Financial Accounting - Accounting for Depreciation (Foundation Level)

 

Financial Accounting

Accounting for Depreciation

(Foundation Level)

 

Part A: Discussion of basic theories, formulas, tables and journal entries pertaining to different methods of computation of depreciation and different methods of accounting for depreciation

Part B: Five Illustrations with Solutions

Part A

Introduction

As per AS – 10,

(a)           Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.

(b)           Depreciable amount is the cost of an asset, or other amount substituted for cost, less its residual value.

(c)           Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction or, where applicable, the amount attributed to that asset when initially recognised in accordance with the specific requirements of other Accounting Standards.

(d)           The residual value of an asset is the estimated amount that an enterprise would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.

(e)           Useful life is:

(1)       The period over which an asset is expected to be available for use by an enterprise; or

(2)       The number of production or similar units expected to be obtained from the asset by an enterprise.

 

Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion 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 asset. Depreciation includes amortisation of assets whose useful life is predetermined.

 

Depreciation can also be defined as the amount of reduction in value of a fixed asset over a period of accounting year, the amount of reduction being charged to profit and loss account to arrive at profit or loss of the same period of time. Value of a fixed asset may be reduced due to the following reasons:

1.             Wear and tear in the asset due to its use.

2.             Elapse of time.

3.             Availability of a better product of the similar type in the market.

4.             Technological advancements and innovations.

 

Another way to define depreciation is from the point of view of matching concept of accounting. In this case, depreciation may be defined as a systematic and rational process of distributing the cost of acquisition of a tangible asset over the economic life of the asset.

 

Depreciation may also be defined from the point of view of financial prudence in arranging necessary fund to replace an existing asset. In this case, an equal amount of depreciation is charged to profit and loss account every year and an amount equal to the same is invested every year in the outside securities in such a way that at the time of replacement of the existing asset by a new one, necessary fund is readily available.

 

Methods of computing depreciation

The following are the important methods of computing depreciation:

1.             Straight line method (also known as fixed instalment method or equal instalment method).

2.             Reducing balance method (also known as written-down-value method or declining balance method or diminishing balance method).

3.             Sum-of-years’-digits method.

4.             Annuity method.

5.             Sinking fund method.

6.             Machine hour rate method.

7.             Production unit method.

8.             Depletion method.

 

Straight line method

Under this method, an equal amount of depreciation is charged every year to profit and loss account. This equal amount can be calculated in two ways:

(a)     If depreciation percentage is given, the amount of depreciation of an asset to be charged to profit and loss account every year will be calculated at the same percentage of the original cost of the asset (i.e. the cost of acquisition of the asset). In this case, cost of acquisition includes the purchase price of the asset and all other relevant and necessary expenses required to be incurred before the asset is ready to be used or becomes operational. In other words,

Cost of Acquisition =

Purchase Price + Import Duty (when the asset is imported) + Transportation Expenses + Installation and Erection Expenses.

 

(b)     If the depreciation percentage is not given, amount of depreciation of an asset to be charged to profit and loss account every year will be calculated by using the following formula:

 

D =	(C – S) ÷ N
Where,
D =	Amount of depreciation to be charged to P/L A/c every year
C =	Cost of acquisition of the asset (as calculated above)
S =	Scrap value or salvage value at the end of economic life of the asset (also called Residual Value)
N =	Number of years of economic life of the asset

    

Important note:

1.         If in any problem both of ‘depreciation percentage’ as well as ‘scrap value and economic life’ are given, yearly depreciation will be calculated using the formula as given in (b) above.

2.         Rate of depreciation (ROD) under SLM can be calculated as follows:

ROD =

(D ÷ C) × 100 %

 

Written-down-value method

Under this method, amount of depreciation of an asset charged to profit and loss account decreases every year, because depreciation of an asset for an accounting year is calculated at the given percentage on the book value of the asset at the beginning of the accounting year, and the book value of the asset at the end of the accounting year (which becomes book value of the asset at beginning of the next accounting year) is arrived at by deducting the amount of depreciation as calculated above from the book value of the asset at the beginning of the year.

 

Example:

A machine was purchased on 1.4.2016 at a cost of Rs 20 Lakh. Depreciation is charged @ 15% p.a. under diminishing balance method. Find out the book value of the machine as on 1.4.2020. If the machine is sold for Rs 10 Lakh on 30.9.2020, find out profit or loss made on such sale.

