DEPRECIATION

• Value of Fixed Assets decreases with passage of time and its utilisation. Value of the portion of asset utilised for generating revenue must be recovered during that accounting year to ascertain real income. Portion of the cost of a fixed asset allocated to a particular accounting year is called Depreciation and is charged to Profit and Loss Account

DEPRECIATION

• According to American Institute of Certified Public Accountants (AICPA) ‘ 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 the unit (which ,may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation. Depreciation for the year is portion of the total charge under such a system that is allocated to the year’

Characteristics of DepreciationCharacteristics of Depreciation

• Related to fixed assets only

• Fall in the book value of asset

• Permanent decrease in the book value of an asset

• Continuous decrease in the book value of an asset

CAUSES OF DEPRECIATIONCAUSES OF DEPRECIATION

• Physical wear and tear

• With the passage of time

• Changes in economic environment

• Expiration of legal rights

NEED FOR PROVIDING DEPRECIATION

• To ascertain true results of operations• To present true and fair view of the financial position• To ascertain the true cost of production• To comply with legal requirements• To accumulate funds for replacement of assets

FACTORS DETERMINING THE AMOUNT FACTORS DETERMINING THE AMOUNT OF DEPRECIATIONOF DEPRECIATION

• Historical Cost

• Expected useful life

• Estimated residual value

Methods of Allocating DepreciationMethods of Allocating Depreciation

• Straight Line Method

• Written Down Value Method

‘‘Straight Line Method’ of Straight Line Method’ of DepreciationDepreciation• A fixed and equal amount in the form of

depreciation, according to a fixed percentage on the original cost, is written-off during each accounting period over the expected useful life of the asset.

• Amount of Dep. = Original Cost – Residual Value

Expected Useful Life of the Asset • Rate of Dep. = Amount of Depreciation x 100 Original Cost

Illustration 1:Illustration 1:

On 1st Jan., 2003, X Ltd. Purchased a second – hand machine for Rs.52,000/- and spent Rs. 3,000/- as shipping charges, Rs.5,000/- as import duty and Rs.2,000/- as installation charges. It was estimated that machine will have a scrap value of Rs.2,000/- at the end of its useful life which is 10 years. On 30th Sep., 2003 repairs amounted to Rs.2,000/- . On 1st July, 2005 this machine was sold for Rs.30,600/-. Prepare Machinery A/c for the first three years.

‘‘Written Down Value Method’ of Written Down Value Method’ of DepreciationDepreciation• Depreciation according to a fixed

percentage calculated upon the original cost (in the first year) and written down value (in subsequent years) of an asset, is written off during each accounting period over the expected useful life of the asset.

• The rate of depreciation remains constant year after year whereas the amount of depreciation goes on decreasing

Illustration 2:Illustration 2:

On 1st Jan., 2003, X Ltd. Purchased a second – hand machine for Rs.58,000/- and spent Rs. 2,000/- on its erection. On 1st July, 2005 this machine was sold for Rs.28,600/-. Prepare Machinery A/c for the first three years according to the Written Down Value taking the depreciation rate at 10% p.a.

Change in the Method of DepreciationChange in the Method of Depreciation

According to revised AS-6 issued by ICAI, the depreciation method selected should be applied consistently, to provide comparability of results of the operations of the enterprise from period to period. A change from one method of providing depreciation to another should be made only if, the adoption of the new method is required by statute or for compliance with an Accounting Standard or, if it is considered that a change would result in more appropriate preparation of the financial statements of the enterprise. When such change of method of depreciation is made, depreciation should be recalculated in accordance with the new method from the date of the asset coming into use.

Change in method of Depreciation with Change in method of Depreciation with Retrospective EffectRetrospective Effect

1. Calculate the aggregate Depreciation already provided on existing assets (i.e. other than sold or discarded) under the existing method up to the end of previous accounting year.

2. Calculate the aggregate depreciation on the existing assets retrospectively from the date of the asset coming into use under the new method up to the end of previous accounting year.

3. Calculate the difference between the existing method (1) and the new method (2)

4. Adjust the short depreciation (excess of step 2 over step 1) by Dr. P&L A/c and Cr. Asset A/c

OR Adjust the excess depreciation (excess of step 1 over step 2) by

Dr. Asset A/c and Cr. P&L A/c5. Charge depreciation from the current accounting year and

onwards by adopting new method.

