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12.13 References/suggested readings
12.0 OBJECTIVES
After going through this lesson, you should be able to- ∑ Know the meaning, need and causes of depreciation. ∑ Know the different methods of charging depreciation. ∑ Understand the accounting treatment of charging depreciation.
12.1 INTRODUCTION
The term depreciation refers to the reduction in or loss of quality or value of a fixed asset through wear or tear in or tear, in use, effusion of time, obsolescence through technology and market changes or from any other cause. Depreciation take place in case of all fixed assets with certain possible exceptions e.g. land and antiques etc, although the process may be invisible or gradual. Depreciation does take place irrespective of regular repairs and proper maintenance of assets. The word ‘depreciation’ is closely related to the concept of business income. Unless it is charged against revenues, we cannot say that the business income has been ascertained properly. This is because of the fact that the use of long term assets tend to consume their economic value and at some point of time these assets become useless. The economic value so consumed must be recovered from the revenue of the firm to have a proper measure of its income. Hence, the reader’s must understand that the process of charging depreciation is the technique used by accountants for recovering the cost of fixed assets over a period.
The following definition will make the understanding of the concept of depreciation more convenient to the learner’s. According to IAS-4, “Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life,”
According to AS-6, “depreciation is a measure of wearing out, consumption or other of value of a depreciable asset arising from use, effusion of time or obsolescence through technology and market changes. 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 assets. Depreciation includes amortisation of assets whose useful life is pre determined.”
The American Institute of Certified Public Accountants (AICPA) employed the definition as given below
“Depreciation Accounting is a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage value (if any) over the estimated useful life of unit (which may be a group of assets) in a systematic and retional manner. It a process of allocation, not of valuation. Depreciation for the year is the portion of the total charge under such a system that is allocated to the year.”
From the above definitions it is clear that each accounting period must be charged with a fair proportion of the depreciable amount of the asset, during the expected useful life of the asset. Depreciable amount of an asset is its historical cost less the estimated residual value. Finally, it could be concluded that depreciation is a gradual reduction in the economic value of an asset from any cause.
Depreciation, Depletion and Amortisation : The terms depreciation, depletion and amortisation are used often interchangeably. However, these different terms have been developed in accounting usage for describing this process for different types of assets. These terms have been described as follows:
Depreciation: Depreciation is concerned with charging the cost of man made fixed assets to operation (and not with determination of asset
etc. The term “amortisation” is generally used to indicate the reduction in the value of such assets.
3. Depletion : Depletion also causes decline in the value of certain assets. This is true in case of wasting assets such as mines, oil wells and forest-stands. On account of continuous extraction of minerals or oils, these assets go on declining in their value and finally they gets completely exhausted. 4. Obsolescence : There may not be any physical deterioration in the asset itself. Despite of this there may be reduction in the utility of an asset that results from the development of a better method, machine or process. For example, an old machine which is still in good working condition may have to be replaced by a new machine because of the later being more economical as well as efficient. In fact, new inventions, developments in production processes, changes in demand for product or services, etc. make the asset out of date. 5. Accidents : An asset may get reduction in its value if it meets an accident. 6. Permanent Fall in the Market Value : Certain assets may get permanent fall in their value and this decline in their value is treated as depreciation. For example, a permanent decline in the market value of securities and investment may be assumed as depreciation
12.3 NEED FOR PROVIDING DEPRECIATION
The need for providing depreciation arises on account of the following points:
1. To Ascertain the Profits or Losses : The true profits or losses could be ascertained when all costs of earning revenues have been properly charged against them. Fixed assets like building, plant and machinery, furniture, motor vehicles etc are important tool in earning business income. But the cost of the fixed asset is not charged to profit and loss of the accounting period in which the asset is purchased. Therefore, the cost of the fixed asset less its salvage value must be allocated rationally to the periods that receive benefit from the use of the asset. Thus, depreciation is an item of business expense and must be provided for a proper matching of costs with the revenue. 2. To show the Asset as its Reasonable Value : The assets get decrease in their value over a period of time on account of various such as passage of time, constant use, accidents, etc. Therefore, if the depreciation is not charged then the asset will appear in the balance sheet at the over stated value. This practice is unfair as the balance sheet fail to present the true financial position. 3. Replacement of assets : Business assets become useless at the expiry of their life and, therefore, need replacement. The cash resources of the concern are saved from being distributed by way of dividend by providing for depreciation. The resources so saved, if set aside in each year, may be adequate to replace it at the end of life of the asset. 4. To Reduce Income Tax : If tax is paid on the business income without providing for depreciation then it will be in excess to the actual income tax. This is a loss to the business
3. Scrap Value of the Asset : The salvage value of the asset is that value which is estimated to be realised on account of the sale of the asset at the end of its useful life. This value should be calculated after deducting the disposal costs from the sale value of the asset. If the scrap value is considered as insignificant, it is normally regarded as nil
12.5 METHODS OF RECORDING DEPRECIATION
There are two methods of recording depreciation in the books of accounts:
12.5.1 When a provision for depreciation account is maintained
The following journal entries are passed in case method is followed:
i) Depreciation account Dr. To provision for Depreciation Account (for providing depreciation) ii) Profit and loss Account Dr. To Depreciation account (for closing depreciation account) iii) Provision for Depreciation account Dr. To Asset Account (entry on sale of an asset) iv) Any amount realised on account of sale of the asset is credited to the Asset Account. The balance, if any, in the Asset Account is transferred to the profit and loss Account.
