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ABSTRACT

Depreciation is an accounting process by which a company allocates an asset's cost


over the duration of its useful life. In other words, it records how the value of an asset
declines over time. Each time a company prepares its financial statements, it records a
depreciation expense to allocate a portion of the cost of the buildings, machines or
equipment it has purchased to the current fiscal year. The purpose of recording
depreciation as an expense is to spread the initial price of the asset over its useful life.
For intangible assets such as brands and intellectual property, this process of allocating
costs over time is called amortization. For natural resources such as minerals, timber and oil
reserves, it's called depletion. There is always an outflow of cash whenever company incurs
any expense. But in depreciation, there is no outflow of resources. It is a non-cash
expenditure. Hence, wherever important financial decisions are taken, an important
consideration has to be taken on the inclusion or exclusion of depreciation. Most commonly
used benchmark for judging the profitability of the company is EBITDA (Earnings before
interest, tax, depreciation and amortization) which excludes the impact of depreciation.

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INTRODUCTION:
It is important to analyze how company's use depreciation, which can represent a big
portion of the expenses found on a firm's income statement, and which can impact the
value of an investment opportunity in the short term. While there are rules governing how
depreciation is expensed, there is still plenty of wiggle room for management to
make creative accounting decisions that can mislead investors. It pays to examine
depreciation closely. Companies tend to work hard to make sure their fundamentals look
good to investors and analysts. So good judgment should be exercised when examining
numbers that appear on financial statements. It's not enough to know simply whether a
company has, say, great-looking earnings per share (EPS) or a low book value. Investors
need to be aware of the assumptions and accounting methods that produce those figures.

Depreciation is an accounting process by which a company allocates an asset's cost


over the duration of its useful life. In other words, it records how the value of an asset
declines over time. Each time a company prepares its financial statements, it records a
depreciation expense to allocate a portion of the cost of the buildings, machines or
equipment it has purchased to the current fiscal year. The purpose of recording
depreciation as an expense is to spread the initial price of the asset over its useful life.
For intangible assets—such as brands and intellectual property—this process of allocating
costs over time is called amortization. For natural resources—such as minerals, timber
and oil reserves—it's called depletion.

The accounting process of gradually connection unexpired cost of fixed asset into expenses
over a series of accounting periods is called depreciation. The word ‘depreciation’ is derived
from Latin word ‘Depretium’ where ‘De’ means decline and ‘pretion’ means price.

 ‘Depreciation is the permanent decrease in the value of an asset due to use and or
the lapse of the time”. – CIMA, London.
 “Depreciation is the permanent and continuous domination in the quality, quantity
or value of an asset”. – William Pickles.

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OBJECTIVES:

 To calculate proper profits.


 To show the asset at its reasonable value.
 To maintain the original monetary investment of the asset intact.
 Provision of depreciation results in some incidental advantages also.
 To provide for replacement of an asset.

METHODOLOGY:
 Here all the data are collected from secondary data which have been collected from
different books and different website and journal. Externally those sources may include
in the books, or periodical, published report, etc. For the Complications of the projects,
I have consulted the secondary data. The data included various newspaper, Magazines,
Journal different website. It is also included the suggestions of our teachers.

Characteristics of Depreciation:-

 It is a non-cash expense.
 It may be physical or functional.
 It is a process of allocation of cost and not of valuation of fixed assts.
 It is charged in respect of find out asset only.
 It is a continuous fall in the utility of a picked asset till the end of its useful life.

Courses of Depreciation

1) Physical
2) Functional
1) Physical :-
(a) Wear and tear : Some assets physically deteriorate due to wear and tear in use. The
constant use of asset wears cut the asset.
(b) Destruction : The physical destruction of an asset reduces its utility value.
(c) Decay : It refers to lessening in the utility of an asset by the effect of nature.

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2) Functional :
(a) Obsolescence: Some assets are discarded they are worn out because of changed
conditions.
(b) Inadequacy: It refers to the termination of the use of an asset due to increase in the
volume of business activities.
(c) Effluxion of time : Such assets became valueless after the expiry of period of their
life.
(d) Depletion : In case of oil wells, mines, etc. the value is reduced with the contraction
of oil and minerals.
(e) Exhaustion : Assets lose their value gradually with the passage of time They have
their own age and exhaust in value after the expiry of contain period of their age.

