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216 views13 pagesBook Keeping & Accountancy (Unit-4)
Accounting
Uploaded by
varun guptaCopyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF or read online on Scribd
emits
MODULE - Iv
Depreciation; Provision
and Reserves
DEPRECIATION
Expenditure on assets of the business like furniture, fixtures and fittings of the shop,
‘motor vans, machines and equipments are neither goods nor expenses of a year.
Expenditures ofthis nature give services tothe business for many years and therefore
called fixed assets. Ifthe expenditure on the fixed assets is deducted from the profit
of any one year, it would be wrong. Since their benefit is enjoyed by the business for
‘more than one years, The correct thing will be to distribute their cost over the years
of their useful life to the business. The portion of the cost of fixed assets charged
each year as expense is named as depreciation.
Inthis lesson you will leam about the meaning and methods of charging depreciation
and how depreciation is recorded in the books of accounts, together with the
preparation of Fixed Assets account,
OBJECTIVES
After studying this lesson you will be able to:
. understand the meaning and concept of depreciation;
‘© explain the causes of depreciation;
‘© explain the objectives of depreciation;
* _Ieammethods of charging depreciation and
© prepare fixed asset account showing the amount of depreci
for every year.
eae Any
‘You already know the meaning of terms assets and liabilities. Assets are broadly
divided in to two categories- current assets (cash, debtors or customers balances,
stock of materials and goods) and fixed assets (buildings, furniture and fixtures,
‘machinery and plant, motor vehicles).
Fixed assets are also called long term assets as they provide benefits to the
business for more than one year. Most fixed assets loose their value over time
as these are put in use and as the years pass by. The fixed assets loose their
ACCOUNTANCY we
Poors
4c. These are
e,the cost of
f the cost is
usefulness due to arrival of new technologies and change of fashions ¢
then generally required to be replaced, as their usefill life is over. Henc
a fixed asset is allocated over its useful life. Each year’s allocation o
changed as depreciation expense for that year.
Forexample an office chair is purchased for 2,500 and its estimated that
yearsit willbe scraped, The usefl ie ofthe chairis ten yearsover which the cost oF
2,500 will be distributed. Each year’s allocation may be calculated as:-
afterten
‘Thus 250 is the depreciation expense for each year.
“Thus, depreciationis an expense charged during a year forthe reduction inthe value
of fixed assets, arising due to:
* Normal wear and tear out ofits use and passage of time
© Obsolescence due to change in technology, fashion, taste and other market
Following are the causes for which depreciation is provided in accounts.
i) Normal wear and tear
(a) Duetousage- Every asset has a life for which it can run, produce
or give service. Thus, as we put the asset to use its worth
decreases. Like decrease in the efficiency and functioning of a
bicycle due to its running and usage.
(b) _ Duetopassage of Time—As the time goes by elements of nature,
‘wind, sun, rain etc, cause physical deterioration in the worth of,
an asset. Like reduction in the worth of a piece of furniture due
to passage of time even when it is not used,
i) Obsolescence
(@) Due to development of improved or superior equipment :
Sometimes fixed assets are required to be discarded before they
are actually worn out due to either of the above reasons. Arrival
of superior equipments and machines etc, allow production of
goods at lower cost. This makes older equipments worthless as
production of goods with their use will be costlier and non
ACCOUNTANCY.
ee
MODULE - IV
Depreciation, Provision
and Reserves
cy
Tone
verngs oouLe -IV 7
‘ation, Provision|
Dap es CT
Competitive. For example, Steam engines became obsolete with the
arrival of diesel and electric locomotives. |
Due to change in fashion, style, taste or market conditions :
Obsolescence may also result due to decline in demand for
Certain goods and services with a change in fashion, style, taste
‘or market conditions. The goods and services that are no longer
in vogue lead to decrease in the value of the assets which were
‘engaged in their production - like factories or machines meant
for making old fashioned hats, shoes, furniture ete.
