Faculty of Business Administration

Course: B.Com

SBAX1003 financial Accounting -1

Unit -4 DEPRECIATION

Every business acquires some non-trading fixed assets. These fixed assets are used in the
business for facilitating its trading activities and enhancing its revenue earning capacity. These
assets are basically purchased for the business with the intention of permanent use and not for
resale.
All fixed assets except the value of land decreases with the passage of time. The value of these
assets decrease each year. Such gradual reduction or decrease in the value of fixed assets for the
purpose of earning revenue is called depreciation. Depreciation is closely related with the
determination of profit or loss for the period. Unless depreciation is charged to the revenues, the
true income of the business cannot be ascertained properly. As such, depreciation is a revenue
expense.

The characteristics of depreciable assets are as follows.

* The expected life of the asset is more than one accounting period.
*Those assets have a limited useful life.
* Those assets are held by the business for use in production of goods and services.
* Those assets are not for the purpose of sale in the ordinary course of business.
The cost of fixed asset indicates 'the price for the future service of the assets'. It is necessary to
spread its cost over a number of years during which benefit of the asset is received. This process
of allocating the cost of fixed assets is termed as 'depreciation'.
Definition

According to ICMA (Institute of Cost and Management Accountants - London) Terminology

Depreciation is the diminution in intrinsic value of asset due to use and / lapse of time.

Carter defines depreciation as the gradual and permanent decrease in the value of an asset from
any cause.
Need for Providing Depreciation:

The need for providing depreciation in accounting records arises due to any one or more of the
following reasons.

1. To ascertain correct profit / loss

For proper matching of cost with revenues, it is necessary to charge depreciation against
revenue in each accounting year, to calculate the correct net profit or net loss.

2. To present a true and fair view of the financial position

If the amount of depreciation is not provided on fixed assets in the books of account, the
value of fixed assets will be shown at a higher value than its real value in the balance sheet. As
such it will not reflect the true and fair financial position of the business. Hence, to present a true
and fair view of the financial position of the business, it is necessary that depreciation must be
deducted from the book value of the assets in the balance sheet.

3. To ascertain the real cost of production

For ascertaining the real cost of production, it is necessary to provide depreciation.

4. To comply with legal requirements

As per Section 205(1) of the Companies Act 1956, it is compulsory for companies to
provide depreciation on fixed assets before it declares dividend.

5. To replace assets
 Depreciation is provided to replace the assets when it becomes useless.

Causes of Depreciation

Causes of
Depreciation

Internal External

1. Wear and Tear 1. Obsolescence

2. Disuse 2. Effluxion of time
3. Maintenance 3. Time factor
4. Depletion

The causes of depreciation may be internal or external. The internal causes arise from operation
of any cause natural to or inherent in the asset itself. External causes arise from the operation of
forces outside the business. These are being discussed below:

I. Internal Causes

1. Wear and tear:

Wear and tear is an important cause of depreciation in case of tangible fixed asset. It is due to use
of the asset.

2. Disuse:
When a machine is kept continuously idle, it becomes potentially less useful.

3. Maintenance:
The value of machine deteriorates rapidly because of lack of proper maintenance.

4. Depletion:
It refers to the physical deterioration by the exhaustion of natural resources eg., mines, quarries,
oil wells etc.

II. External Causes

1. Obsolescence:
The old asset will become obsolete (useless) due to new inventions, improved techniques and
technological advancement.

2. Effluxion of time:
When assets are exposed to forces of nature, like weather, wind, rain, etc., the value of such
assets may decrease even if they are not put into any use.

3. Time Factor:
Lease, copy-right, patents are acquired for a fixed period of time. On the expiry of the fixed
period of time, the assets cease to exist.

Factors Determining the Amount of Depreciation

1. Original cost of the asset

It implies the cost incurred on its acquisition, installation, commissioning and for additions or
Improvements thereof which are of capital nature.
2. Estimated life:
It implies the period over which an asset is expected to be used.

3. Residual value:
It implies the value expected to be realized on its sale on the expiry of its useful life. This is
otherwise known as scrap value or turn-in value.
Methods of Calculating Depreciation

1. Straight line method or fixed installment method.

2. Written down value method or diminishing balance method
3. Annuity method.
4. Depreciation Fund method.
5. Insurance Policy method.
6. Revaluation method.

Straight line method or fixed installment method

The simplest and most commonly used method, straight-line depreciation is calculated by taking
the purchase or acquisition price of an asset, subtracting the salvage value (value at which it can
be sold once the company no longer needs it) and dividing by the total productive years for
which the asset can reasonably be expected to benefit the company. Depreciation under this
method may be calculated as follows:
Depreciation per annum = (Net Book Value - Residual Value) / Life time

Written down value method or diminishing balance method

Reducing Balance Method charges depreciation at a higher rate in the earlier years of an asset.
The amount of depreciation reduces as the life of the asset progresses. Depreciation under
reducing balance method may be calculated as follows:
Depreciation per annum = (Net Book Value - Residual Value) x Rate%

Annuity method.

