Financial Accounting
Accounting for Depreciation
(Foundation Level)
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 1st April,
2013 Machinery costing Rs 30,000. It purchased further machinery on 1st
October, 2013 costing Rs 20,000 and on 1st July, 2014 costing Rs 10,000.
On 1st January, 2015 one third of the Machinery installed on 1st
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.
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 31st March, 2015.
Illustration:
3
Raghav Verma Ltd., whose
books are closed on 31st March, purchased Machinery for Rs 1, 50,000
on 1st April, 2011. Additional machinery was acquired for Rs 40,000
on 30th September, 2012 and for Rs 25,000 on 1st April,
2014. Certain machinery, which was purchased for Rs 40,000 on 30th
September, 2012, was sold for Rs 34,000 on 30th September, 2014.
Give the Machinery
Account for the four years ending 31st March, 2015 taking into
account depreciation on machinery at 10% per annum on the written-down value.
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 31st
March, 2016.
Illustration: 5
M/s Suba Pharmaceuticals
has imported a machinery on 1st 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 1st January, 2013. On 1st 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
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