Lesson 2.1: Depreciation
2.1.1 Introduction
With the passage of time, all fixed assets lose their capacity to
render services, the exceptions being land and antics. Accordingly, a
fraction of the cost of the asset is chargeable as an expense in each of the
accounting periods in which the asset renders services. The accounting
process for this gradual conversion of capitalised cost of fixed assets into
expense is called depreciation. This lesson explains the different aspects of
depreciation.
2.1.2
Understand the meaning of depreciation.
Know the causes of depreciation.
Appreciate the need for depreciation accounting.
Evaluate the methods of depreciation.
2.1.3 Contents
2.1.3.1 Meaning Of Depreciation
2.1.3.2 Causes Of Depreciation
2.1.3.3 Need For Depreciation Accounting
2.1.3.4 Methods Of Depreciation
2.1.3.5 Straight Line Method Of Depreciations
2.1.3.6 Diminishing Balance Method
2.1.3.7 Annuity Method Of Depreciation
2.1.3.8 Summary
2.1.3.9 Key Words
2.1.3.10 Self Assessment Questions
2.1.3.11 Key To Self Assessment Questions
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2.1.3.12 Case Analysis
2.1.3.13 Books For Further Reading
2.1.3.1 Meaning Of Depreciation
In common parlance depreciation means a fall in the quality or value
of an asset. But in accounting terminology, the concept of depreciation
refers to the process of allocating the initial or restated input valuation
of fixed assets to the several periods expected to benefit from their
acquisitions and use. Depreciation accounting is a system of accounting
which aims to distribute the cost or other basic value of tangible capital
assets, less salvage (if any), over the estimated useful life of the unit (which
may be a group of assets) in a systematic and rational manner. It is a process
of allocation and not of valuation.
The international accounting standards committee (iasc) (now
international accounting standards board) defines depreciation as follows:
depreciation is the allocation of the depreciable amount of an asset over
the estimated useful life. The useful life is in turn defined as the period
over which a depreciable asset is expected to be used by the enterprise.
The depreciable amount of a depreciable asset is its historical cost in the
financial statements, less the estimated residual value. Residual value or
salvage value is the expected recovery or sales value of the asset at the end
of its useful life.
2.1.3.2 Causes Of Depreciation
Among other factors, the two main factors that contribute to the
decline in the usefulness of fixed assets are deterioration and obsolescence.
Deterioration is the physical process wearing out whereas obsolescence
refers to loss of usefulness due to the development of improved equipment
or processes, changes in style or other causes not related to the physical
conditions of the asset. The other causes of depreciation are:
1.
Efflux of time – mere passage of time will cause a fall in the
value of an asset even if it is not used.
2.
Accidents – an asset may reduce in value because of meeting
with an accident.
3.
Fall in market price – a sudden fall in the market price of
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the asset reduces its value even if it remains brand new.
2.1.3.3 Need For Depreciation Accounting
The need for depreciation accounting arises on three grounds:
(i)
To calculate proper profit: according to matching concept
of accounting, profit of any year can be calculated only when all costs of
earning revenues have been properly charged against them. Asset is an
important tool in earning revenues. The fall in the book value of assets
reflects the cost of earning revenues from the use of assets in the current
year and hence like other costs like wages, salary, etc., it must also be
provided for proper matching of revenues with expenses.
(ii) To show true financial position: the second ground for
providing depreciation is that it should result in carrying forward only
that part of asset which represents the unexpired cost of expected future
service. If the depreciation is not provided then the asset will appear in the
balance sheet at the overstated value.
(iii) To make provision for replacement of assets: if no changes
were made for depreciation, profits of the concern would be more to that
extent. By making an annual charge for depreciation, a concern would
be accumulating resources enough to enable it to replace an asset when
necessary. Replacement, thus, does not disturb the financial position of
the concern.
