DEPRECIATION

Fixed Assets like Plant and Machinery etc. are used in the business for the purpose of production of goods or for
providing useful services in the course of production. These fixed assets are utilized during operations of a
business for a number of successive accounting periods. Value of such fixed assets decreases with passage of
time and its utilization i.e. wear and tear. Value of portion of fixed asset utilized for generating revenue must be
recovered during a particular accounting year to ascertain true income. This portion of cost of Fixed Asset
allocated to a particular accounting year is called depreciation.

Depreciation has been defined as 'the diminution in the utility or value of an asset, due to natural wear and tear,
exhaustion of the subject-matter, effluxion of time accident, obsolescence or similar causes'. The words
"accident", "obsolescence" and the phrase "effluxion of time" included in the definition, signify that when an asset
held by a business cannot be employed for even one of the purposes for which it was acquired due to some
damage suffered, the assets having become out of date or due to no occasion having arisen for it to be used, the
loss caused to the business will be depreciation. Depreciation caused by any one of the last mentioned factors
often is described as external depreciation, to distinguish it from the natural wear and tear of assets which is
known as internal depreciation.

Depreciation 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 the depreciable amount in each accounting period
during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is
predetermined.

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.

Useful Life is either (i) the period over which a depreciable asset is expected to be used by the enterprise; or (ii)
the number of production or similar units expected to be obtained from the use of the asset by the enterprise.

Depreciable Amount of a depreciable asset is its historical cost, or other amount substituted for historical cost1 in
the financial statements, less the estimated residual value.
OBJECTIVES FOR PROVIDING DEPRECIATION:
(1) Correct Income Measurement: Depreciation should be charged for proper estimation of periodic profit or loss.
(2) True Position Statement: Value of the fixed assets should be adjusted for depreciation charged in order to
depict the actual financial position.
(3) Funds for Replacement: Generation of adequate funds in the hands of the business for replacement of the
asset at the end of its useful life.
(4) Ascertainment of True Cost of Production: For ascertaining the cost of the production, it is necessary to
charge depreciation as an item of cost of production.

Further depreciation is a non-cash expense and unlike other normal expenditure (e.g. wages, rent, etc.) does not
result in any cash outflow. Further depreciation by itself does not create funds it merely draws attention to the
fact that out of gross revenue receipts, a certain amount should be retained for replacement of assets used for
carrying on operation.

METHODS FOR PROVIDING DEPRECIATION

Generally, methods for providing depreciation are based on formula, developed on a study of the behaviour of
the assets over a period of years for readily computing the amount of depreciation suffered by different forms of
assets. Each of the methods, however, should be applied only after carefully considering nature of the asset and
the conditions under which it is being used.

The two most common methods for providing depreciation are the Straight Line Method and the Reducing
Balance Method. The Straight Line Method is the most suitable and accurate method to adopt in most cases.
The Income Tax Rules, however, prescribe the Reducing Balance Method except in the case of assets of an
undertaking engaged in generation and distribution of power.

STRAIGHT LINE METHOD

According to this method, an equal amount is written off every year during the working life of an asset so as to
reduce the cost of the asset to nil or its residual value at the end of its useful life. The advantage of this method is
that it is simple to apply and gives accurate results especially in case of leases, patents and copy rights, and also
in case of plant and machinery. Calculation of depreciation for additions to plant and machinery may be a
complicated affair unless different classes of machines are classified separately in a plant register based on year
of additions. This method is also known as Fixed Instalment Method.

Straight Line Depreciation = (Cost of Asset - Scrap Value) / Useful life

Straight Line Depreciation Rate = (Straight Line Depreciation / Cost of Asset) x 100
REDUCING BALANCE METHOD
Under this system, a fixed percentage of the diminishing value of the asset is written off each year so as to
reduce the asset to its break - up value at the end of its life, repairs and small renewals being charged to
revenue. This method is commonly used for plant, fixtures, etc. Under this method, the annual charge for
depreciation decreases from year to year, so that the earlier years suffer to the benefit of the later years. Also,
under this method, the value of asset can never be completely extinguished, which happens in the earlier
explained Straight Line Method. However, it is very simple to operate. The other advantage of this method is that
the total charge to revenue is uniform when the depreciation is high, repairs are negligible; and as the repairs
increase, the burden of depreciation gets lesser and lesser. On the other hand, under the Straight Line Method,
the charge for depreciation is constant, while repairs tend to increase with the life of the asset. Among the
disadvantages of this method is the danger that too low a percentage may be adopted as depreciation with the
result that over the life of the asset full depreciation may not be provided; also if assets are grouped in such a
way that individual assets are difficult to identify, the residue of an asset may lie in the asset account even after
the asset has been scrapped. The last mentioned difficulty could be, however, over come if a Plant register is
maintained.