12.5.2 When a provision for depreciation account is not
maintained
The following journal entries are passed in this method:
i) Depreciation account Dr. To Asset Account (Entry for providing depreciation) ii) Profit and loss Account Dr. To Depreciation Account (Entry for closing Depreciation Account) iii) In case the asset is sold, the amount realised is credited to the Asset Amount. Any profit or loss on sale of the asset is transferred to the Profit and loss account.
12.6 METHODS OF CALCULATING DEPRECIATION
The following are various methods of depreciation in use:
- Fixed instalment method or straight line method.
- Machine hour rate method.
- Diministing Balance method.
- Sum of years digits method
- Annuity method
- Depreciation Fund Method
- Insurance Policy Method
- Depletion Method.
12.6.1 Straight Line Method
This is also known as fixed instalment method. Under this method the depreciation is charged on the uniform basis year after year. When the amount of depreciation charged yearly under this method is plotted on a graph paper, we shall get a straight line. Thus, the straight line method assumes that depreciations is a function, of time rather than use in the sense that each accounting period received the same benefit from using the asset as every other period. The formula for calculating depreciation charge for each accounting period is:
Date Particulars Rs. Date Particulars Rs. 1990 To Bank 22000 Dec. 31 By Depreciation 4000 Jan. 1 To Bank 2000 “ By Balance C/d 21000 To Bank 1000 25000 25000 1991 To Balance b/d 21000 1991 By Depreciation 4000 Jan.1 Dec.31 Balance c/d 17000 21000 21000 1992 To Balance/b/c 17000 1992 By Depreciation 4000 Jan.1 Dec. 31 By Balance c/d 13000 17000 17000 1993 To Balance b/c 13000 1993 By Depreciation 4000 Jan.1 Dec.31 By Balance 9000 13000 13000 1994 To Balance b/d 9000 1994 By Depreciation 4000 Jan.1 Dec.31 By Balance c/d 5000 9000 9000
This method is very suitable particularly in case of those assets which get depreciated more on account of expire of period e.g. lease hold properties, patents, etc.
12.6.2 Machine Hour Rate Method
In case of this method, the running time of the asset is taken into account for the purpose of calculating the amount of depreciation. It is suitable for charging depreciation on plant and machinery, air-crafts, gliders, etc. The amount of depreciation is calculated as follows:
= AcquisitioLifencostoftheoftheAssetassetsinhours–Scrapvalue
For example, if machinery has been purchased for Rs. 20000 and it will have a scrap value of Rs. 1000 at the end of its useful life of 1900 hours, the amount of depreciation per hour will be computed as follows:
Depreciation = AcquisitioLifencostoftheoftheAssetassetsinhours–Scrapvalue
= Rs. 1900 20,000hours–1, = Rs. 10 per hour
If in a particular year, the machine runs for 490 hours, the amount of depreciation will be Rs. 4900 (i.e., Rs. 10x490). It is obvious from this example that under machine hour rate method the amount of depreciation is closely related with the frequency of use of an asset. The simplicity in calculations and under standing is the main advantage of this methods. However, it can be used only in case of those assets whose life can be measured in terms of working time.