  Solution:

Particulars	Rs
Book value as on 1.4.2016	20,00,000
LESS: Depreciation for the year 2016 – 17 (15% on Rs 20,00,000)	3,00,000
Book value as on 1.4.2017	17,00,000
LESS: Depreciation for the year 2017 – 18 (15% on Rs 17,00,000)	2,55,000
Book value as on 1.4.2018	14,45,000
LESS: Depreciation for the year 2018 – 19 (15% on Rs 14,45,000)	2,16,750
Book value as on 1.4.2019	12,28,250
LESS: Depreciation for the year 2019 – 20 (15% on Rs 12,28,250)	1,84,238
Book value as on 1.4.2020	10,44,012
LESS: Depreciation for the period 1.4.2020 – 30.9.2020 [Rs 10,44,012 x 15% x ½]	78,301
Book value as on 30.9.2020 (the date of sale of the machine)	9,65,711
Sale proceeds of the machine	10,00,000
Profit on sale of the machine	34,289

 

GENERAL NOTES:

1.             Depreciation percentage may be given with or without the words “per annum”. But, in any case, where, during any financial year, any addition has been made to any asset, or any asset has been sold, discarded, demolished or destroyed, the depreciation on such assets shall be calculated on a pro rata basis from the date of such addition up to the end of the year or, as the case may be, up to the date on which such asset has been sold, discarded, demolished or destroyed from the beginning of the year. [As per Schedule II (Part C, Note 2) of the Companies Act, 2013]

2.             If the date of purchase of the asset or, as the case may be, the date on which the asset has been sold, discarded, demolished or destroyed is not given, the amount of depreciation on such asset will be calculated at the given percentage for a period of six months.

3.             Rate of depreciation (ROD) under WDV Method can be calculated as follows:

ROD =

[1 – (S ÷ C)^(1/n)] × 100 %

 

Difference between SLM and WDV Method

	SLM	WDV Method
1	Depreciation is calculated on the original cost of a fixed asset.	Depreciation is calculated on the diminishing balance or Written Down Value of a fixed asset.
2	The amount of depreciation remains the same in every year.	The amount of depreciation reduces year after year.
3	At the expiry of the economic life of the asset, the balance in the Asset Account may reduce to zero.	At the expiry of the economic life of the asset, the balance in the Asset Account will never reduce to zero.
4	Total cost of depreciation and repairs is lower in the initial years and higher in the later years.	Total cost of depreciation and repairs remains, more or less, equal in all the years of economic life of the asset.
5	This method is more suitable for assets which get depreciated on account of expiry of working life of the asset.	This method is suitable for those assets which require more and more repairs in the later years of their working lives.

 

Sum-of-years’-digits method

Under this method, the depreciation expense for each year with respect to an asset is calculated by multiplying the cost of the asset by a fraction based on the sum of the number of years of the useful economic life of the asset. The depreciation expense for each year, under this method, is computed as follows:

 

Depreciation of a year  =

(Cost – Salvage Value) × (Number of years of life remaining at the beginning of the year ÷ Sum of the years’ digits)

 

Annuity method

Under this method, net cost of acquisition of the asset is assumed to be a loan to be repaid in fixed periodical instalments (including interests on unpaid balances at a fixed rate of interest per cent per period) over a fixed period of time. These fixed periodical instalments (as assumed) are actually the equal amounts of depreciation per period over the fixed period of time. Therefore, under this method, the total amount of depreciation written off during the life of the asset equals the net cost of acquisition of the asset plus total of interests on unpaid balances. Under annuity method, therefore, depreciation expense for each year is computed as follows:

 

Depreciation     =	Net cost of acquisition of the asset ÷ PVIFAkn
Where,
PVIFAkn     =	Present value interest factor for an annuity of Rs 1 at interest rate ‘k’ for ‘n’ years.

 

Note: Here, Discount rate ‘k’ represents rate of depreciation and ‘n’ represents economic life of the asset.