Need for charging Depreciation :

1) Correct calculation of profit : This purpose is achieved when depreciation is charged


as expense to the profit and loss Account,
2) True and fair view in balance sheet : This over valuation of fixed asset will not
represent a true and fair view of the state of affairs of the business
3) Accounts ascertainment of cost : Depreciation on these assets is a factory
overhead, which must be include to find out cost of production accurately.
4) Distribution of dividend out of profits only : If depreciation is not provided out of
profit and loss Account, the profits will be more and the excess dividend will be paid
out of capital.
5) Replacement of assets : Application of proper method of depreciation will be make
it convenient to make arrangements for the replacement of asset after the expiry of
its life.
6) Saving in income tax : When depreciation is debited to profit and loss Account, the
profits are reduced. Consequently the tax liability on profit is also reduced.

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Factors Determining the Amount of Depreciation :

(1) Cost of asset : The original cost of asset paid on acquisition of asset, is increased with
the amount spent on installation freight, loading and unloading charges, transit
insurance, octroi, etc. The aggregate amount is called ‘cost of asset’.
(2) Estimated working life : Technical expertise is required to estimate the working life
of an asset.
(3) Salvage/Residual/Scrap value : It refers to the estimated amount which will be
realized when asset is sold, discarded or exchanged for a new asset at the end of its
working life.
(4) Legal provisions : If there are some legal provisions for providing depreciation on
asset the same should be taken into consideration.

Distinction between depreciation, depletion, obsolescence, amortization and


dilapidation, fluctuation :

Depletion : Depletion implies removal of an available but irreplaceable resource, such as,
extracting coal from a coal mine or oil out of oil well.

Amortization : The process of writing off intangible assets, such as goodwill, patents, trade
marks or license etc., which cannot be seen or touched is called amortization.

Dilapidation : The term dilapidation reforms to the damage done to a building or other
property during tenancy.

Obsolescence : This means reduction or loss of usefulness of an old asset due to a new
invention or improved design of an existing asset. Obsolescence may be due to various
factors :-

 Change in the method of production


 Change in product design
 Change in model
 Change in demand of product
Fluctuation : Fluctuation is a temporary upward or downward variation in the market price
of fixed asset on account of operation of market mechanism of demand and supply.

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Method For Recording Depreciation

 No provision for Depreciation Account


 Provision for Depreciation Account

No Provision for Depreciation Account

(i) For purchase of asset


Asset A/c Dr
To Cash /Bank
(Being asset purchase)

(ii) For providing depreciation


Depreciation A/c Dr
To Asset A/c
(Being annual depreciation is changed)

(iii) For transferring of depreciation


Profit & Loss A/c Dr
To depreciation A/c

(Being depreciation is transferred to P & L A/c)


[(ii) & (iii) are repeated till asset is sold or scraped]

(iv) For sale of asset at a loss


Bank A/c Dr
Depreciation A/c Dr
Profit & less A/c Dr
To Asset A/c
(Being asset is sold at a loss)
(v) For sale of asset at a profit
Bank A/c Dr
Depreciation A/c Dr
To Asset A/c
To P & L A/c
(Being asset sold a profit)

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Distinction between Depreciation Account and provision for depreciation account

Depreciation Account Provision Depreciation Account


1) It is in the nature of a nominal account 1) It is in the nature of a valuation account
2) It is generally debited to profit and loss 2) It has no place or shelter in profit and loss
account. account.
3) It is a long period account and is closed when
3) It is a shared period account and as such it is
asset is sold or expiry of the span of asset.
closed by a transfer to profit and loss
4) This account usually shows a credit balance
account.
5) It is shown in the liability side of the balance
4) This account shows a debit balance.
sheet.
5) It ensures showing of asset at written down
6) It is shown in the liability side of the balance
value in the balance sheet.
sheet
6) It is not reflected or shown in balance sheet

Depreciation is regarded as gradual reduction in the value of fixed asset. An account


prepared to record such graduate reduction is termed as depreciation account. Depreciation
account becomes a direct charge against asset and at the end of the years depreciation
account is closed by a transfer to P & L account. When depreciation is not a direct charge
against asset, provision for depreciation account is maintained it is usually credited.

Provision for Depreciation Account

(i) For purchase of asset


Asset A/c Dr
To cash/Bank
(Being asset purchase)
(ii) For providing depreciation
Depreciation A/c Dr
To provision for depreciation A/c

(Being depreciation is provided)

(iii) For transferring depreciation


P & L A/c Dr
To depreciation A/c

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(Being transfer of depreciation)

[(ii) & (iii) entries are recorded till asset is sold or becomes absolute.]

(iv) When sold at a loss


Bank A/c Dr
Provision for depreciation A/c Dr
P & L A/c
To Asset A/c

(Being asset is sold at a loss)

(v) When sold at a profit


Bank A/c Dr
Provision for depreciation A/c Dr
To asset A/c
To P & L A/c
(Being asset is sold at a profit)

Methods of Charging Depreciation

(1) Fixed installment method (straight line or original cost method):

Under this method, a fixed proportion of original cost of the asset is writer off
annually so that, by the time asset is worn out, its value in the books is reduced to zero
or residual value.