12.6.3 Diministing Balance Method
This is also known as Written down value method [WDV]. Under the diminishing balance method depreciation is charged at fixed rate on the reducing balance (i.e., cost less depreciation) every year. Thus, the amount of depreciation goes on decreasing every year. Under this method also the amount of depreciation is transferred to profit and loss account in each of the year and in the balance sheet the asset is shown at book value after reducing depreciation from it. For example, if an asset is purchased for Rs. 10,000 and depreciation is to be charged at 20% p.a. on reducing balance system then the depreciation for the first year will be Rs. 2000. In the second year, it will Rs. 1600 (i.e. 20% of 8000), in the third year Rs. 1280 (i.e. 20% of 6400) and so on. The rate of depreciation under this method can be computed by using the following formula:
Suitability
This method is suitable in those cases where the receipts are expected to decline as the asset gets older and, it is believed that the allocation of depreciation of depreciation ought to be related to the pattern of assets expected receipts.
Illustration 2 : A company purchases Machinery on 1st^ April 1990 for Rs. 20,000. Prepare the machinery account for three years charging depreciation @ 25% p.a. according to the written Down value Method.
MACHINERY ACCOUNT Date Particulars Rs. Date Particulars Rs. 1990 To Bank 20000 1991 By Depreciation 5000 Apr. 1 Mar. 31 By Balance C/d 15000 20000 20000 1991 To Balance b/d 15000 1992 By Depreciation 3750 Apr.1 Mar.31 By Balance c/d 11250 15000 15000 1992 To Balance b/d 11250 1993 By Depreciation 2812. Apr 1 Mar.31 By Balance c/d 8437. 11250 11250
12.6.4 Sum of Years digits (SYD) Method
Under this method also the amount of depreciation goes on diministing in the future years similar to that under diministing Balance method.
For calculating the amount of depreciation to be charged to the profit and loss account this method takes into account cost, scrape value, and life of the asset. The following formula is used for determining depreciation:
= RemainingSumofthe^ lifedigitsoftherepresentiAssetsatngthetheendlifeofofthetheyearasset+^1 ¥AcquisitionCost
For example, an asset having an effective life of 5 years is purchased at a cost of Rs. 20,000. It is estimated that its scrap value at the end of its effective life will be Rs. 2000. The depreciation on this asset, if SYD method is followed, will be calculated as follows from one to five years: Year Depreciation Amount 1 = 155 × 18000 = Rs. 6000 2 = 154 × 18000 = Rs. 4800 3 = 15
(^3) × 18000 = Rs. 3600
4 = 152 × 18000 = Rs. 2400 5 = 151 × 18000 = Rs. 1200
12.6.5 Annuity Method
Sofar we have described such methods of charging depreciation which ignore the interest factor. Also, some times it becomes inconvenient for a company to follow any of the methods discussed earlier. Under such circumstances the company may use some special depreciation systems. Annuity method is one of these special systems of depreciation. Under this system, the depreciation is charged on the basis that besides losing the acquisition cost of the asset the business also loses interest on the amount used for purchasing the asset. Here, interest refers to that income which the business would have earned otherwise if the money used in buying the asset would have been committed in some other profitable investment. Therefore, under the annuity method the amount of total depreciation is determined by adding the cost and interest thereon at an expected rate. The annuity table is used to help in the determination of the amount of depreciation. A specimen of Annuity Table is as follows:
Demerits
(i) This method is comparatively more difficult than the methods discussed so far. (ii) It makes no arrangement of money to replace the old asset with the new one at the expiry of its life. (iii) Under this method the burden on the profit and loss account is no similar in each year because the depreciation remains constant year after year but the interest goes on decreasing. Illustration : On 1st^ January, 1990 a firm purchased a leasehold property for 4 year at a cost of Rs. 24000. It decides to depreciate the lease by Annuity Method by charging interest at 5% per annum. The Annuity Table shows that the annual necessary to write off Rs. 1 at 5% Rs. 0.282012. You are required to prepare the lease Hold Property Account for four years and show the net amount to be charged to the profit and loss account for these four years.
