Accounting For Fixed Assets

Depreciation Accounting

Meaning and Definition of

Depreciation
Depreciation is the diminution or loss in the value of
depreciable asset, due to natural wear and tear,
obsolescence or changes in technology or similar causes.
Depreciation is allocated so as to charge (against profits)
a fair proportion of depreciable amount in each accounting
period during the expected useful life of the asset.
Depreciable assets:
i) Are those which are expected to be used during more
than one accounting period.
ii) Which have a limited useful life
iii) Are held by an enterprise for use in production or for use
in supply of goods and services.
iv) These assets are not for the purpose of sale in the
ordinary course of business

Objectives of Providing
Depreciation
The cost of an asset used for the purposes of business has to be
written off over its economic (not physical) life. At the end of
the economic life, an asset has some value as scrap.

Objectives:
i)
ii)
iii)
iv)

Correct Income Measurement: Depreciation should charged

to the profits of the year so that correct income figure can be
ascertained
To depict true financial position: Value of the asset should be
adjusted for depreciation to show correct financial position
To arrange funds for replacement: Each year the amount of
depreciation is retained out of gross revenue receipts, for the
replacement of assets.
Ascertainment of true cost of production: To ascertain the true
cost of production, it is necessary to charge depreciation as
an item of cost of production

Factors in the Measurement of

Depreciation
Cost of asset including expenses for
installation, commissioning, trial run etc.
ii) Estimated useful life of the asset.
iii) Estimated scrap value (if any) at the end
of the useful life of the asset.
Depreciation = Depreciable amount
Estimated useful life
Where Depreciable amount = Acquisition cost
less scrap value
i)

Illustration 1
A machinery is purchased for $10,000. Amount
spent on installation is $1000
The residual/scrap value is estimated at $1000.
It is estimated that the machinery will work for 5
yrs.
Calculate the amount of depreciation to be written
off each year.
Depreciation = 11000-1000 = $2000 every year
5

Methods of Providing Depreciation

Straight Line Method

Reducing Balance Method
Sum of Years of Digits Method
Machine Hour Method
Production Units Method

Straight Line Method

According to this method, an equal amount is written off
every year during the working life of an asset so as to
reduce the cost of the asset to Nil or its residual value at
the end of its useful life.
This method is also known as Fixed Installment Method.
Straight Line Dep.= Cost of Asset- Scrap Value /
Useful life
Advantages : Simple, gives accurate results in case of
Plant and machinery, patents etc.
Disadvantages: It divides the cost of asset equally during
its lifetime but in reality the expenditure on repairs and
maintenance will be low in earlier years.

Reducing Balance Method

Under this method the annual charge for depreciation decreases from
year to year.
Depreciation Expense= Remaining Book Value X Depreciation Rate
Advantages :
i) Simple to operate
ii) The burden of depreciation gets lesser and lesser as the asset
becomes older.
Disadvantages:
i) The value of the asset can never be completely written off
ii) Depreciation rate applied may be too low

Sum of years of digits Method

In this method annual Depreciation is calculated
Cost of asset

X The number of years of remaining life of asset

Total of all digits of the life of the asset (yrs.)

Suppose the estimated life of an asset is 10 yrs., the total of all the
digits from 1 to 10 is 55 i.e. 10+9+8+7+6+5+4+3+2+1.
Therefore, Annual depreciation written off for the first year will be 10/55
X Depreciable cost of the asset
(Depreciable cost is the total cost of the asset less scrap value)
Depreciation for the second year will be 9/55 X Depreciable cost and
so on

Illustration 2
Jenson and Sons acquired a machine on 1st
Jan,2007 at the cost of $14000 and spent
$1000 on its installation. The firm writes off
depreciation at 10% of the original cost every
year i.e. its useful life is estimated to be 10
years. The books are closed on 31st December
every year. Calculate the amount of
Depreciation for the year 2007, and for year
2008.
i) Straight Line Method
ii) Reducing Balance Method
iii) Sum of years of Digits Method

Solution to Illustration 2
1) Straight Line Method =
Depreciation= Cost of Asset- Scrap Value (2007)
Useful Life
Dep. = (14000+1000)- 0
10
= $1,500
In this method $1,500 will be charged every
year as depreciation, for 10 years including
the year 2007.
Equal Depreciation for 2007 & 2008 i.e. $1,500

Reducing Balance Method

Depreciation Expense= Remaining Book
Value X Depreciation Rate
Dep. For 2007= 15,000 X 10%
= $ 1,500
Dep. For 2008= (15000-1500) X 10%
= 13,500 X 10%
= $1,350

Sum of years of digits Method

In this method annual Depreciation is calculated
Cost of asset X The number of years of remaining life of
asset
Total of all digits of the life of the asset
(yrs.)
Cost of asset = 14000+1000 = 15000
The number of years of remaining life of asset including the present
year for 2007= 10 years.
Total of all digits of the life of the asset = 55
(10+9+8+7+6+5+4+3+2+1)
Depreciation = 15000 X 10
(2007)
55
= $2,727.27
Depreciation = 15,000X 9
(2008)
55
= $2,454.54

Machine Hour Method

Illustration
A machine was purchased for $300,000 having an
estimated total working of 24,000 hours. The
scrap value is expected to be $20,000 and
pattern of distribution of effective hours is as
follows:
Year
1-3
3000 hours per year
4-6
2,600 hours per year
7-10
1,800 hours per year
Determine annual depreciation under machine
hour rate method

Solution
Depreciation =
Estimated Hours worked X (cost scrap value)
Total working hours

Annual Depreciation
Year 1-3
Year 4-6
Year 1-3

3000 X ($300,000-$20,000) = $35,000

24000
2600 X ($300,000-$20,000) = $30,333
24000
1800 X ($300,000-$20,000) = $21,000
24000

Production Units Method

Illustration
Under this method depreciation of the asset is calculated by comparing the
annual production with the estimated total production. The amount of
depreciation is computed using the formula:
Depreciation = Production during the period X (cost less scrap value)
(for the period) Estimated Total Production
A machine is purchased for $200,000. Its estimated scrap value at the
end of its useful life of 10 years is $20,000. The machine is expected to
produce 150,000 units during its lifetime.
Expected distribution pattern of production is as follows:
Year
Production
1-3
20,000 units per year
4-7
15,000 units per year
8-10
10,000 units per year
Determine the value of depreciation for each year using production units
method

Solution
Production Units Method
Statement showing Depreciation under
Production Units Method
Year
1-3
4-7
8-10

Annual depreciation
20,000 X ($200,000 - $20,000) = $24,000
150,000
15,000 X ($200,000 - $20,000) = $18,000
150,000
10,000 X ($200,000 - $20,000) = $12,000
150,000