Depreciation
= original cost of fixed asset - Estimated scrap value
Estimated life of asset in years
or > D = C - S
N
Merits :
1) Simple : It is very easy method of providing depreciation and the calculations are
very simple.
2) Asset is fully written off : According to this method, the asset account is written off
fully at the end of its working life.

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3) Knowledge of total depreciation charged : The amount of total depreciation
charged to profit and loss account can be easily ascertained by multiplying the
annual installment of depreciation with the number of years, the machine has been
used.
4) Suitable for fixed life assets : This method is very suitable for that assets which have
a fixed working life.

Demerits :
1) Interest on capital : This method does not take into consideration the interest on
capital invested in fixed assets.
2) Repairs and maintenance : Since the amount of depreciation remains constant every
year, the expenses incurred on repairs and maintenance increase gradually as the
asset grows older and as such, profit and loss account is charged heavily in the later
years.
3) Decrease in utility : Asset in the earlier part of its later period when asset gradually
becomes older thus benefit and cost are not matched rationally.
4) Income tax : This method is not fully recognized by income tax department.

Diminishing balance method(written down value method):


Under this method, a fixed rate or percentage of depreciation is charged each year
on the diminishing value of the asset till amount is reduced to scrap value whereas, the
straight line method assumes that the net cost of an asset be allocated to successive periods
in uniform amounts, the diminishing balance method assures that the rate of allocation
should be constant throughout time.

Merits :

1) Rational matching : Under this method, higher depreciation charged in earlier years
when the machine is most useful and produces high revenues. Thus, the cost and
revenues are matched nationally.
2) Obsolescence : Obsolescence does not effect much because the major part of the
asset is written off as depreciation and the management has no difficulty in replacing
the asset.

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3) Recognition from income tax department : This method assumes more significance
because income tax authorities recognize this method for accounting purpose.
4) Suitable for long life asset : This method is suitable for those assets which have long
life.

Demerits :-

(1) Interest on capital : The interest on capital invested in fixed asset is ignored under
this method also, with the result the profits are overstated.
(2) No funds for replacement : This method does not solve the problem of availability of
funds at the time of replacement of assets. Though depreciation is charged every
year but the amount charged is retained in the business.
(3) Asset is not reduced to zero : The value of asset under this method is never reduced
to zero. Though the asset becomes useless after its working life is over but the book
value is not extinguished.
(4) Rate of depreciation : As compared to straight-Line method, it is difficult to calculate
the rate of depreciation under this method.

Example - 1 Problems of Rate of Depreciation

Types Purchase price Capitalised Scrap value Expected life


(Rs) expenses (Rs.)
Road king 1,00,000 20,000 10,000 5 years
Road master 8,000 2,000 4,000 10 years
Road tiger 45,000 5,000 10,000 8 years

Solution :
Calculation of rate of depreciation involves the following steps :
Step-1 : Calculation of total cost : Total cost of an asset is the sum total of purchase price +
capitalized expenditure involved.

Road king : Rs. 1,00,000 + Rs.20,000 = Rs.1,20,000

Road master : Rs. 8,000 + Rs. 2,000 = Rs. 10,000

Road tiger : Rs. 45,000 + Rs. 5,000 = Rs. 50,000

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Step-2 : Computation of Annual Depreciation:

Annual Depreciation = Total cost - scrap


Expected line in years

Road king : Rs.1,20,000 - Rs.10,000 = Rs. 22,000


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Road master : Rs.10,000 - Rs. 4,000 = Rs. 600


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Road tiger : Rs. 60, 000 - Rs. 10,000 = Rs. 5,000


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Step-3 : Computation of rate of Depreciation:

Rate = Annual Depreciation X 100


Total cost

Road King: Rs. 600____ X 100 = 18.33%


Rs.1,20,000

Road master : Rs.600__ X 100 = 6%


Rs.10,000

Road tiger : Rs. 5,000 X 100 = 10%


Rs. 50,000

Example-2 : Annual Depreciation when No Rate of Depreciation:

A machine costing Rs.75,000/- is purchased on 1st January, 2016. A sum of


Rs.45,000/- was incurred for carriage and installation. Residual value after 4 years is
Rs.20,000. Calculate amount of depreciation is case purfchase of machine is made on :

(a) 1st April, 2016


(b) 30th June, 2016
(c) 1st October, 2016
State also now depreciation amount will be different in the above case. When

rate of depreciation of 5% appearing in question.

