Depreciation

Depreciation

Depreciation means decrease in the value of fixed assets due to their

use in business, passage of time or obsolescence.

Depreciation is a measure of the wearing out, consumption or other

loss of value of a depreciable asset arising from use, defluxion 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 amortization of assets whose useful life is

predetermined.
Depreciable Asset

Depreciable assets are assets which-

I. are expected to be used during more than one accounting period; and
II. have a limited useful life; and
III. are held by an enterprise for use in the production or supply of goods and
services, for rental to others, or for administrative purposes and not for the
purpose of sale in the ordinary course of business.

Causes of Depreciation
 Wear and tear
 Exhaustion
 Obsolescence
 Efflux of time
 Accidents
Depletion

The term ‘Depletion’ refers to the physical deterioration by the

exhaustion of natural resources, like, quarries, mines, oil-wells,
etc. Due to mining or extraction, the stock of minerals/oil, etc. is
depleted/reduced.

Amortization
The process of writing off intangible assets is termed as
amortization. like, goodwill, patents, trademark, copyright have a
limited useful life. Hence, their cost must be written off over such
period.
Obsolescence

The term ‘Obsolescence’ refers to the economic deterioration of

assets, due to change in technology, invention of improved
equipment, market decline due to change in taste and fashion,
etc., or inadequacy of existing plant to meet the increased
business.
Depreciation is affected by obsolescence as it decreases the value
of asset.
Objectives of Providing Depreciation

 To ascertain the true and fair profits

 To show the asset at its proper value
 To make arrangement of funds for replacement of fixed asset
 Ascertaining accurate cost of production
 To comply with legal provisions
Factors affecting the amount of depreciation

Assessment of depreciation and the amount to be

charged in respect thereof in an accounting period
are usually based on the following three factors:
i. historical cost or other amount substituted for the
historical cost of the depreciable asset when the asset
has been revalued;
ii. expected useful life of the depreciable asset; and
iii. estimated residual value of the depreciable asset.
Methods of Providing Depreciation

 Straight Line Methods

 Written Down Value Method
 Machine Hour Rate method
 Annuity Method
 Group Depreciation Method
 Insurance Policy Method
 Depreciation Fund Method
 Straight Line Method
 Depreciation is charged by a given rate of depreciation on the original cost.
 Due to this reason depreciation charged annually remains fixed and so the
method is called ‘Fixed Installment Method.
 This is also called original cost method as the depreciation is charged every
year on the original cost of the asset. estimated scrap value of the asset.

If rate of depreciation is not given then annual depreciation and rate of

depreciation is calculated by applying the following formulas:
Example: A firm purchased a machine for Rs, 1,75,000 and
spent installation charges Rs. 45,000. It’s economic life is 10
years and estimated residual value after 10 years is Rs. 20,000.
Charge depreciation by SLM.

Annual Depreciation = 2,20,000 −20,000

10
= 20,000
Calculation of Depreciation and WDV – SLM

Example: Cost of machine – Rs. 77,760, useful life – 5 years,

estimated scrap value after 5 years – Rs. 31,250 Charge
depreciation by SLM.
SLM and WDV Calculation of Depreciation
Year Open. SLM(Rs.) Rate of Dep. SLM Dep. (Rs) Clos. SLM(Rs)

1 77,760 11.92% 9,302 68,458

2 68,458 11.92% 9,302 59,156

3 59,156 11.92% 9,302 49,854

4 49,854 11.92% 9,302 40,552

5 40,552 11.92% 9,302 31,250

 Merits of Straight Line Method of Depreciation

 This method is simple to understand and easy to calculate

 The value of the asset can be reduced to zero
 This method is suitable in case of those asset which get depreciated
more on account of expiry of period.

Demerits of Straight Line Method of Depreciation

 Unequal charge against income.
 Unsuitable for long term assets.
 Interest factor ignored.
 Undue pressure in later years
 Difficult to estimate scrap value
 No provision of funds for replacement
Written Down Value Method of depreciation

 Under this method depreciation is charged at a fixed rate on the

opening balance of the asset.

 Thus, it is clear that under this method value of asset as well as

depreciation charged goes on reducing every year. Due to this
reason this method is also called “Reducing Installment
Method.” The value of asset left after charging depreciation is
called, written down value. Due to this reason, this method is
called “Written Down Value Method.”