Illustration 3: Change in the method of Depreciation

ABC Ltd. Purchased on 1st January,2001 second-hand plant for Rs.30,000 and immediately spent Rs.20,000 in overhauling it. On 1stJuly,2001 additional machinery of a cost of Rs.25,000 was purchased. On 1st July,2003, the plant purchased on 1st Jan.,2001became obsolete and was sold for Rs.10,000. On that date new machinery was purchased at a cost of Rs.60,000Depreciation was provided for annually on 31st December, at 10% p.a. on the original cost of the asset. In 2004, however, the company changed this method of providing for depreciation and adopted the method of writing off 15% on the diminishing value.Show the Plant & Machinery Account as it would appear in the books of the company for the years 2001 – 2005.

Illustration 4:On 1st January 2001, X Ltd. purchased a machine for Rs.58,000 and spent Rs.2,000 on its erection. On 1st July 2001, an additional machinery costing Rs.20,000 was purchased. On 1st July 2003, the machine purchased on 1.1.2001 was sold for Rs.28,600 and on the same date a new machine was purchased at a cost of Rs.40,000. Depreciation was provided for annually on 31st December, at the rate of 10% p.a. on the written down value of the machinery. In 2004 company decided to change the method of depreciation from written down value to straight line method @ 5% with effect from 1st January 2001.Prepare the Machinery Account for the first four calendar years.

When a Provision for Depreciation is When a Provision for Depreciation is maintainedmaintained

In order to record depreciation, a provision for depreciation may or may not be maintained. In case a ‘Provision for Depreciation Account’ is maintained, the respective asset appears at its original cost since the depreciation is credited to ‘Provision for Depreciation Account’ instead of the asset A/c.

Journal Entries when Provision for Journal Entries when Provision for Depreciation is maintainedDepreciation is maintained1 For Providing Depreciation Depreciation A/c Dr.

To Provision for Depreciation A/c

2 For closure of Depreciation A/c

Profit & Loss A/c Dr.

To Depreciation A/c

3 On disposal of an asset

(i) For transfer of original cost of asset disposed off

Asset Disposal A/c Dr.

To Asset A/c

(ii) For transfer of accumulated depreciation on asset disposed off

Provision for Depreciation A/c Dr.

To Asset Disposal A/c

(iii) For recording sale proceeds

Bank A/c Dr.

To Asset Disposal A/c

(Iv) For transfer of balance in Asset Disposal A/c

(a) In case of Profit Asset Disposal A/c Dr.

To Profit & Loss A/c

(b) In case of Loss Profit & Loss A/c Dr.

To Asset Disposal A/c

Illustration 5:Illustration 5:

On 1st Jan.,2005 , X Ltd. Purchased a machinery for Rs.12,00,000/-. On 1st July, 2007, a part of the machinery purchased on 1st Jan., 2005 for Rs.80,000/- was sold for Rs.45,000/- and a new machinery at a cost of Rs.1,58,000/- was purchased and installed on the same date. The company has adopted the method of providing 10% depreciation on the original cost of the machinery.

Show the necessary ledger accounts assuming that :(a) Provision for Depreciation A/c is not maintained, (b) Provision for Depreciation Account is maintained.

Date Particulars Rs. Date Particulars Rs.

2001

Jan.1

July 1

To Bank A/c

To Bank A/c

To Bank A/c

58,000

2,000

20,000

80,000

2001

Dec.31 By Depreciation A/c

By Balance c/d

7,000

73,000

80,000

2002

Jan 1

To Balance b/d 73,000

73,000

2002

Dec.31

By Depreciation A/c

By Balance c/d

7,300

65,700

73,000

2003

Jan.1

July 1

To Balance b/d

To Bank A/c

65,700

40,000

1,05,700

2003

July 1

July 1

July 1

Dec. 31

Dec. 31

By Bank A/c

By Depreciation A/c

By P & L A/c

By Depreciation A/c

By Balance c/d

28,600

2,430

17,570

3,710

53,390

1,05,700

Solution : (Illustration 4)Dr. Machinery A/c Cr.

2004

Jan.1

Dec. 31

To Balance b/d

To P & L A/c

(Dep. Written back on account of change from WDV to SLM)

53,390

3,110

56,500

2004

Dec.31

Dec.31

By Depreciation A/c

By Balance c/d

3,000

53,500

56,500