Depreciation

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Depreciation

  1. 1. CHAPTER 5 DEPRECIATION
  2. 2. <ul><li>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 </li></ul>DEPRECIATION
  3. 3. <ul><li>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’ </li></ul>
  4. 4. Characteristics of Depreciation <ul><li>Related to fixed assets only </li></ul><ul><li>Fall in the book value of asset </li></ul><ul><li>Permanent decrease in the book value of an asset </li></ul><ul><li>Continuous decrease in the book value of an asset </li></ul>
  5. 5. CAUSES OF DEPRECIATION <ul><li>Physical wear and tear </li></ul><ul><li>With the passage of time </li></ul><ul><li>Changes in economic environment </li></ul><ul><li>Expiration of legal rights </li></ul>
  6. 6. <ul><li>NEED FOR PROVIDING DEPRECIATION </li></ul><ul><li>To ascertain true results of operations </li></ul><ul><li>To present true and fair view of the financial </li></ul><ul><li>position </li></ul><ul><li>To ascertain the true cost of production </li></ul><ul><li>To comply with legal requirements </li></ul><ul><li>To accumulate funds for replacement of assets </li></ul>
  7. 7. FACTORS DETERMINING THE AMOUNT OF DEPRECIATION <ul><li>Historical Cost </li></ul><ul><li>Expected useful life </li></ul><ul><li>Estimated residual value </li></ul>
  8. 8. Methods of Allocating Depreciation <ul><li>Straight Line Method </li></ul><ul><li>Written Down Value Method </li></ul>
  9. 9. ‘ Straight Line Method’ of Depreciation <ul><li>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. </li></ul><ul><li>Amount of Dep. = Original Cost – Residual Value </li></ul><ul><li>Expected Useful Life of the Asset </li></ul><ul><li>Rate of Dep. = Amount of Depreciation x 100 </li></ul><ul><li>Original Cost </li></ul>
  10. 10. Illustration 1: <ul><li>On 1 st 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 30 th Sep., 2003 repairs amounted to Rs.2,000/- . On 1 st July, 2005 this machine was sold for Rs.30,600/-. Prepare Machinery A/c for the first three years. </li></ul>
  11. 11. ‘ Written Down Value Method’ of Depreciation <ul><li>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. </li></ul><ul><li>The rate of depreciation remains constant year after year whereas the amount of depreciation goes on decreasing </li></ul>
  12. 12. Illustration 2: <ul><li>On 1 st Jan., 2003, X Ltd. Purchased a second – hand machine for Rs.58,000/- and spent Rs. 2,000/- on its erection. On 1 st 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. </li></ul>
  13. 13. Change in the Method of Depreciation <ul><li>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. </li></ul>
  14. 14. Change in method of Depreciation with Retrospective Effect <ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>Calculate the difference between the existing method (1) and the new method (2) </li></ul><ul><li>Adjust the short depreciation (excess of step 2 over step 1) by Dr. P&L A/c and Cr. Asset A/c </li></ul><ul><li>OR </li></ul><ul><li>Adjust the excess depreciation (excess of step 1 over step 2) by Dr. Asset A/c and Cr. P&L A/c </li></ul><ul><li>5. Charge depreciation from the current accounting year and onwards by adopting new method. </li></ul>
  15. 15. Illustration 3: Change in the method of Depreciation ABC Ltd. Purchased on 1 st 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 1 st July,2003, the plant purchased on 1 st Jan.,2001became obsolete and was sold for Rs.10,000. On that date new machinery was purchased at a cost of Rs.60,000 Depreciation was provided for annually on 31 st 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.
  16. 16. Illustration 4: On 1 st January 2001, X Ltd. purchased a machine for Rs.58,000 and spent Rs.2,000 on its erection. On 1 st July 2001, an additional machinery costing Rs.20,000 was purchased. On 1 st 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 31 st 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 1 st January 2001. Prepare the Machinery Account for the first four calendar years.
  17. 17. When a Provision for Depreciation is maintained <ul><li>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. </li></ul>
  18. 18. Journal Entries when Provision for Depreciation is maintained Profit & Loss A/c Dr. To Asset Disposal A/c (b) In case of Loss Asset Disposal A/c Dr. To Profit & Loss A/c (a) In case of Profit (Iv) For transfer of balance in Asset Disposal A/c Bank A/c Dr. To Asset Disposal A/c (iii) For recording sale proceeds Provision for Depreciation A/c Dr. To Asset Disposal A/c (ii) For transfer of accumulated depreciation on asset disposed off Asset Disposal A/c Dr. To Asset A/c (i) For transfer of original cost of asset disposed off On disposal of an asset 3 Profit & Loss A/c Dr. To Depreciation A/c For closure of Depreciation A/c 2 Depreciation A/c Dr. To Provision for Depreciation A/c For Providing Depreciation 1
  19. 19. Illustration 5: <ul><li>On 1 st Jan.,2005 , X Ltd. Purchased a machinery for Rs.12,00,000/-. On 1 st July, 2007, a part of the machinery purchased on 1 st 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. </li></ul><ul><li>Show the necessary ledger accounts assuming that : </li></ul><ul><li>Provision for Depreciation A/c is not maintained, </li></ul><ul><li>Provision for Depreciation Account is maintained. </li></ul>
  20. 20. Solution : (Illustration 4) Dr. Machinery A/c Cr. 28,600 2,430 17,570 3,710 53,390 1,05,700 By Bank A/c By Depreciation A/c By P & L A/c By Depreciation A/c By Balance c/d 2003 July 1 July 1 July 1 Dec. 31 Dec. 31 65,700 40,000 1,05,700 To Balance b/d To Bank A/c 2003 Jan.1 July 1 7,300 65,700 73,000 By Depreciation A/c By Balance c/d 2002 Dec.31 73,000 73,000 To Balance b/d 2002 Jan 1 7,000 73,000 80,000 By Depreciation A/c By Balance c/d 2001 Dec.31 58,000 2,000 20,000 80,000 To Bank A/c To Bank A/c To Bank A/c 2001 Jan.1 July 1 Rs. Particulars Date Rs. Particulars Date 3,000 53,500 56,500 By Depreciation A/c By Balance c/d 2004 Dec.31 Dec.31 53,390 3,110 56,500 To Balance b/d To P & L A/c (Dep. Written back on account of change from WDV to SLM) 2004 Jan.1 Dec. 31

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