1 – n √ (Residual Value / Cost of asset) x100

Accounting Entries under Straight Line and Reducing Balance Methods:

There are two alternative approaches for recording accounting entries for depreciation.

First Alternative
A Provision for Depreciation Account is opened to accumulate the balance of depreciation and the assets are
carried at Historical Cost.
Accounting Entry
 Profit and Loss Account Dr.
To Provision for Depreciation Account

Second Alternative
Amount of Depreciation is credited to the Asset Account every year and the Asset Account is carried at historical
cost less depreciation.

Accounting Entries:
 Depreciation Account Dr.
To Asset Account

 Profit and Loss Account Dr.

To Depreciation Account
Illustration 1
Jain Bros. acquired a machine on 1st July, 2010 at a cost of Rs 14,000 and spent Rs 1,000 on its installation.
The firm writes off depreciation at 10% p.a. of the original cost every year. The books are closed on 31st
December every year. Show the Machinery Account and Depreciation Account for the year 2010 and 2011.

As per Straight Line Method

MACHINERY ACCOUNT
Dr.         Cr.
2010 Rs 2010 Rs
Jul-01 To Bank A/c 14,000 Dec. 31 By Depreciation A/c - 10% on Rs 15,000 750
Jul-01 To Bank A/c - Installation Expenses 1,000 Dec. 31 By Balance c/d 14,250
    15,000   15,000

2011   Rs 2011   Rs
Jan. 1 To Balance b/d 14,250 Dec. 31 By Depreciation A/c - 10% on Rs 15,000 1,500
    Dec. 31 By Balance c/d 12,750
    14,250     14,250

DEPRECIATION ACCOUNT
Dr.         Cr.
2010   Rs 2010   Rs
Dec. 31 To Machinery A/c 750 Dec. 31 By Profit & Loss A/c 750
2011   2011  
Dec. 31 To Machinery A/c 1,500 Dec. 31 By Profit & Loss A/c 1,500

Illustration 2
Jain Bros. acquired a machine on 1st July, 2010 at a cost of Rs 14,000 and spent Rs 1,000 on its installation.
The firm writes off depreciation at 10% p.a. every year. The books are closed on 31st December every year.
Show the Machinery Account on diminishing balance method for the year 2010 and 2011.

Reducing Balance Method

MACHINERY ACCOUNT
Dr.         Cr.
2010 Rs 2010 Rs
Jul-01 To Bank A/c 14,000 Dec. 31 By Depreciation A/c - 10% on Rs 15,000 750
Jul-01 To Bank A/c - Installation Expenses 1,000 Dec. 31 By Balance c/d 14,250
    15,000   15,000
 2011   2011  
Jan. 1 To Balance b/d 14,250 Dec. 31 By Depreciation A/c - 10% on Rs 14,250 1,425
    Dec. 31 By Balance c/d 12,825
    14,250     14,250

PROFIT OR LOSS ON THE SALE / DISPOSAL OF DEPRECIABLE ASSETS:

Whenever any depreciable asset is sold during the year, depreciation is charged on it for the period it has been
used in the sale year. The written down value after charging such depreciation is used for calculating the profit or
loss on the sale of that asset. The resulting profit or loss on sale of the asset is ultimately transferred to profit and
loss account.

Illustration 3:
A firm purchased on 1st January, 2010 certain machinery for Rs 58,200 and spent Rs 1,800 on its erection. On
July 1, 2010 another machine for Rs 20,000 was acquired. On 1st July, 2011 the machinery purchased on 1st
January, 2010 having become obsolete was auctioned for Rs 38,600 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 the rate of 10 per cent p.a. on written down value.
Prepare machinery account.