)
Loss in the value of fixed assets for such reasons is called obsolescence and also
charged as depreciation, ‘
Following are the objectives of charging depreciation of Assets:
i) ‘To show the True Financial Position of the Business : As are Fixed ;
Assets have some effective working life during which itcan be economically
operated. Depreciation is the gradual loss in the value of fixed assets. If
depreciationis not provided, profit and oss A/c will not disclose the tue profit
‘made during the accounting period, At the same, the Balance Sheet will not
disclose the true Financial position as Fixed assets appearing in the Balance q
Sheet will be over valued. If depreciation is ignored year after year, ultimately
when asset is wor out, the proprietor will not bei position to continue the
business smoothly. t
ii) To retain funds in the business for replacement of the asset : Net
profits the yield of the capital invested by proprietor and may be wholly
withdrawn by him in the form of cash. If depreciation is provided, this
figure of net profit [Link] reduced and the amount withdrawn by the
proprietor will also be decreased. As such the cash equivalent to the
change for depreciation will be left over the business. This accumulated
‘amount will enable the proprietor to replace a new asset.
Fillin the blanks :
i. Depreciation represents a
ji, Scrap value of an asset means the
in the value of fixed assets.
that it fetched on sale at
the end of its___— :
Depreciation is calculated as cost of asets less scrap value divided by
ee ee MODULE - 1y
Depreciation, Provisi, Mol
1s due to and Reserves pepreci
Obsolescence one ofthe situations on fixed asses which ais
change in , and fashion, taste and other market con
1) Cost of Asset : Cost of asset isthe purchase price of the asset and includes
all such expenses which are incurred before itis first puto use. For example
expenses on loading, carriage, installation, transportation and unloading of
the asset up to the point ofits location, expense on its erection and assembly.
ii) Useful Life of the Asset: Useful life is the expected number of years for
which the asset will remain in use.
fii) Scrap Value : Scrap value is the residual value at which the asset could be
sold to scrap dealer (Kabari) after its useful life.
iv) Depreciable value of asset : Depreciable value is the cost of asset minus
the scrap value,
Mlustration 1
‘A generator was purchased for 5,00,000. & 1,[Link] paid forthe crane for its
Toading on the truck, 7,000 was paid for transporting the generator tothe factory,
2,000 was spent on its unloading at the factory site. The generator was estimated |
to run for 10 years and thereafter would be saleable for € 60,000. Calculate the
depreciable value of the generator. |
The cost of the asset is: Purchase price % 5,00,000
Expenses on Loading = & 1,500
Expenses on unloading % 2,000
‘The usefil life ofthe generator is 10 years
The scrap value is & 60,000.
‘Transportation = 7,000
|
t
|
Depreciable value of the generator=¥ 5,10,500 8 60,000 = 4,50,500
ACCOUNTANCY rm
Mostppopularly used metho
‘popula Xs for charging depreciation are: i, Straight Line Method
and ii. Diminishing Balance Method
Straight Line Method of Depreciation
‘Under this method, the:
: ‘amount of depreciation is uniform from year to year. Suppose,
if'an asset costs & 1,
00,000 and depreciation is fixed @ 10%, then % 10,000
Would be written off every year. That is why this method is also called ‘Fixed
Installment Method’ or ‘Original Cost Method! In this method, the amount to be
written off every year is arrived at as under:
Out of the cost of the asset, its scrap value is deducted and it is divided by the
number of years of ts estimated life,
For example: a machine is purchased for € 1,20,000 and it is estimated that its
useful life is 10 years. After its useful life its scrap value is€ 20,000. Depreciation
of one year can be calculated as under:
If its scrap cannot be sold or no money can be realized from its scrap, then
depreciation of one year is:
In this method the amount of depreciation is same for each year. Therefore this
method is called Straight Line Method, Fixed Installment Method or Original
Cost Method.
Mlustration 2
“Amachine was purchased on January 1,2011 for 1,00,000 and its useful life is 10
years. After completing ts useful life the machine will be scraped and nothing will be
realized from it Its decided to charge depreciation on this machine @ 10% p. a. on
Straight Line Method.
Calculate amount of deprecis
ion for each year during the useful life of this machine.