 

Alternatively,

Depreciation =	[Net cost of acquisition of the asset x (r ÷ 100)] ÷ [1 – {1 + (r ÷ 100)} ^ (−n)]
Where,
r =	Rate of depreciation in percentage
n =	Economic life of the asset

 

Sinking fund method

Under this method, a fund is created by the regular investment of a fixed amount to accumulate to the amount of money required to replace an asset at a set date in the future. This method is based on concept of present value. The fund is created by debiting Depreciation Account and crediting Sinking Fund Account. Depreciation Account is ultimately transferred to Profit and Loss Account. An amount equal to the amount of depreciation plus interest received on previous year’s investment is invested every year outside the business in gilt-edged or other securities by debiting Sinking Fund Investment Account and crediting Bank Account. The investments are allowed to accumulate at compound interest so as to produce the required amount to replace the asset after a specified period of time. When interest on investments is received, Bank Account is debited and Interest on Sinking Fund Investment Account is credited. Later on, the interest on investment is transferred from Interest on Sinking Fund Investment Account to Sinking Fund Account.

 

The asset is shown in the Balance Sheet, every year, at its original value. Sinking Fund is shown on the liabilities side and Sinking Fund Investment is shown on the assets side of the Balance Sheet. At the end of the useful life of the asset, all the investments are sold away. The proceeds are utilised for purchasing the new asset. Profit or loss on sale of investment is transferred to the Sinking Fund Account. The Sinking Fund Account is closed by transferring the balance to the Asset Account. Finally, the Asset Account is closed by transferring the balance to the Profit and Loss Account.

 

The equal amount of depreciation to be debited to Profit and Loss Account every year can be determined by any of the following two methods:

 

Depreciation     =	Net amount required to replace the asset at a future date ÷ FVIFAkn
Where,
FVIFAkn     =	Future value interest factor for an annuity of Rs 1 at interest rate ‘k’ for ‘n’ years.

 

Note: Here, Interest rate ‘k’ represents rate of depreciation and ‘n’ represents economic life of the asset.

 

Alternatively,

Depreciation =	[Amount required to replace the asset x (r ÷ 100)] ÷ [{1 + (r ÷ 100)}^n – 1]
Where,
r =	Rate of depreciation in percentage
n =	Economic life of the asset

 

Machine hour rate method

Under this method, annual machine hours worked is compared with the total anticipated machine hours over the life of the machine. Under machine hour rate method, depreciation expense for each year is computed as follows:

 

Depreciation of a year             =	Depreciation per machine hour x Actual hours worked by the machine in the year
Depreciation per machine hour =	(C – S) ÷ N
C =	Cost of acquisition of the machine
S =	Scrap value or salvage value or residual value at the end of economic life of the asset
N =	Estimated effective life of the machine in terms of machine hours

 

Production unit method

Under this method, depreciation of the asset is determined by comparing the annual production with the estimated total production achievable by the asset over the life of the asset. The amount of depreciation expense for each year is computed as follows:

 

Depreciation of a year =	Depreciation per unit x Actual production of the year in units
Depreciation per unit   =	(C – S) ÷ N
C =	Cost of acquisition of the machine
S =	Scrap value or salvage value or residual value at the end of economic life of the asset
N =	Estimated total production achievable over the life of the machine in terms of units

 

Depletion method

This method is applied to wasting assets such as mines, quarries, and the like where the output for each year depends on the quantity extracted. Under this method, depreciation is calculated first by making an estimate in advance of the total quantity to be extracted over its life and then the cost of the asset is apportioned over the period of the asset in proportion to the rate of extraction.

 

For example, suppose a coal mine is acquired for Rs 10, 00,000 and it is estimated that 2, 50,000 tonnes of coal can be extracted over its life. Therefore, the rate of depreciation per tonne of coal is Rs (10, 00,000 ÷ 2, 50,000) = Rs 4. If 50,000 tonnes are extracted in a particular year, then the depreciation for that year will be = 50,000 x Rs 4 = Rs 2, 00,000.