MACHINERY ACCOUNT
Dr.         Cr.
2010   Rs 2010   Rs
Jan. 1 To Bank A/c 58,200 Dec. 31 Depreciation A/c 7,000
Jan. 1 To Bank A/c - Erection Charges 1,800  
July 1 To Bank A/c 20,000 Dec. 31 By Balance c/d 73,000
  80,000   80,000
2011   Rs 2011   Rs
Jan. 1 To Balance b/d 73,000 July 1 By Depreciation- machine sold 2,700
July 1 By Bank A/c 38,600
July 1 To Bank A/c 40,000 July 1 By Profit and Loss A/c 12,700
Dec. 31 By Depreciation A/c 3,900
Dec. 31 By Balance c/d 55,100
    1,13,000     1,13,000

PARTICULARS Machine
 I II III
Cost 60,000 20,000 40,000
Depreciation for 2010 6,000 1,000
Written Down Value 54,000 19,000 40,000
Depreciation for 2011 2,700 1,900 2,000
Written Down Value 51,300 17,100 38,000
Sale Proceeds 38,600  
Loss on Sale 12,700    

Illustration 4:
A company's plant and machinery account at 31st December, 2011 and the corresponding depreciation provision
account, broken down by year of purchase are as follows:

Yr of Purchase Plant and Machinery (at Cost) Depreciation Provision

1995 20,000 20,000
2001 30,000 30,000
2002 1,00,000 95,000
2003 70,000 59,500
2010 50,000 7,500
2011 30,000 1,500
Total 3,00,000 2,13,500

Depreciation is at the rate of 10% per annum on cost. It is the Company's policy to assume that all purchases,
sales or disposal of plant occurred on 30th June in the relevant year for the purpose of calculating depreciation,
irrespective of the precise date on which these events occurred. During 2012 the following transactions took
place:
 Purchase of Plant and Machinery amounted to Rs 1,50,000
 Plant that had been bought in 2001 for Rs 17,000 was scrapped.
 Plant that had been bought in 2002 for Rs 9,000 was sold for Rs 500.
 Plant that had been bought in 2003 for Rs 24,000 was sold for Rs 1,500.
You are required to:
Calculate the provision for depreciation of plant and machinery for the year ended 31st December, 2012. In
calculating this provision you should bear in mind that it is the company's policy to show any profit or loss on the
sale or disposal of plant as a completely separate item in the Profit and Loss Account.
Prepare the following Accounts for 2012
i. Plant and Machinery A/C at cost ;
ii. Depreciation provision A/C;
 iii. Sales or disposal of Plant and Machinery A/C.

Solution
Calculation of provision for depreciation of plant and machinery for the year ended 31st December, 2012.

Yr of Purchase PARTICULARS Rs Rs
1995   Nil
2001   Nil
2002   5,000
1/2 year at 10% on Rs 24,000 1,200
2003
1 year at 10% on Rs 46,000 4,600 5,800
2010 10% on Rs 50,000 5,000
2011 10% on Rs 30,000 3,000
2012 1/2 year at 10% on Rs 1,50,000 7,500
Total 26,300

MACHINERY ACCOUNT
Dr.         Cr.
01-01-2012 To Balance b/d 3,00,000 30-06-2012 By Disposals Account:  
30-06-2012 To Purchases A/c 1,50,000   Scrapped 17,000
      Sold 33,000
    31-12-2012 By Balance c/d 4,00,000
       
    4,50,000     4,50,000

DEPRECIATION PROVISION ACCOUNT

Dr.         Cr.
30-06-2012 To Disposal Account :   01-01-2012 By Balance b/d 2,13,500
  Scrapped - 2001 assets 17,000 30-06-2012 By Profit and Loss Account 26,300
  Sold - 2002 assets 9,000    
  Sold - 2003 assets 21,600    
31-12-2012 To Balance c /d 1,92,200    
    2,39,800     2,39,800

SALE OR DISPOSAL OF PLANT AND MACHINERY ACCOUNT

Dr.         Cr.
30-06-2012 To Plant and Machinery   31-12-2012 By Provision for Depreciation 47,600
  Scrapped 17,000 30-06-2012 By Cash-Sales Proceeds 2,000
   Sold 33,000 30-06-2012 By Loss on sales 400
    50,000     50,000

Illustration 5:
The Machinery Account of a Factory showed a balance of RS 1,90,000 on 1st January, 2012. Its accounts were
made up on 31st December each year and depreciation is written off at 10% p.a. under the Diminishing Balance
Method.
On 1st June 2012, new machinery was acquired at a cost of RS 28,000 and installation charges incurred in
erecting the machine works out to RS 892 on the same date. On 1st June, 2012 a machine which had cost RS
4,374 on 1st January 2010 was sold for RS 750. Another machine which had cost RS 437 on 1st January, 2011
was scrapped on the same date and it realised nothing.
Write a plant and machinery account for the year 2012, allowing the same rate of depreciation as in the past
calculating depreciation to the nearest multiple of a Rupee.

MACHINERY ACCOUNT
Dr.       Cr.
 

