Depreciation accounting

Definition of Depreciation
• It is “ a measure of the wearing out, consumption
or other loss of value of a depreciable asset arising
from use, effluxion of time or obsolescence
through technology and market changes.
Depreciation is allocated so as to charge a fair
proportion of depreciable amount in each
accounting period during the expected useful life
of the asset.”
(Institute of Chartered Accountants of India )
 Definition of Depreciation Accounting

“ A system of accounting which aims to distribute the

cost or other basic value of tangible capital assets
less salvage (if any) over the estimated useful life of
the unit in a systematic and rational manner.”
 Other terms
Amortisation :
• It is charging off a part fo the cost of an intangible
asset in the income statement.

Depletion:
• It refers to the physical deterioration by the
exhaustion of natural resources (ore deposits in
mines, oil well, quarries, etc). It implies removal
of an available but irreplaceable resource such a s
extracting coal from a coal mine.
Factors Determining the Amount of Depreciation

• Historical cost: cost incurred on acquisition,

installation, commissioning and for additions to or
improvements of a depreciable asset which are of
capital nature.
• Expected useful life
• Estimated residual value (scrap value/ salvage value):
Value expected to be realised on its sale or exchange
on the expiry its useful life.
 Causes of Depreciation

• Wear and tear

• Exhaustion
• Obsolescence
• Passage of time
• Accidents
Objectives of providing depreciation

• Ascertainment of true profits

• Presentation of true financial position
• Replacement of assets
 Methods of Recording Depreciation
1. Where a provision for depreciation account is NOT
maintained:
a) The entry to be made on writing off depreciation is
Depreciation Account Dr.
To Asset Account
b) For transfer of depreciation to the Profit and Loss
Account:
Profit and Loss Account Dr.
To Depreciation Account
Methods of Recording Depreciation (cont….)
1. Where a provision for depreciation account is NOT
maintained:
c) On sale of asset:
Cash or Bank Account Dr.
To Asset account
In case of profit on sale of an asset
Asset A/c Dr
To Profit and Loss A/c
In case of loss on sale of an asset
Profit and Loss Account Dr.
To Asset Account
Methods of Recording Depreciation (cont….)

2. When a provision for depreciation account is

maintained:
i. For providing depreciation:
Depreciation account Dr.
To Provision for Depreciation Account
ii. For transfer of depreciation to Profit and Loss Account.
Profit and Loss Account
To Depreciation Account
Methods of Recording Depreciation (cont….)
iii. On sale of asset:
a. Provision for Depreciation Account Dr.
To Asset account
(By total depreciation charged on asset till date of sale)
b. Cash or Bank Account Dr.
To Asset account
(being sales proceeds on sale of asset)
c. In case of profit or loss on sale of an asset
• In case of profit on sale of an asset
Asset A/c Dr
To Profit and Loss A/c
• In case of loss on sale of an asset
Profit and Loss Account Dr.
To Asset Account
 Methods for providing Depreciation

• Straight line method

• Diminishing balance method
 Straight Line Method
(Fixed Installment Method)
• Depreciation is charged evenly every year throughout
the effective life of the asset. The amount of
depreciation is calculated as follows:
Depreciation
Original cost - Estimated Scrap Value
= Life of the Asset in Number of
Accounting Periods.

D = C–S
N
 Straight Line Method
(Fixed Installment Method)

The rate of depreciation charged each year is

calculated as follows:

R = D X 100
C

The rate is applied on original cost every year.

 Advantages of Straight Line Method

1. Simple to understand, and easy to apply

2. Value of asset can be reduced to zero or scrap value.
3. Suitable method for assets which get depreciated due
to expiry of period eg. Leasehold properties, patents,
etc.
 Disadvantages of Straight Line Method

1. It does not take into account effective utilization of the

asset as the same amount of depreciation is charged
every year.
2. Even though the asset is used uniformly from period to
period, the total charge for the use of the asset (i.e.
depreciation and repairs) keeps on increasing every
year. This is because cost of repairs in each subsequent
year rises though equal amount of depreciation is
written off every year.
 Example
On 1st April 2002, X Ltd, purchased a machinery for Rs
1,00,000 and incurred Rs 7,000 towards freight and
insurance, Rs 1,000 towards carriage inwards and Rs
2,000 towards installation charges. The machinery will
have a scrap value of Rs 10,000 at the end of its useful
life which is 4 years. On 1 April 2005, Rs 2000 were
incurred on repairs and renewals of machine.
Show the machinery account for the first four financial
years ending 31st March each year according to the
SLM.
 Diminishing Balance Method

• Also known as Reducing Balance Method/ Written

Down Value method
• Depreciation is charged on the book value(original
cost – accumulated depreciation) of the asset each
year.
• Thus the amount of depreciation decreases every
year.
• Depreciation Rate = 1 - n Net Residual Value
Acquisition Cost
Where n = economic life of the asset in years
 Advantages of Diminishing Balance Method

• Simple and easy method

• Every year there is an equal burden for using the assets
because depreciation decreases every year whereas
costs of repairs increases.
• As and when additions are made to the asset, fresh
calculations of depreciation are not necessary.
• Income tax authorities recognize this method.
Disadvantages of Diminishing Balance Method

• It is difficult to determine an appropriate rate of

depreciation
• The value of the asset cannot be brought down to
zero
 Example

• A firm purchases a plant and machinery on 1st January,

2000 for Rs 10,000. Prepare a plant account for three
years charging depreciation @10% p.a. according to
the diminishing balance method.
 Depreciation on an asset purchased in the
course of a year.