 The rate of depreciation charged under this method is higher than

that charged in straight line method.
Calculation of rate of depreciation under WDV Method

R = {1 - 𝑛 𝑆/𝐶}*100

R = Rate of Depreciation
N = useful life of the asset
S = Scrap value of the asset
C = Cost of the asset
Example: Somesh buy a second hand motor car for Rs 40,000, and
its scrap value is Rs 10,480 and the useful life of the car is 6 years,
the rate of depreciation under diminishing balance method would
be:
R = {1 - 𝑛 𝑆/𝐶}*100

R = 1 - 6 10480/40000*100
R = 1 - 6 0.262*100
R= 1-0.80X100
=20%
Merits of WDV method of depreciation

 Calculation of depreciation is very

 Equal charge against income.
 No undue pressure in later years.
 Approved by taxation authorities.

Demerits of WDV Method of Depreciation

 Difficulty in determining the rate of depreciation.
 No provision of funds for replacement
 Asset can not be completely written off
 No information about original cost and accumulated
depreciation
Q. A firm purchase plant on 1st Jan. 2012 for Rs 1,00,000. Prepare the plant
account for 3 years charging depreciation @10% p.a. according to diminishing
balance method.
Plant Account
Date Particulars Amount Date Particulars Amount

1 Jan. To Bank A/c 1,00,000 31 Dec. By Depreciation 10,000

2012 2012 By Balance c/d 90,000
1,00,000 1,00,000

1 Jan. To Balance b/d 90,000 31 Dec. By Depreciation 9,000

2013 2013 By Balance c/d 81,000
90,000 90,000

1 Jan. To Balance b/d 81,000 31 Dec. By Depreciation 8100

2014 2014 By Balance c/d 72,900
81,000 81,000
QUESTION:
Mr Azad Ltd. purchased furniture on October 01, 2014 for
₹ 4,50,000. On March 01, 2015 it purchased another furniture for
₹ 3,00,000. On July 01, 2016 it sold off the first furniture
purchased in 2014 for ₹ 2,25,000. Depreciation is provided
at 15% p.a. on written down value method each year. Accounts are
closed each year on March 31. Prepare furniture account and
accumulated depreciation account for the years ended on
March 31, 2017.
Q. A firm purchase Truck for a sum of Rs 1,00,000 on 1 st Jan. 2000. It charge
20% depreciation per annum according to the DBM. The truck was sold on 1 st
July, 2001 for sum of Rs 80,000. You are required to prepare Truck account
for 2 years.
Truck Account
Date Particulars Amount Date Particulars Amount

1 Jan. To Bank A/c 1,00,000 31 Dec. By Depreciation 20,000

2000 2000 By Balance c/d 80,000
1,00,000 1,00,000

1 Jan. To Balance b/d 80,000 30 June. By Depreciation 8,000

2001 To P&L A/c (Profit) 8,000 2001 By Bank A/c 80,000
1 July
2001
88,000 88-,000
Change in the method of Depreciation

Sometimes a change in the method of depreciation may be desired to required.

In such a case, there can be 2 different situations-

 Change in the method of depreciation may be desired from the current year
onwards. In such a case, depreciation will be charged according to the new
method from the current year.

 Change in the method of depreciation may be desired from a back date. This
will require necessary adjustments to be made in the current year for any extra
or less depreciation which has already been charged according to the old
method and the amount of depreciation that is to be charged according to the
new method. The difference, if any, should be credited (or debited) to the
Asset Account in the current year and should be shown as a separate charge
or income in the P&L Account of the current year of the firm.
Q. On 1st July 2014 a company purchased a plant for Rs 20,000. Depreciation was
provided at 10% p.a. on SLM on 31st December of every year. With effect from
1.1.2016, the company decided to change the method of depreciation to
Diminishing Balance Method @ 15%p.a. On 1.7.2017, the plant was sold for Rs
12,000. Prepare Plant Account from 2014-17.
Q. On 1st July 2014 a company purchased a plant for Rs 20,000. Depreciation was
provided at 10% p.a. on SLM on 31st December of every year. Prepare Plant Account from
2014-17, if the firm decides on 1.1.2016 to change depreciation according to Diminishing
Balance Method @ 15% p.a. w.e.f. 1.1.2014, and to make adjustments for arrears of
depreciation in the year 2016. On 1.7.2017, the plant was sold for Rs 12,000.
 Particulars Amount
Working Note-1
Book value on 1-1-2011 30,000

Less: Depreciation 2011-12 (3000)

Less: Depreciation 2012-13 (3000)

Less: Depreciation for 3 months (750)

Book value on the date of sale 23,250

Less: Sales price 16,000

Loss on sale 7,250

Working Note-2
Particulars SLM (10%) DBM (20%)
Machine-1 Cost 1,70,000
Less: Depreciation 2011-12 17,000 34,000
2012-13 17,000 27,200
Machine-2 Cost 10,000
Less: Depreciation 2011-12 250 500
2012-13 1,000 1900
Machine-3 Cost 20,000
Less: Depreciation 2012-13 1,000 2,000
Arrear of Dep. (65600-36250=29,350) 36,250 65,600