ACCOUNTANCY rw
Don ae
2012 10% 10,000
2013 10% 10,000
2014 10% 10,000
2015 10% 10,000
2016 10% 10,000
2017 10% 10,000
2018 10% 10,000
2019 10% 10,000
2020 10% 10,000
Amount of depreciation is same in every year, so this method is called ‘Straight Line
‘Method’ or ‘Fixed Installment Method’ or ‘Original Cost Method’,
12.6 MERITS OF STRAIGHT LINE METHOD
i) Simplicity : Calculation of depreciation under this method is very simpleand
therefore the method is widely popular. Once the amount of depreciation is
calculated, the same amounts writen offas depreciation each year. Hence this
method is simple and calculations are easier to understand,
i) _ Asset is completely Written Off: Under this method, the book value of
an asset is reduced to net scrap value or zero value. In other words, in the
books of accounts the value ofthe asset atthe end ofits useful life is equal to
zero orits residual value.
12.7 LIMITATION
i) Difficulty in Computation : When there are various machines having
different life-spans, the computation of depreciation becomes
complicated because the depreciation on each machine will have to be
calculated separately for each asset.
TRAIGHT LINE METHOD.
fi) logical : Itis well known thatthe expense on its repairs and maintenance
increases as the asset becomes older. Thus, the total burden on Profit and
Loss Account, depreciation plus repair expenses, is more in later years in
comparison to earlier years. This is illogical because the efficiency and
productivity of the asset is more in earlier years and less in later years,
Mlustration3
X limited purchased a machine on April 1, 2011 for‘ 1,00,000 whose life was
expected to be 10 years. Its estimated scrap value at the end of 10 years was «
10,000. Find the amount of depreciation tobe charged to Profitand Lass Account
every year. Calculate therate on which depreciation is tobe charged every year,
ACCOUNTANCY
MODULE - 1y
Depreciation, Provisi MOL
and Reserves" __Deprecia
anc eo 4
AOD Ma
ie
MODULE - Iv
Depreciation, Provision
and Reserves
Solution
In this question the information available is as under: The amount of depreciation that
will be charged to Profit and Loss Account will be calculated as :
Calculation of amount of depreciation
. jired a machine on July 1, 2008 at a cost of € 70,000
and Usman Bros, acqui tof 270,000
sa arwaca sie Seren pg a ea ae gag MODULE - IV
pepreciation, Provision
and Reserves
Fillin the blanks :
i, The assumption underlying the fixed installment method of depreciation
is that the amount of the fixed assets over different years ofits useful life
remainthe_
ii Straight ine method of charging depreciation is also known as,
or i
iii, _ Under straight line method the value of the assets at the end ofits useful
life is equal to or its
ix Under aight line method the total burden on Profit and Loss Account in
Comparision to earlier years is,
12.8 DIMINISHING BALANCE METHOD §
‘Under tis method; asthe vale oT asset goes on diminishing year after year, the
amount of depreciation charged every year goes on declining. The amount of
depreciation is calculated as a fixed percentage ofthe diminishing value of the asset
shown in the books atthe beginning of each year. Under this method the value ofan
asset never comes to zer0.
Suppose, the cost of the asset is & 40,000 and the percentage to be written off
each year is 10%. Inthe first year the amount of the depreciation will be & 4,000
ise., 10% of € 40,000. This will reduce the book value to € 36,000 i.e.
% 40,000 - & 4,000. Now, at the beginning of the next year the book value is&
36,000. The amount of the depreciation for the next year will be & 3,600, ie.,
10% of € 36,000. Thus, every year the amount of the depreciation will go on
reducing. This method of charging depreciation is also known as Reducing Balance
‘Method or written down value method.
Illustration 7
“Armachine was purchased on January 1,2011 for 1,00,000 and ts useful life is 10
years. After completing itsusefl lie themachine willbe scraped and 4,000 willbe
Jealized from it. Itis decided to charge depreciation on this machine @ 10% [Link]
Diminishing Balance Method.
