Unit 3

Depreciation
Depreciation meaning
• Depreciation – Fall in value of tangible
fixed asset because of its usage or with efflux
of time or due to obsolescence or accident.
• Depreciation is permanent, continuing and
Gradual fall in the value of fixed asset.
• Depreciation is charged on all fixed assets
except land because unlike other fixed assets
such as machinery, it has infinite economic
life.
Depreciation features
• Depreciation is a fall in the Book value of tangible
fixed asset.
• The fall in book value of an asset is permanent,
gradual and of continuing nature.
• Depreciation is an expense which does not involve
cash.
• Depreciation is an expense and therefore, it is debited
to profit & loss account whether there is profit or not.
• It reduces the book value of asset but not its market
value.
• The term depreciation is used only for tangible fixed
asset, the term is not used for wasting assets and
fictitious assets such as depletion of natural resources
and amortization of goodwill respectively.
Depreciation, Amortisation &
Depletion
• Depreciation - is a measure of wearing out,
consumption or other loss of value of a depreciable
asset, arising from use, efflux of time and
obsolescence through technology and market
changes.
• Amortisation – is a gradual and systematic writing off
of intangible asset over its estimated useful life. Ex.
Patents, copyrights, purchased goodwill etc.
• Depletion – it is measure of exhaustion of wasting
asset such as extraction of material from quary, mine
etc.
Reasons/ causes of
depreciation
• Use of asset.
• Efflux of time. (Estimated life)
• Obsolescence.(Out of date)
• Accidents.
Depreciation & depreciation
accounting
• Depreciation accounting is a process of
allocating the cost less salvage value of
tangible fixed asset over the useful life.
• Depreciation accounting is a system of
accounting which aim to distribute cost or the
basic value of tangible capital assets less
salvage, over the estimated useful life of the
unit, in a systematic and rational manner, it is a
process of allocation and not valuation.
Objective/ Need for providing
depreciation
• To determine the correct profit & Loss.
• To show a true & fair view of the financial
position.
• To determine the cost of production.
• To provide fund for replacement.
• To comply with legal provision.
Factor/ Basis of providing
depreciation
• Historical cost of an asset.
• Historical cost = purchase price + freight and
other cost + installation cost.
• Estimate residual / Scrap value.
• Useful / Economic life of the asset.
Methods of recording
depreciation
1. When depreciation is charged to asset account
2. When provision for depreciation/accumulated
depreciation account is created.
When depreciation is charged
credited to asset account
• Assets A/c …..Dr.
To Bank A/c
(Being the Assets purchased)
• Depreciation A/c ……Dr.
To Asset A/c
(Being the deprecation on asset charged)
• Profit and loss A/c ……..Dr.
To Deprecation A/c
(Being the depreciation transferred to profit and loss A/c)
When provision for
depreciation/accumulated
depreciation account is
maintained
• Assets A/c …..Dr.
To Bank A/c
(Being the Assets purchased)
• Deprecation A/C ……..Dr.
To provision for Deprecation A/C
(Being the deprecation on assets charged)
• Profit and loss A/C …………Dr.
To deprecation A/C
(Being the deprecation transferred to profit and loss account)
Methods for providing
depreciation
• uniform charge methods:
• Fixed instalment method/ Fixed Percentage on Original
Cost/ Fixed instalment Method
• Depletion method.
• Machine hour rate method.
• Declining charge or accelerated
depreciation methods:
• Written Down Value Method/ Fixed Percentage on
Diminishing Balance/ Reducing Instalment Method
• Sum of years digits method.
• Double declining method.
Other methods
• Group depreciation method.
• Inventory system of depreciation.
• Annuity method.
• Depreciation fund method.
• Insurance policy method.
Uniform charge methods
• In case of these methods depreciation is
charged on uniform basis year after year. Such
methods are considered appropriate only for
such assets which are uniformly productive.
Fixed installment method/
straight line method (SLM)
• Under SLM, a percentage of original cost of the
asset is written off every year as depreciation.
• As a result of this, the amount of depreciation is
uniform every year.
• Example- if asset costs Rs. 1,00,000 and 10%
depreciation is thought proper Rs. 10,000 would
be written off every year as depreciation.
• According to this method, depreciation is charged
evenly every year throughout the effective life of
the asset. The amount of depreciation is
calculated as follows:
Original cost of the fixed asset – Estimated Scrap Value
• Depreciation = Life of the Asset in Number of Accounting Periods
• Rate of Depreciation can be calculated with help of following formula:
• Rate of Depreciation (R) = Amount of Depreciation X 100 = ……%

