DEPRECIATION

INTRODUCTION:

Except for land, most fixed assets, such as building, plant, machinery, office equipments, etc. have a limited useful
life. Depreciation is the process of allocating the cost of a fixed asset over its estimated useful life in a rational and
systematic manner.

IS DEPRECIATION AN EXPENSE?

All goods and services consumed by a business are for producing revenue. Since fixed assets are used to make
goods for sale during a number of periods, it is necessary to spread its cost over all the periods in which it works and
must, therefore, be charged as an expense in each of these periods.

OBJECTS OF PROVIDING DEPRECIATION:

1. To fin out net profit or loss for an accounting period, we add the revenues of that period and deduct all the
expenses incurred in that period in earning those revenues. One such expense is the portion of the cost of the
fixed assets that has expired during the period.
2. To present a true and fair view of the state of affairs of the business, the assets must be valued correctly on the
balance sheet. Unless depreciation is charged, the assets may be overstated in the balance sheet. Hence, the
value at which the fixed assets will be shown in the balance sheet is its original cost less the amount charged as
depreciation. This value is called net book value or written down value.
3. A continuous decline in the value of the asset over several years may lead to a decision to replace the asset. If
depreciation is not charged and profit available for distribution is not reduced, it is quite likely that the whole of
the profits may be withdrawn during the life of the asset. In such a case, the business may not have sufficient
funds to call for the replacement.

EFFECTS OF NOT PROVIDING FOR DEPRECIATION:

If depreciation is not provided for, the income statement (Profit and Loss Account) and the Balance Sheet will not
exhibit a true or fair view of the business, and in effect:
i Periodic expenses will be understand
ii Profits will be overstated
iii Asset valuation will be overstated
iv Capital depletion will take place
v Cost of production will be understated
vi Price determination will be inappropriate
vii Net worth will be overstated
In the process of measuring depreciation from an accounting viewpoint, the following three judgments as estimates
must be made for each fixed asset:

1. COST OF THE ASSET: The cost of an asset is the basis for all the subsequent accounting for the asset.
Generally, the cost of an asset means its acquisition cost, which is the sum of all costs incurred in acquiring the
asset, and all other incidental costs involved in bringing the asset into working condition.
When the business concern itself manufactures some assets, the cost of an asset will mean its production cost,
which will include a reasonable proportion of direct costs and interest on capital borrowed to finance
production.

2. THE RESIDUAL OR SCRAP VALUE OF THE ASSET: This is the estimated value of a fixed asset at the
end of its economic life. It is the amount which is expected to be received when the asset is sold after being
 removed from service. It is often assumed to be zero as the scrap value of an asset is very difficult to estimate at
the time of acquisition, for it is a matter of many imponderables and uncertainties. The purpose of estimating
residual value is to ascertain the net cost of the asset (acquisition cost – scrap value), which is allocated to
different accounting periods during which the asset is usually employed.

3. USEFUL LIFE OF THE ASSET: The basic objective of estimating the useful life of an asset is to allocate the
net cost of the asset over its useful life by means of depreciation. The useful life of an asset is its service life
which can be defined as the number of accounting periods during which it will be useful to the business. It is
generally based on one of the following:
i Extent of use
ii Consumption or extraction
iii Physical deterioration
iv Obsolescence

METHODS OF DEPRECIATION:

i STRAIGHT-LINE METHOD:
This is the most popular method because of its simplicity and consistency. The method requires an allocation of
an equal amount to each period. A fixed amount of the original cost is charged as depreciation every year. Thus,
the asset is written-down in value each year by the same amount. This amount is such that the book value of the
asset may be reduced to zero or its residual value, at the end of its life. The rate of depreciation is the reciprocal
of the estimated useful life.