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Solution :
 Calculation of Annual depreciation when no rate is given :
In this case depreciation amount for the year is computed by following formula :-
Formula : Total cost - scrap
Useful life
So, annual depreciation amount is :
75,000 + 45,000 - 20,000
4 years
= Rs. 25,000
 Calculation of Annual depreciation when rate is given :
In this case, annual depreciation calculated at the given percentage on original cost.
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So, annual depreciation is : Rs.120,000 × ×
100 12

= Rs. 6,000/-
 Computation of annual depreciation under different dates of purchase.
Date of purchase When no rate of When rate is given
depreciation given
1st April, 2016 25,000 X 9 = 18,750 6,000 X 9 = 4,500
th
30 June, 2016 12 12
st
1 October, 2016 25,000 X 6 = 12,5000 6,000 X 6 = 3,000
12 12
25,000 X 3 = 6,230 6,000 X 3 = 1,500
12 12
Example -4
Subhalaxmi brought a machine by cheque for Rs.1,80,000 on 1st January, 2012. Its
probable working like was estimated at 10 years and its scrap value was estimated was
Rs.20,000. It was decided to write off depreciation by equal annual installments. You are
required to pass necessary journal entries for first two years and show necessary accounts
and balance sheet, when depreciation is provided y creating depreciation provision account.
Books are closed each year on 31st December.
Solution
Annual depreciation = 1,80,000 – 20,000 = Rs.16,000
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January
Dr Cr
Date Particular L.F. Dr Cr
Amount Rs. Amount Rs.
2012 Machinery a/c Dr 1,80,000
Jan-1 To Bank A/c 18,000
(Being machinery purchased)
Dec-31 Depreciation a/c Dr 16,000

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To provision for depreciation a/c 16,000
(being provision for depreciation)
2013 Depreciation a/c Dr 16,000
Dec-31 To provision for depreciation a/c 16,000
(being provision for depreciation)
Dec-31 Profit & Loss a/c Dr 16,000
To Depreciation a/c 16,000
(Being depreciation transferred to P & L a/c
Machinery Account
Dr Cr
Date Particular Amount Date Particulars Amount Rs.
2012
Jan-1 To Bank A/c 1,80,000 By balance c/d 1,80,000

2013 2012
Jan-1 To Balance b/d 1,80,000 Dec-31 By balance c/d 1,80,000

2014
Jan-1 To balance b/d 1,80,000 2013
Dec-31

Dr Cr
Date Particular Amount Date Particulars Amount Rs.
2012 2012
Jan-1 To Bank A/c 16,000 Dec-31 By depreciation a/c 16,000

2013 2013
Jan-1 To Balance b/d 32,000 Jan-1 By balance b/d 16,000
By depreciation a/c 16,000
Dec-31 32,000
30,000 2014
Jan-1 By balance b/d 32,000

Balance sheet
As on 31st December, 2012
Liabilities Amount Assets Amount
Machinery 1,80,000
Less provision
For depreciation 16,000 1,64,000
Balance sheet
As on 31st December, 2013

Liabilities Amount Assets Amount


Machinery 1,80,000
Less provision
For depreciation 1,32,000 1,48,000

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CONCLUSION

Depreciation is the charge on the use of the asset. But it is quite different from other
operating expenses. For operating expenses like rent, salaries, and etc. cash has to be
incurred. There is always an outflow of cash whenever company incurs any expense. But in
depreciation, there is no outflow of resources. It is a non-cash expenditure. Hence,
wherever important financial decisions are taken, an important consideration has to be
taken on the inclusion or exclusion of depreciation. Most commonly used benchmark for
judging the profitability of the company is EBITDA (Earnings before interest, tax,
depreciation and amortization) which excludes the impact of depreciation. Despite being a
non-cash expenditure, it cannot be overlooked because true profits have to consider an
impact of depreciation.

This Standard applies to all depreciable assets, except the following items to which
special considerations apply :-

(i) forests, plantations and similar regenerative natural resources;


(ii) Wasting assets including expenditure on the exploration for and extraction of
minerals, oils, natural gas and similar non regenerative resources.
(iii) expenditure on research and development;
(iv) goodwill and other intangible assets;
(v) live stock. This standard also does not apply to land unless it has a limited useful
life for the enterprise

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REFERENCE

Books
 DOUBLE ENTRY BOOK- KEEPING
Author:
 C. Mohan Juneja
 J.S. Arora
 R.C Chawla
 P.C. Sahoo

Website

 www.wikipedia. account.depreciation com


 www.google.com

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CONTENTS

 Introduction
 Objectives
 Methodology
 Courses Of Depreciation
 Need For Charging Depreciation
 Method For Recording Depreciation
 Distinction Between Depreciation Account And Provision
For Depreciation Account
 Conclusion
 Reference

*****

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