Calculate amount of depreciation foreach year during the usefl life ofthis machine,
ACCOUNTANCY Solution
ate of Depreciation | Amount of Depreciation |
2011 10% 10,000
2012 10% 9,000
2013 10% 8,100
2014 10% 7,290
2015 10% 6,561
2016 10% 5,905
2017 10% 5,314
2018 10% 4,783
2019 10% 4,305
2020 10% 3,874
Amount of depreciation is decreased year after year in this method that is why
this method is called ‘Diminishing Balance Method’ or ‘Reducing balance
method’ or ‘written down value method”.
12.9 MERITS OF DIMINISHING BALANCE METHOD
i) Equal Burden on Profit & Loss Account
‘The productivity of the asset is more hence its contribute to profit is also relatively
greater. Therefore the cost charged in terms of depreciation should also be
greater.
In the initial year, the depreciation charges are more and repair expenses are less. In
later years, depreciation charges are less and repair expenses are more. Hence the
total burden, depreciation plus repair expenses, is some what equal on Profit &
Loss Account for each year.
12.10 DEMERITS OF DIMINISHING BALANCE METHOD}
i) _ Asset cannot be completely written off: Under this method, the value of
an asset is not reduced to zero even when there is no scrap value.
fi) Complexity : Under this method, the rate of depreciation cannot be
determined easily.
[@ nrexrqusons
Fillin the blanks with suitable words
@ Depreciation represents a in the value of fixed assets
i) The amount of depreciation on machinery is credited to account.
(iii) Depreciation is calculated on under the straight line method,
ACCOUNTANCY
e
MODULE-iv | st
Depreciation, Provision | Dept
and Reserves wwe
MODULE - Iv
Depreciation, Provision
and Reserves (iv) _ Depreciation is calculated on under the diminishing balance
method.
@) The value of an assets is not reduced to even when there is no
scrap value in diminishing balance method of depreciation. Distinction between Straight Lihe Method and Diminishing Balarice viethod—
Basis of Depreciation is calculated Depreciation is calculated on
Calculation | onoriginal costoftheasset. _| original cost in first year and
asset in subsequent years.
y
Amountof | The amount of depreciation The amount of depreciation
Depreciation] remains the same forall years. goes on reducing year after year.
Straight 7 Diminishing Balance Method
on written down value of the
Value of The book value of the asset The book value of the asset can
Asset can be reduced to zero. never be reduced to zero. em
MODULE - Iv
Ci seine, Proven
t and Reserves
i mn account
Depreciation] The combined cost on account eee ate fo
and Repairs | ofdepreciation and repairs is She eee
lower in the initial years and remains, more of oH
higher in the later years. __|throughout the period.
1. State which of the following statements are true and which are false:
ii,
iii,
iv,
i.
ii,
iv.
Amount of depreciation goes
Straight Line Method.
on reducing year after year in
‘The amount of depreciation remains the same for all years in
Diminishing Balance Method,
The book value of the asset can be reduced to zero in Straight
Line Method.
‘The book value of the asset can never be reduced to zero in
Diminishing Balance Method.
Multiple Choice Questions
Depreciation is charged on :
a) Stock of Goods
©) Fixed Assets
Obsolescence term is used for :
a) Tear and wear of the Assets
b) Current Assets
4) Liquid Assets
+b) Decrease in the value of the assets which are engaged in
production
©) Development of improved or
superior quality of equipment.
4) Due to usage and age of assets
‘Changing depreciation on Fixed Assets by Straight line method,
The value of the asset is taken into consideration:
a) Original value
©) Scrap value
b) Diminished value
4) Book value
Charging depreciation on Fixed assets by Reducing balance
method, the value of the asset is taken into consideration,
4) Original cost method b) Diminished value
©) Scrap value d
Book value
The amount calculated for charging depreciation :
4) Includes the amount of scrap value of the Asset,
b) Do not include the amount of scrap value of the asset
¢) Costof assets less scrap value
4) None of the above.
a a ee
J nm
HODULE - Iv a
greciation, Provision EET
and Reserves Out of the following which is not the cause of