Cost of the asset – Residual Value

Annual Depreciation = --------------------------------------------------
Estimated Economic Life
ADVANTAGES:
i It is simple to calculate and easy to understand.
ii It can reduce the book value of the asset to zero.
iii The valuation of the asset each year in the Balance Sheet is reasonably fair.
DISADVANTAGES:
i This method ignores the fact that the service yielding ability of the assets tend to fall but the repairs and
maintenance costs increase with the passage of time. Though each year’s charge for depreciation is the same,
the charge for repairs and renewals goes on increasing as the asset becomes older. Therefore, the charge to the
Profit and Loss Account increases over the years.
ii If an additional asset is acquired, the amount to be charged as depreciation needs to be recalculated.

METHODS OF RECORDING DEPRECIATION:

There are two methods of recording depreciation in the books:
FIRST METHOD: WHEN NO PROVISION FOR DEPRECIATION ACCOUNT IS MAINTAINED
Under this method, depreciation is directly charged to an Asset Account by debiting Depreciation Account and
crediting the Asset Account. At the end of the accounting period, Depreciation Account is closed by transferring it
to the Profit and Loss Account. In the Balance Sheet, the asset appears at its written-down value (cost less
depreciation provided to-date). Here, actual cost of an asset and the total amount of depreciation that has been
provided cannot be ascertained from the Balance Sheet.
Journal Entries:
i Depreciation A/c ------- Dr.
To Asset A/c
(Being the depreciation provided for the accounting year)
 ii Profit and Loss A/c ----- Dr.
To Depreciation A/c
(Being depreciation transferred to Profit and Loss Account)

SECOND METHOD: WHEN PROVISION FOR DEPRECIATION ACCOUNT IS MAINTAINED

Under this method, depreciation is not directly charged to the Asset Account. The depreciation for the period is
debited to Depreciation Account and credited to ‘Accumulated Depreciation Account’ or ‘Provision for
Depreciation Account’. Depreciation Account is closed by transferring it to the Profit and Loss Account. In the
Balance Sheet, asset appears at its original cost and the accumulated depreciation is shown as a deduction from the
Asset Account. Here, from the Balance Sheet, the original cost of the asset and the total depreciation to-date that has
been changed on that asset can be easily ascertained. As the year passes, the balance of the accumulated depreciation
goes on increasing since constant credit is given to this account in each accounting year. After the expiry of the
useful life, these two accounts are closed by debiting Accumulated Depreciation Account and crediting Asset
Account – any balance in Asset Account is transferred to the Profit and Loss Account.
Journal Entries:
i Depreciation A/c ------ Dr.
To Accumulated Depreciation A/c
(Being the depreciation provided for the accounting period)
ii Profit and Loss A/c ------ Dr.
To Depreciation A/c
(Being the depreciation for the period charged to Profit and Loss Account)

ii DIMINISHING BALANCE METHOD:

This method assumes that the rate of allocation should be constant through time. Under this method, instead of a
fixed amount, a fixed rate on the reduced balance of the asset is charged as depreciation every year. Since a
constant percentage rate is being applied to the written-down value, the amount of depreciation charged every
year decreases over the life of the asset. Though the percentage at which depreciation is charged remains fixed,
the amount of depreciation goes on diminishing year after year.

S where n = the expected useful life in years

r=1- n ------- S = the residual value
C C = the acquisition cost
r = the rate of depreciation to be applied
ADVANTAGES:
i As the decreasing charge for depreciation cancels out the increasing charges for repairs over the years, it gives a
fair charge for depreciation.
ii No recalculation is necessary when additional assets are purchased.
iii This method is applicable for income-tax purposes.
DISADVANTAGES:
i This method lacks simplicity – the ascertainment of the percentage to be applied.
ii The method cannot be applied for assets with a very short life.
iii The asset is never fully depreciated.

PROFIT AND LOSS ON DISPOSAL OF FIXED ASSETS:

Owing to technological developments, a depreciated asset become obsolete and it may be sold out before its useful
life. The sale value of such asset may not be equal to its written-down value. If the asset is sold at a price which is
more than its written-down value, it produces a profit. When the asset is sold at a price which is less than its written-
down value, it is a case of loss on sale of asset.
In the year of disposal or sale, we make an adjustment in the Profit and Loss Account in respect of any difference
that exists between the written-down value and the realized value of the asset.