2012   Rs 2012   Rs
Jan. 1 To Balance b/d 1,90,000 June. 1 By Bank (Sales) 750
June. 1 To Bank (28,000 + 892) 28,892   By Depreciation (on sold machine) 148
      2,645
By Loss on sale
      By Loss on scrapping the machine 377
  By Depreciation (scrapped machinery) 16
   
      By Depreciation (Note iii) 20,291

        By Balance c/d 1,94,665

    2,18,892     2,18,892
Working Note :
(i) Calculation of loss on sale of machine on 1-6-2012

RS
Cost on 1-1-2010 4,374
Less : Depreciation @ 10% on RS 4,374 (437)
W.D.V. on 31-12-2010 3,937
Less : Depreciation @ 10% on RS 3,937 (394)
 W.D.V. on 31-12-2011 3,543
Less : Depreciation @ 10% on RS 3,543 for 5 months (148)
3,395
Less : Sale proceeds on 1-6-2012 (750)
Loss 2,645
(ii) Calculation of loss on scrapped machine RS
Cost on 1-1-2011 437
Less : Depreciation @ 10% on RS 437 (44)
W.D.V. on 1-1-2012 393
Less : Depreciation @ 10% on RS 393 for 5 months (16)
Loss 377
(iii) Depreciation
Balance of machinery account on 1-1-2012 1,90,000
Less : W.D.V.of machinery sold 3,543
W.D.V. of machinery scrapped 393 (3,936)
W.D.V. of other machinery on 1-1-2012 1,86,064
Depreciation @ 10% on Rs 1,86,064 for 12 months 18,606
Depreciation @ 10% on Rs 28,892 for 7 months 1,685
20,291

CHANGE IN THE METHOD OF DEPRECIATION

The depreciation method selected should be applied consistently 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 the statute or for compliance with the accounting standard or if it is considered that the change would result in
the more appropriate preparation and presentation of the financial statements of the enterprise. Whenever any
change in depreciation method is made, depreciation should be recalculated in accordance with the new method
from the date of asset coming into use. The deficiency or surplus arising from retrospective recomputation of
depreciation should be debited or credited to Profit and Loss account in the year in which the method of
depreciation is changed. Such change is treated as change in accounting policy. Its effect needs to be quantified
and disclosed.

Illustration 6:

A firm purchased on 1st January, 2009 certain machinery for Rs 52,380 and spent Rs 1,620 on its erection. On
January 1, 2009 another machine for Rs 19,000 was acquired. On 1st July, 2010 the machinery purchased on
1st Januray, 2009 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 annually on 31st December at the rate of 10 per cent on written down value. In 2011,
however, the firm changed this method of providing depreciation and adopted the method of providing 5 per cent
per annum depreciation on the original cost of the machinery with retrospective effect.

MACHINERY ACCOUNT
Dr.         Cr.
2009   Rs 2009   Rs
Jan. 1 To Bank 52,380 Dec. 31 By Depreciation A/c 7,300
Jan. 1 To Bank- Erection charges 1,620 Dec. 31 By Balance c/d 65,700
Jan. 1 To Bank 19,000    
    73,000     73,000
2010   Rs 2010   Rs
Jan. 1 To Balance b/d 65,700 Jan. 1 By Depreciation A/c 2,430
July. 1 To Bank 40,000   By Bank (Sales) 28,600
      By Profit and Loss A/c 17,570
    Dec. 31 By Depreciation A/c 3,710
    Dec. 31 By Balance c/d 53,390
    1,05,700     1,05,700
2011   Rs 2011   Rs
Jan. 1 To Balance b/d 53,390 Dec. 31 By Depreciation A/c 2,950

To Profit and Loss A/c

Dec. 31 2,710 Dec. 31 By Balance c/d 53,150
(Excess Dep. written back)

    56,100     56,100

Working Notes:
(1) Book Value of Machines:

  Machine I Machine II Machine III

Cost 54,000 19,000 40,000
Depreciation for 2009 5,400 1,900  
Written down value 48,600 17,100  
Depreciation for 2010 2,430 1,710 2,000
Written down value 46,170 15,390 38,000
Sale Proceeds in 2011 28,600  
 Loss on Sale 17,570    

(2) Written down value on the basis of 5% depreciation on straight line basis as at 31st Dec., 2010.

Machine II Machine III

Cost 19,000 40,000

Less : Depreciation for 2 years 1,900  

Depreciation for 1/2 year   1,000

17,100 39,000
Total Rs 56,000

(3) The book value appearing in the books is Rs 53,390; Rs 2,710 has to be written back to make this figure
Rs 56,100.

Note : The rate of 10% is assumed to be per annum.