There are two alternatives treatments:

1. Depreciation may be charged for the full year
irrespective of the date of purchase at the given rate.
2. Depreciation may be charged only for that part of the
year for which the asset was used. This is usually if
the rate of depreciation has been given as a certain
percentage per annum and the date of the purchase of
the asset has been given.
• Note: In the absence of instructions in question, give
assumptions
 Sale of an Asset during the year

• The amount realized should be credited to the asset

Account.
• Depreciation for the period for which the asset should
be written off in the usual manner
• Any balance in the asset account representing profit or
loss should be transferred to the profit and loss
Account.
 Example (Sale of an Asset)

• A firm purchases a truck for a sum of Rs

1,00,000 on 1st January, 1999. It charges
20% depreciation per annum according to
the Diminishing balance method. The truck
was sold on 1st July,2000 for a sum of Rs
80,000. You are required to prepare the
Truck Account for 1999 and 2000.
 Example (Additions and Sale of an Asset)
• On 1 Jan 2002, X Ltd. purchased a machinery for Rs
58,000 and spent Rs 2,000 on its erection. On 1st July
2002 an additional machinery costing Rs 20,000 was
purchased. On 1st July 2004, the machine purchased on
1.1.2002 was sold for Rs 28,600 and on the same date, a
new machine was purchased at a cost of Rs 40,000.
Show the Machinery Account for the first four calendar
years according to written down value method @ 10%
p.a.
 Change in the Method of Depreciation
The method of depreciation may be changed from
Straight Line Method to Diminishing Balance Method
or vice-versa. There can be two situations:
1. Change in the method of depreciation may be desired
from the current year onwards. In this case,
depreciation will be charged according to the new
method, from the current year.
2. Change in the method of depreciation may be desired
from a back date (retrospective change). This requires
necessary adjustments to be made in the current year
for any extra or less depreciation charged in the earlier
years.
 Procedure for recording a change in the method of
depreciation with retrospective effect
1. Calculate the aggregate depreciation on existing assets
(i.e. assets other than sold/discarded/destroyed/exchanged):
– already provided under the existing method up to the end of
previous accounting year
– retrospectively from the date of asset coming into use by
adopting the new method up to the end of previous accounting
year
2. Calculate the difference between the aggregate
depreciation under existing method and that under new
method.
• There may be short depreciation (arrears of depreciation i.e.
excess of depreciation under new method over depreciation under
old method) or conversely excess depreciation
Procedure for recording a change in the method of
depreciation with retrospective effect
3. Pass journal entries for recording the difference as
follows:
Profit and Loss Account Dr.
To Asset A/c or Provision for dep’n A/c
(Adjustment for short depreciation)
Asset A/c or Provision for dep’n A/c Dr.
To Profit and Loss Account
(Adjustment for excess depreciation)
4. Charge depreciation from the current accounting year
and onwards by adopting new method.
Illustration (Change in the Method of Depreciation)
a. On 1st July, 2005, a company purchased a Plant for Rs
20,000. Depreciation was provided at the rate of 10% p.a.
on the SLM on 31 December every year. With effect from
1.1.2007, the company decided to change the method of
depreciation to the Diminishing Balance Method @ 15 %
p.a. On 1.7.2008, the plant was sold for Rs 12,000. Prepare
a Plant Account from 2005 to 2008.
b. On the basis of the above information, prepare a Plant
Account from 2005 to 2008, if the firm decides on
1.1.2007 to charge depreciation according to Diminishing
balance method w.e.f. 1.7. 2005 and to make adjustment
for arrears of depreciation in the year 2007.
 Example (change of method but NOT
retrospectively)
• A firm purchased a certain machinery for Rs 58,200 on 1st
January, 2004 and spent Rs 1,800 on its erection. On 1st July
2004, additional machinery costing Rs 20,000 were
purchased. On 1st July, 2006, the machinery purchased on
1st January 2004, having become obsolete was auctioned for
Rs 28,600 and on the same date fresh machinery was
purchased at a cost of Rs 40,000.
• Depreciation was provided for annually on 31st December at
10 per cent on written down value. In 2007, however, the
firm changed this method of providing depreciation on the
original cost @ 5 % p.a. of the machinery. Give the
machinery Account as it would stand at the end of each year
from 2004 to 2007.