Total Cost of Asset
Important point
• The amount of Depreciation is same for every
year.
• If the rate of depreciation is given, Depreciation is
computed on the original cost.
• If the asset is purchased or sold during the year,
Depreciation is charged for the part of the year the
asset is used.
• Ex. Asset install on 1st july 2017 and A/C closed/
Sale 31st March 2018, then depreciation charged
for 9 month not for full year (2000*9/12)
Merit & Demerits
• Simple method of calculating.
• Asset can be depreciated up to the estimated
scrap value or zero value.
• Every year, the P & L A/C is debited by the
same amount of depreciation, so there is same
effect on the profit & loss Account every year.
Written Down Value Method (WDV)/
Diminishing Balance method/ Reducing
Balance Method
• Under this method, Depreciation is charged at a
fixed rate on the Book Value, i.e. Reducing
Balance ( Cost Less Depreciation ) every year.
• A percentage known as Rate of Depreciation is
applied to the Book Value and Not to the Cost of
the Asset.
• Ex. Cost 1,00,000, depreciation rate 20%
• Year I II III IV
• Car 1,00,000 80,000 64,000 51,200
• Dep. 20,000 16,000 12,800 10,240
Rate of Depreciation
• ROD can be determined on the basis of Cost,
Scrap Value and Useful Life of the Asset as
follows:
• R= Rate of depreciation in percent.

• N= useful life of asset.
• S= Scrap value or residual value at the end of the
useful life.
• C= Cost of the asset.
Features
• This method is accepted under the Income Tax
Act.
• In this method, value of asset Cannot Become
Zero.
• It is Difficult to ascertain proper Rate o
Depreciation.
SLM Vs WDVM
SLM WDVM
Depreciation is calculated on the original Depreciation is calculated on the

cost of a fixed asset. diminishing balance or written down value
of fixed asset.
The amount of depreciation remains the The amount of depreciation reduces year
same for all years. after year.
At the expiry of working life of asset, the The balance in the asset account will not
balance in the asset account reduces to reduce to zero.
zero.
It is easy to calculate the rate of It is difficult to calculate the rate of

depreciation. depreciation.
Goodwill
• Goodwill is the value of the reputation of a
firm in respect of the profits expected in future
over and above the normal profits.
• In accounting the monetary value of such
advantage is known as Goodwill.
• It is regarded as an intangible assets.
• Thus goodwill exists only when the firm earns
super profits any firm that earns normal profits
or is incurring losses has no goodwill.
Need for valuing goodwill
• When there is change in profit-sharing ratio.
• When a new partner is admitted.
• When a partner retires or expires.
• When partnership firm is sold as a going
concern.
• When the firms amalgamate.
Factors affecting the value
of goodwill
• Nature of business: high value added products or having a
stable demand, more profits more goodwill.
• Location: centrally located or place having heavy customer
traffic more goodwill.
• Efficiency of management: a well managed concern,
advantage of high productivity and cost efficiency, higher
profits, goodwill will also be high.
• Market situation: the monopoly condition or limited
competition, high profits, higher goodwill.
• Special advantages: like import licenses, low rate and
assured supply of electricity, long-term contracts for supply
of materials, well-known collaborators, patents, trademarks,
etc. enjoy higher value of goodwill.
Classification of Goodwill
• Purchased goodwill: Goodwill acquired by
making a payment. Ex. Purchase of a running
business or brand.
• Self- Generated Goodwill: Internally
generated, good quality product, efficient
management.
Methods of valuation of
goodwill
• Since goodwill is an intangible asset it is very
difficult to accurately calculate its value.
Goodwill calculated by one method may differ
from the goodwill calculated by another method.
• The important methods of valuation of goodwill
are as follows:
• Average profits method
• Super profits method
• Capitalisation method
Average profits method
• (a) simple average profit method.
• (b) weighted average profit method.
• Simple average profit method:
• Average profit = total profit + number of years for
which profit/loss are given.
• Goodwill = average profit X Number of years of
purchase.
• NOYP- how many years the firm will earn the
same amount of profit because of its past efforts.

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Depreciation

• Rate of Depreciation can be calculated with help of following formula:

• Rate of Depreciation (R) = Amount of Depreciation X 100 = ……%

• R= Rate of depreciation in percent.

Depreciation is calculated on the original Depreciation is calculated on the

It is easy to calculate the rate of It is difficult to calculate the rate of

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