Financial Accounting - 3

By: Manju Asht LFBAA LPU, Phagwara

Depreciation- Definition
Depreciation is a measure of wearing out, consumption or other loss of value of depreciable asset arising from use, time or obsolescence. Depreciation 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. Depreciation includes amortization of assets whose useful life is pre-determined.

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.

Need of Charging Depreciation

1

To ascertain true results of operations

To present true position statements To ascertain true cost of production To comply with legal requirements To accumulate funds for replacement of assets

ALLOCATION OF DEPRECIATION
Frequently used terms -Original cost of the asset -Salvage values -Useful life -Depreciable cost -Written down value

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.

Straight Line Method

Depreciation = Cost of the asset Residual value Estimated economical life

Rate of Dep = Amount of Depreciation X 100 Original cost

Suitability of SLM
Suitable for those assets in relation to which a) Repair charges are less, b) The possibility of obsolescence is less c) Eg. Furniture, patents, copyrights, trademarks, lease etc

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

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

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 the same amount each year.

 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 the asset'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 of n in the first year and decreases by one each year until it equals one in the final year of the asset's estimated service life.

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

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 AS etc.

 In case of change, depreciation should be recalculated with the new method from the date 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.

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.

Method
A sinking fund (Depreciation fund) is established for accumulating funds for replacement of asset An amount equal to annual depreciation is charged 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.

 Above procedure is repeated every year till last year. From the second year onwards till last year, interest on sinking fund investment is received and reinvested. In the last year such investments are realized with interest Profit / loss on investment is transferred to sinking fund investment account. The amount realized from sale of investment is used for the replacement of asset.

Journal Entries First Year

For providing depreciation on asset: 1. Depreciation A/c Dr. To Sinking Fund Account For closure of depreciation account 2. Profit and loss a/c Dr. To Depreciation For making investment 3. Sinking Fund A/c Dr. To Bank A/c

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)

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

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.

Meaning of Provisions
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Distinction Between Provisions and Reserves

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