LEASE HOLD PROPERTY ACCOUNT Date Particulars Rs. Date Particulars Rs. 1990 To Bank 24000.00 1990 By Depreciation 6768. Jan. 1 Dec. 31 To interest 1200.00 Dec.31 By balance c/d 18431. 25200.00 25200. 1991 To balance b/d 18431.71 1991 By Depreciation 6768. Jan.1 Dec. Dec.31 To Interest 921.59 Dec.31 By Balance c/d 12585. 19353.30 19353. 1992 To balance b/d 12585.01 1992 By Depreciation 6768. Jan.1 Dec. Dec. 31 To Interest 629.25 Dec.31 By Balance c/d 6445. 13214.26 13214. 1993 To balance b/d 6445.97 1993 By Depreciation 6768. Jan.1 Dec.31 By Balance c/d 9000 Dec.31 To Interest 322.30 13000 6768.27 6768.
NET AMOUNT CHARGEABLE TO THE PROFIT AND LOSS ACCOUNT
Year Depreciation debited Interest Credited Net Charge against Profit 1990 6768.29 1200.00 5568. 1991 6768.29 921.59 5846. 1992 6768.29 629.25 6139. 1993 6768.29 322.30 6445. Rs. 27073.16 3073.14 24000.
12.6.6 Depreciation Fund Method
Business assets become useless at the expiry of their life and therefore, need replacement. However, all the methods of depreciation discussed above do not help in accumulating the amount which can be readily available for the replacement of the asset its useful life comes to an end Depreciation fund method takes care of such a contingency as it incorporates the benefits of depreciating the asset as well as accumulating the necessary amount for its replacement. Under this method, the amount of depreciation charged from the profit and loss account is invested in certain securities carrying a particular rate of interest. The interest received on the investment in such securities is also invested every year together with the amount of annual depreciation. In the last of the life of asset the depreciation amount is set aside interest is received as usual. But the amount is not invested because the amount is immediately needed for the purchase of new asset. Rather all the investments so far accumulated are sold away. Cash realised on the sale of investments is utilised for the purchase of new asset. The following accounting entries are generally made in order to work out this system of depreciation.
1. At the end of the first year
(i) for setting aside the amount of depreciation: The amount to be charge by way of depreciation is determined on the basis
Note : In the last year no investment will be made, because the amount is immediately required for the purchase of new asset. (iii) For the sale of investment: Bank A/c Dr. To Depreciation Fund Investment A/c (iv) For the transfer of profit or loss on sale on investments: The profit or loss on the sale of these investments is transferred to the Depreciation Fund Account. The entry for loss: Depreciation Fund A/c Dr. To Depreciation Fund Investment A/c The entry for profit Depreciation Fund Investment A/c To Depreciation Fund A/c (v) For the sale of old asset: Bank A/c Dr. To asset A/c (vi) The depreciation fund is transferred to asset account and any balance left in the asset account is transferred to profit and loss account. The entry is: Depreciation Fund A/c. Dr. To asset A/c (vii) The balance in Asset Account represents profit or loss. Therefore it will be transferred to the profit and loss account. (viii) The cash realised on the sale of investments and the old asset is utilised for the purchase of new asset.
Illustration : Amitabh Company Ltd. purchased 4 year lease on January , 1990 for Rs. 60,000. The company decided to charge depreciation according to depreciation fund method. It is expected that investments will earn interest @5% p.a. Sinking Fund Table shows that Rs. 0.232012 invested each year will produce Rs. 1 at the ent of 4 years
at 5% p.a. At the expiry of lease , the Depreciation Fund Investments were sold for Rs. 45200. A new lease is purchased for Rs. ................ on 1.1.1994. Show the journal entries and prepare the necessary accounts in the book the company.
JOURNAL Date Particulars Debit Credit 1.1.1990 Lease A/c Dr. 60, To Bank A/c 60, (Being the purchase of lease) 31.12.90 Depreciation A/c Dr. 13920. To Depreciation Fund A/c 13920. (Being annual amount of depreciation as per sinking fund tables) 31.12.90 Depreciation Fund Investment A/c Dr. 13920. To Bank A/c 13920. (Being purchase of the investments against the depreciation fund) 31.12.91 Bank A/c Dr. 696. To depreciation fund A/c 696. (Being the receipt of interest on depreciation fund investment A/c transfer to depreciation fund A/c 31.12.91 Depreciation A/c Dr. 13920. To Depreciation Fund A/c 13920. (Being annual depreciation set-aside) 31.12.91 Depreciation Fund Investment A/c Dr. 14616. To Bank A/c 14616. (Being purchase of the investments against the depreciation fund) 31.12.92 Bank Account Dr. 1426. To depreciation fund A/c 1426. Being receipt of interest and its transfer to depreciation fund A/c)