2.1.3.4 Methods Of Depreciation
The amount of depreciation of a fixed asset is determined taking
into account the following three factors: its original cost, its recoverable
cost at the time it is retired from service and the length of its life. Out of
these three factors the only factor which is accurately known is the original
cost of the asset. The other two factors cannot be accurately determined
until the asset is retired. They must be estimated at the time the asset is
placed in service. The excess of cost over the estimated residual value
is the amount that is to be recorded as depreciation expense during the
assets’ life-time. There are no hard and fast rules for estimating either the
period of usefulness of an asset or its residual value at the end of such
period. Hence these two factors, which are inter-related are affected to a
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considerable extent by management policies.
Let the reader consider the following example: a machine is
purchased for rs.1,00,000 with an estimated life of five years and estimated
residual value of rs.10,000. The objective of depreciation accounting is
to charge this net cost of rs.90,000 (original cost – residual value) as an
expense over the 5 year period. How much should be charged as an expense
each year? To give an answer to this question a 100 number of methods of
depreciation are available. In this lesson three such methods viz.
1.Straight line method,
2.Diminishing balance method and
3.Annuity method are discussed.
2.1.3.5 Straight Line Method Of Depreciation
This method which is also known as ‘fixed installment system’,
provides for equal amount of depreciation every year. Under this method,
the cost of acquisition plus the installation charges, minus the scrap value,
is spread over the estimated life of the asset to arrive at the annual charge.
In other words, this method writes off a fixed percentage, say 20%, of the
original cost of the asset every year in such a way that the asset is reduced
to nil or scrap value at the end of its life.
Evaluation:
The chief merit of this method is that it is easy to calculate
depreciation, and hence, it is simple. Depreciation charge is constant from
year to year, regardless of the extent of use of the asset. This method can be
employed in the case of assets like furniture and fixtures, short leases, etc.,
which involve little capital outlay, or which have no residual value. This
method is criticized on the ground that the depreciation charge remaining
the same every year, cost of repairs and maintenance would be increasing
as the asset becomes older. With the efficiency of the asset declining, it is
unfair to charge the same amount of depreciation every year.
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2.1.3.6 Diminishing Balance Method
This method which is also known as the, `reducing installment
system’, or `written down value method’, applies depreciation as a fixed
percentage to the balance of the net cost of the asset not yet allocated at
the end of the previous accounting period. The percentage of depreciation
is so fixed that, theoretically, the balance of the unallocated cost at the end
of the estimated useful life of the asset should be equal to the estimated
residual value.
Evaluation:
Unlike the fixed installment system, depreciation under this
method is not fixed, but gradually decreasing. As such, in the initial
periods, the amount will be much higher, but negligible in the later period
of the asset. Thus, this method tends to offset the amount of depreciation
on the one hand and repairs and maintenance on the other. This method is
also simple, although the calculation of depreciation is a bit complicated.
Further, as and when additions are made to the asset, fresh calculations do
not become necessary. This method is best suited to assets such as plant
and machinery which have a long life.
Entries Required:
The entry to be made on writing off depreciation under any method
is:
Depreciation a/c ….. Dr
To
asset
a/c
The depreciation account goes to the debit of the profit and loss account.
The entry for this is:
Profit and loss a/c … dr
To depreciation a/c
The asset appears at its reduced value in the balance sheet.
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Illustration 1:
On 1-1-2003, machinery was purchased for rs.3,00,000. Depreciation
at the rate of 10% has to be written off. Write up the machinery account for
three years under:
1. Straight line method (SLM) and
2. Written down value method (WDV)
Solution:
Machinery Account
Date Particulars
SLM
WDV
Date Particulars
SLM
WDV
1-1-
To Bank
3,00,000
3,00,000 31-12-
By
30,000 30,000
2003
A/C
2003
Depreciation 2,70,000 2,70,000
----------
---------- 31-12- By Balance --------- ----------
3,00,000
3,00,000
2003
C/D
3,00,000 3,00,000
----------
----------
--------- ----------
1-1-
To Balance 2,70,000
2,70,000
30,000 27,000
2004
B/D
31-12-
By
2,40,000 2,43,000
----------
----------
2004
Depreciation --------- ----------
2,70,000
2,70,000 31-12- By Balance 2,70,000 2,70,000
----------
----------
2004
C/D
--------- ----------
1-1-
To Balance 2,40,000
2,43,000
30,000 24,300
2005
B/D
2,10,000 2,18,700
----------
---------- 31-12-
By
--------- ----------
2,40,000
2,43,000
2005
Depreciation 2,40,000 2,43,000
----------
---------- 31-12- By Balance --------- ----------
2005
C/D
1-1-
To Balance 2,10,000
2,18,700
2006
B/D
From the above illustration it can be seen that under SLM method
each year depreciation is calculated at 10% on original cost of asset i.e. On
rs.3,00,000, while under WDV method each year depreciation is calculated
at 10% on the written down value i.e. For e.g. In the 2nd year depreciation
is calculated at 10% on rs.2,70,000 and so on.
