, Machine a/c (Being depreciation charged at 10%) 3,600 3,600 Profit & Loss a/c Dr. To, Dep. a/c (Being transfer of depreciation to P/L a/c) 3,600 3,600 In the beg. of 3 rd year Machine a/c Dr. To, Bank a/c (Being purchase of new machinery) 5,000 5,000 At the end of 3 rd year Depreciation a/c Dr. To, Machine a/c (Being depreciation charged at 10%) 3,740 3,740 Profit & Loss a/c Dr. To, Dep. a/c (Being transfer of depreciation to P/L a/c) 3,740 3,740 At the end of 4 th year Depreciation a/c Dr. To, Machine a/c (Being depreciation charged at 10%) 3,366 3,366 Profit & Loss a/c Dr. 3,366 12 To, Dep. a/c (Being transfer of depreciation to P/L a/c) 3,366 At the end of 5 th year Depreciation a/c Dr. To, Machine a/c (Being depreciation charged at 10%) 3,029 3,029 Profit & Loss a/c Dr. To, Dep. a/c (Being transfer of depreciation to P/L a/c) 3,029 3,029
Dr. Machinery Account Cr. Date Particular LF Amount Date Particular LF Amount 1 st year To, Bank 40,000 1 st year By, Dep. a/c By, Bal c/d 4,000 36,000 40,000 40,000 2 nd year To, Bal b/d 36,000 2 nd year By, Dep. a/c By, Bal c/d 3,600 32,400 36,000 36,000 3 rd year To, Bal b/d To, Bank 32,400 5,000 3 rd year By, Dep. a/c By, Bal c/d 3,740 33,660 37,400 37,400 4 th year To, Bal b/d 33,660 4 th year By, Dep. a/c By, Bal c/d 3,366 30,294 33,660 33,660 5 th year To, Bal b/d 30,294 5 th year By, Dep. a/c By, Bal c/d 3,029 27,265 30,294 30,294 6 th year To, Bal b/d 27,265