Annuity depreciation methods are not based on time, but on a level of Annuity. This could be
miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life is
estimated in terms of this level of activity.
 The annuity method considers that the business besides loosing the original cost of the
asset in terms of depreciation and also looses interest on the amount used for buying the asset.
This is based on the assumption that the amount invested in the asset would have earned in case
the same amount would have been invested in some other form of investment. The annual
amount of depreciation is determined with the help of annuity table. This method is used to
calculate depreciation amount on lease.
Depreciation Fund Method or Sinking Fund Method:

Under this method, funds are made available for the replacement of asset at the end of its useful
life. The depreciation remains the same year after year and is charged to Profit and Loss account
every year through the creation of depreciation fund. The amount of annual depreciation is
invested in good securities bearing interest at a specified rate. The aggregate amount of interest
and annual provision is invested every year. When the asset is completely written off or is to be
replaced, the securities are sold and the amount so realized by selling securities is used to replace
the old asset.

Insurance Policy Method:

According to this method, an Insurance policy is taken for the amount of the asset to be replaced.
The amount of the policy is such that it is sufficient to replace the asset when it is worn out. A
sum equal to the amount of depreciation is paid as premium every year. The amount goes on
accumulating at a certain rate of interest and is received on maturity. The amount so received is
used for the purchase of new asset, replacing the old one.

Revaluation Method:

Under this method, the assets like loose tools are revalued at the end of the accounting period
and the same is compared with the value of the asset at the beginning of the year. The difference
is considered as depreciation.
Unit 4
Depreciation

Straight line method:-

1. Hasan purchased a machine on 1sr jan. 1992 at Rs.14400. The scrap value after ten
years, time is expected to be Rs.3400. If depreciation is written off by equal instalments
every dec.31, show the machinery A/c for the first thee years. Calculate the rate of
depreciation.
2. An asset is purchased for Rs.25000. Depreciation is to be provided annually according to
the to the straight line method. The useful life of the asset is 10 years and the residual
value is Rs.5000.
You are required to find out the rate of depreciation and prepare the Asset A/c for the
first three years.
3. A company purchased a machine on 1-1-8 for Rs.80000. On 1stjuly 1984, it purchased
another machine for Rs.20000. On 1stjuly 1985, it sold off the first machine purchased in
1983 for Rs.56000. On the same date, it purchased further machinery for Rs.50000. On
1stjuly 1986, the second machine purchased for Rs.20000 was also sold off for Rs.4000.
Accounts are closed every year on 31st December. Depreciation is written off at 10% per
annum on original cost.
Prepare the machinery A/c for four years ending 31-12-86.
4. A limited company purchased a plant for Rs.10000 on 1-1-91. On 1-7-91 an additional
plant was bought costing Rs.5000. on 1-7-92 the plant bought on 1-1-91 was sold off for
Rs.4000. On 1-7-93 a fresh plant was purchased for Rs.12000 and the plant bought on 1-
7-91 was sold at Rs.4200.
Depreciation is provided at 10% p.a. on original cost on 31 st December every year.
Draw up the plant A/c and provision for depreciation account till the end of 31-12-93.
5. A second-hand machine was purchased on 1.1.90 for 40000. Overhauling and
installation expenses for thee same machine amounted to Rs.10000. Another machine
was purchased on 1.7.90 for Rs.20000.
On 1.7.92, the machine installed on 1.1.90 was sold for 25000. Dismantling charges
for the machine sold on 1.7.92 were Rs.1000. on the same date another machine was
purchased for Rs.80000 and commissioned on 30.9.92. the company has adopted
calendar year as its financial year. Under the existing practice, the company provides
depreciation @10% p.a. on original cost. In 1993, it has been decided that depreciation
will be charged on the diminishing balance @15% p.a. the charge is not to be made with
retrospective effect. Show machinery A/c from 1990 to 1994.
 Diminishing Balance Method / written down value method:-
6. A machine is purchased for Rs.51200. Its life is expected to be 4 years and the scrap
value is expected to be Rs.16200. You are required to determine the rate of depreciation
when diminishing balance method of depreciation is adopted.
7. A company purchased a second hand plant for Rs.30000 and immediately spent Rs.5000
on repairs. The plant was put to use on January 1985. After using it for six years it was
sold for Rs.15000. You are required to prepare the plant A/c for 6 years providing
depreciation at 10% on diminishing balance method. Accounts are closed on 31 st
December.
8. Machinery account in the books of a company was as follows;
Balance as at 1.1.86 Rs.14900
Purchase of machinery on 1.7.86 Rs. 4400
Sale of machinery on 1.10.86 Rs. 1000
The original cost of machinery sold was Rs.6000 on 1.7.83
Machinery is being depreciated at 10% p.a. on diminishing balance of the asset. Show
the machinery A/c in the books of the company for year 1986. The books are closed on
31stdec. each year.
9. On 1.1.92 a plant was purchased for Rs.4000. On 1.7.1994 the plant was replaced by a
new plant costing Rs.3000, the vendor taking the old machine in part exchange at a
valuation of Rs.800. show the plant account upto 31 stdec. 1994 assuming and the plant
employed at the end of each year.
10. Machinery was purchased for Rs.60000 on 1.1.90. On 1.1.91 another machine was
purchased for Rs.120000. On 1.7.1992 one more plant was purchased for Rs.60000
(including the cost of installation of Rs.3000) by disposing off the machinery which was
purchased on 1.1.90 for Rs.21000. On 1.4.1993, another machinery was purchased for
Rs.105000 by disposing off the machinery which was purchased on 1.1.1991 for 105000.
Show the machinery A/c upto 31.12.1993 assuming that the rate of depreciation was @
10% on diminishing balance method.