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Illustration 2:
On 1-1-2002, machinery was purchased for rs.30,000. Depreciation
at the rate of 10% on original cost was written off during the first two years.
For the next two years 15% was written off the diminishing balance of the
amount. The machinery was sold for rs.15,000. Write up the machinery
account for four years and close the same.
Machinery Account
Date
Particulars
SLM
Date
Particulars
SLM
1-1-2002
To Bank
30,000
31-12-
By
3,000
A/C
2002
Depreciation 27,000
----------
31-12-
By Balance ----------
30,000
2002
C/D
30,000
----------
----------
1-1-2003 To Balance
27,000
3,000
B/D
31-12-
By
24,000
----------
2003
Depreciation ----------
27,000
31-12-
By Balance
27,000
----------
2003
C/D
----------
1-1-2004 To Balance 24,000
3,600
B/D
31-12-
By
2,0,400
----------
2004
Depreciation ----------
2,40,000
31-12-
(15% On
24,000
----------
2004
24,000)
----------
20,400
By Balance
3,060
1-1-2005 To Balance
C/D
B/D
15,000
-------
31.122005
2,340
20,400
By
---------
31.12.2005 Depreciation 20,400
31.12.2005
(15% On
20,400)
By Bank
(Sale)
By Profit &
Loss A/C
(Loss On
Sale)
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Illustration 3:
A company, whose accounting year is the calendar year, purchased
a machinery on 1-1-2003 for rs.40,000. It purchased further machinery on
1-10-2003 for rs.20,000 and on 1st july 2005 for rs.10,000. On 1-7-2006,
one-fourth of the machinery installed on 1-1-2003 became obsolete and
was sold for rs.6,800. Show the machinery account for all the 3 years under
fixed installment system. Depreciation is to be provided at 10%p.a.
Machinery Account
Date
Particulars Rupees
Date
Particulars
Rupees
2003
2003
Jan 1
To Bank- 40,000 Dec 31
By Depreciation
Oct 10 Purchase 20,000
-On Rs.40000 For 1
4,000
To Bank-
Year
500
Purchase
Dec 31
-On Rs.20000 For 3
55,500
--------
Month
--------
60,000
60,000
--------
By Balance C/D
--------
2004
2004
Jan 1 To Balance 55,500 Dec 31
B/D
4,000
July 1 To Bank-
2,000
Purchase 10,000
By Depreciation
500
Dec 31
-On Rs.40000 For 1
59,000
--------
Year
--------
65,500
-On Rs.20000 For 1
65,500
--------
Year
--------
-On Rs.10000 For 6
Month
2005
By Balance C/D
59,000
July 1
500
July 1
6,800
July 1
700
2005 To Balance
Jan 1
B/D
Dec 31
By Depreciation
3,000
On Machine Sold
2,000
By Bank-Sale
1,000
By P&L A/C (Loss On
45,000
--------
Sale)
--------
59,000
By Depreciation
59,000
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-On Rs.30000 For 1 Year
-On Rs.20000 For 1 Year
-On Rs.10000 For 1 Year
By Balance C/D
Working Notes – Loss On Sale Of Machinery
Original cost of machinery on 1-1-2003:
= 10,000
Less depreciation for 2003 at 10% 1,000 (4000 x ¼)
= 1,000
--------