 

Methods of accounting for depreciation

There are two methods of accounting for depreciation:

Method: I

[Without opening “Provision for Depreciation Account”]

Method: II

[With “Provision for Depreciation Account”]

 

Journal entries for Method: I

[Without opening “Provision for depreciation Account”]

Date	Particulars		L.F.	Debit (Rs)	Credit (Rs)
1	Depreciation A/c	Dr
	To Asset A/c
	(Depreciation charged for the current year)
2	Profit and loss A/c	Dr
	To Depreciation A/c
	(Depreciation transferred to P/L A/c)
3	Asset A/c	Dr
	To Cash/Bank A/c
	(Fixed asset purchased for cash)
4	Cash/Bank A/c	Dr
	To Asset A/c
	(Fixed asset sold) [Without opening Asset Disposal A/c]
5	Asset disposal A/c	Dr
	To Asset A/c
	(Fixed asset sold) [With Asset Disposal A/c – For the depreciated value of the asset on the date of sale]
6	Cash/Bank A/c	Dr
	To Asset disposal A/c
	(Sale proceeds of the asset received) [With Asset Disposal A/c]
7	Asset A/c	Dr
	To Profit and loss A/c
	(Profit on sale of fixed asset transferred to P/L A/c) [Without Asset Disposal A/c]
8	Asset disposal A/c	Dr
	To Profit and loss A/c
	(Profit on sale of fixed asset transferred to P/L A/c) [With Asset Disposal A/c]
9	Profit and loss A/c	Dr
	To Asset A/c
	(Loss on sale of fixed asset transferred to P/L A/c) [Without Asset Disposal A/c]
10	Profit and loss A/c	Dr
	To Asset disposal A/c
	(Loss on sale of fixed asset transferred to P/L A/c) [With Asset Disposal A/c]

 

Journal entries for Method: II

[With “Provision for depreciation Account”]

Date	Particulars		L.F.	Debit (Rs)	Credit (Rs)
1	Depreciation A/c	Dr
	To Prov for dep A/c
	(Depreciation charged for current year)
2	Profit and loss A/c	Dr
	To Depreciation A/c
	(Depreciation transferred to P/L A/c)
3	Asset A/c	Dr
	To Cash/Bank A/c
	(Fixed asset purchased for cash)
4	Cash/Bank A/c	Dr
	To Asset A/c
	(Fixed asset sold) [Without opening Asset Disposal A/c]
5	Asset disposal A/c	Dr
	To Asset A/c
	(Fixed asset sold) [With Asset Disposal A/c – For the original cost of the asset sold] [NOTE: This entry will not be made, if Asset Disposal A/c is not opened]
6	Prov for dep A/c	Dr
	To Asset disposal A/c
	(Accumulated depreciation on the asset sold transferred) [With Asset Disposal A/c]
7	Prov for dep A/c	Dr
	To Asset A/c
	(Accumulated depreciation on the asset sold transferred) [Without Asset Disposal A/c]
8	Cash/Bank A/c	Dr
	To Asset disposal A/c
	(Amount received on sale of the asset) [With Asset Disposal A/c]
9	Cash/Bank A/c	Dr
	To Asset A/c
	(Amount received on sale of the asset) [Without Asset Disposal A/c]
10	Asset disposal A/c	Dr
	To Profit and loss A/c
	(Profit on sale of fixed asset) [With Asset Disposal A/c]
11	Asset A/c	Dr
	To Profit and loss A/c
	(Profit on sale of fixed asset) [Without Asset Disposal A/c]
12	Profit and loss A/c	Dr
	To Asset disposal A/c
	(Loss on sale of fixed asset) [With Asset Disposal A/c]
13	Profit and loss A/c	Dr
	To Asset A/c
	(Loss on sale of fixed asset) [Without Asset Disposal A/c]

 

GENERAL NOTES:

1.             Under the first method (without provision for depreciation account) asset account balance will be shown as reduced by the amount of depreciation, whereas under the second method (with provision for depreciation account) asset account balance will not change until and unless there is any purchase or sale of the asset.

2.             Under the first method, asset account is maintained at its depreciated value, whereas under the second method asset account is always maintained at its original cost.

3.             Under the first method current year’s depreciation is credited in the asset account, whereas under the second method current year’s depreciation is credited in the provision for depreciation account.

 

Change in the method of depreciation

Method of depreciation may be changed either from Straight Line Method to Written-Down-Value Method or from Written-Down-Value Method to Straight Line Method. This change in method may again be with retrospective effect or may be with prospective effect. When change in method is with retrospective effect, it implies that the change will be with effect from a past date which may be a date a number of years back and in this case the effect of such change has to be calculated and shown in the books of accounts in terms of the impact of such change in the profit and loss account balance. On the other hand, when the change in method is with prospective effect, it implies that the change will be effective from the date on which the decision for such change has been taken or from any future date as might have been considered convenient and necessary by the management. In this case, no past adjustment is required to be calculated and shown in the books of accounts.

 

Adjustment journal entries for change in method with retrospective effect

[Without “Provision for Depreciation Account”]

Date	Particulars		L.F.	Debit (Rs)	Credit (Rs)
1	Asset A/c	Dr
	To Profit and loss A/c
	(Increase in profit due to excess depreciation written back on change in method of depreciation from Straight Line to WDV rate of depreciation being the same under both the method)
2	Profit and loss A/c	Dr
	To Asset A/c
	(Decrease in profit due to additional depreciation charged on change in method of depreciation from WDV to Straight Line rate of depreciation being the same under both the method)

 

Adjustment journal entries for change in method with retrospective effect

[With “Provision for Depreciation Account”]

Date	Particulars		L.F.	Debit (Rs)	Credit (Rs)
1	Prov for dep A/c	Dr
	To Profit and loss A/c
	(Increase in profit due to excess depreciation written back on change in method of depreciation from Straight Line to WDV rate of depreciation being the same under both the method)
2	Profit and loss A/c	Dr
	To Prov for dep A/c
	(Decrease in profit due to additional depreciation charged on change in method of depreciation from WDV to Straight Line rate of depreciation being the same under both the method)

 

Part B

FINANCIAL ACCOUNTING

DEPRECIATION ACCOUNTING

Selected Illustrations and Solutions

(Foundation Level)

 

Illustration: 1

Parkash Paswan Ltd., whose accounting year is the calendar year, purchased on 1^st April, 2013 Machinery costing Rs 30,000. It purchased further machinery on 1^st October, 2013 costing Rs 20,000 and on 1^st July, 2014 costing Rs 10,000. On 1^st January, 2015 one third of the Machinery installed on 1^st April, 2013 became obsolete and was sold for Rs 3,000.

 

Show how the machinery account would appear in the books of the company, it being given that machinery was depreciated by fixed instalment method at 10% per annum.

 

Click here for Solution: 1 in PDF

Illustration: 2

On July 1, 2012 Granites Ltd. purchased second hand machine for Rs 40,000 and reconditioned the same by spending Rs 6,000. On January 1, 2013 a new machine was purchased for Rs 24,000. On June 30, 2014 the machine purchased on January 1, 2013 was sold for Rs 16,000 and another machine was installed at a cost of Rs 30,000. The company writes off 10% on original cost of machinery every year on March 31.

 

Show the Machinery account for three years up to 31^st March, 2015.

 

Click here for Solution: 2 in PDF

Illustration: 3

Raghav Verma Ltd., whose books are closed on 31^st March, purchased Machinery for Rs 1, 50,000 on 1^st April, 2011. Additional machinery was acquired for Rs 40,000 on 30^th September, 2012 and for Rs 25,000 on 1^st April, 2014. Certain machinery, which was purchased for Rs 40,000 on 30^th September, 2012, was sold for Rs 34,000 on 30^th September, 2014.

 

Give the Machinery Account for the four years ending 31^st March, 2015 taking into account depreciation on machinery at 10% per annum on the written-down value.

 

Click here for Solution: 3 in PDF

Illustration: 4

One lathe machine, owned by Udit Narayan Workshops Ltd., whose original value was Rs 1, 20,000 on 1.4.2013, being the date of installation was sold on 30.9.2015 for Rs 1, 00,000. Depreciation is charged at the rate of 10% on reducing balance.

 

Show the machinery account and machinery disposable account for the three years ending on 31^st March, 2016.

 

Click here for Solution: 4 in PDF

 

Illustration: 5

M/s Suba Pharmaceuticals has imported a machinery on 1^st July, 2012 for Rs 1, 60,000 paid custom duty and

Freight Rs 80,000 and incurred erection charges Rs 60,000. Another local machinery costing Rs 1, 00,000 was purchased on 1^st January, 2013. On 1^st July, 2014 a portion of the imported machinery (value one third) got out of order and was sold for Rs 34,800. Another machine was purchased to replace the same for Rs 50,000. Depreciation is to be calculated at 20% p.a. on straight line method.

 

Show the machinery account for 2012, 2013 and 2014. (Accounting period January to December)

Click here for Solution: 5 in PDF