ADJUSTMENT ENTRIES:
i WHEN NO PROVISION FOR DEPRECIATION ACCOUNT IS MAINTAINED:
a. For current year’s depreciation on disposed asset
Depreciation A/c ------ Dr.
To Asset A/c
(Being the depreciation on disposed asset)
b. For sale proceeds
Bank A/c ----- Dr.
To Asset A/c
(Being sale of asset for cash)
c. For profit on sale
Asset A/c ---- Dr.
To Profit and Loss A/c
(Being profit on sale transferred to Profit and Loss Account)
d. For loss on sale
Profit and Loss Account ----- Dr.
To Asset A/c
(Being loss on sale transferred to Profit and Loss Account)
ii WHEN PROVISION FOR DEPRECIATION ACCOUNT IS MAINTAINED:
If the asset account is maintained at cost price, on disposal, the original cost of such asset is transferred to ‘Asset
Disposal Account’ and ‘Accumulated Depreciation’ o such asset is also transferred to this account.
a. For transferring to Disposal Account
Assets Disposal A/c ----- Dr.
To Asset A/c
(Being the original cost of the disposed asset is transferred to Assets Disposal Account)
b. For transferring accumulated depreciation on disposed asset
Accumulated Depreciation A/c ----- Dr.
To Assets Disposal A/c
(Being the accumulated depreciation on disposed asset transferred to Assets Disposal Account
c. For charging current year’s depreciation on disposed asset
Depreciation A/c ------ Dr.
To Assets Disposal A/c
(Being current year’s depreciation on disposed asset)
d. For sale proceeds
Bank A/c ----- Dr.
To Asset Disposal A/c
e. For profit
Assets Disposal A/c ----- Dr.
To Profit and Loss Account
(Being profit on sale of asset transferred to Profit and Loss Account)
f. For loss
Profit and Loss A/c ------ Dr.
To Assets Disposal A/c
(Being loss on sale of asset transferred to Profit and Loss Account)
EXCHANGE OF USED ASSET WITH NEW ASSET:
When a new fixed asset is acquired in exchange for another old asset of the same kind or other, the business is to
pay only the difference. This value of old asset is known as “trade-in-allowance”, which becomes a part of the new
asset. If the trade in allowance is less than the written-down value, it is a loss. If is more than the written-down
value, it is a gain to the business. The loss or gain is nothing but under-depreciation or over-depreciation, should be
transferred to Profit and Loss Account.
Accounting Entries:
a. Ascertain the written-down value of the old asset and pass the following entry:
Assets Disposal A/c ----- Dr. (Written-down value)
To Asset A/c (Written-down value)
b. Ascertain the value of New Asset (which is the sum total of trade-in-allowance and cash payment to the seller)
and pass the following entry:
Asset A/c ----- Dr. (Trade-in-allowance + cash payment)
To Vendor A/c (Trade-in-allowance + cash payment)
c. For e of account with the vendor pass the following entry:
Vendor A/c ----- Dr.
To Bank A/c (Cash payment)
To Assets Disposal A/c (Trade-in-allowance)
d. Ascertain the amount of current year’s depreciation on old asset and pass the following entry:
Depreciation A/c ----- Dr. (Depreciation of the year of disposal)
To Assets Disposal A/c
e. Charge depreciation on new asset in the usual manner.
f. Balance of Disposal Account should be transferred to Profit and Loss Account to close the Disposal Account.

EXERCISES:
1. The purchase of furniture amounted to Rs 4,000 and it is decided to write off 5 per cent on the original cost as
depreciation at the end of each year. Show the ledger account as it will appear during the first four years. Pass
journal entries also.
2. On January 1, 2009 M/s Ram and Sons purchased a machinery for Rs 2,00,000. They spent Rs 12,000 on its
freight and Rs 8,000 for its installation. The expected life of the machine is 10 years. It is expected that the
machine will be sold for Rs 20,000 after its useful life. Prepare machinery account and depreciation account for
3 years. Books of Accounts are closed on December 31, every year.
3. On 1st January, 2008 a Company bought Plant and Machinery costing Rs 35,000. It is estimated that its working
life is 10 years, at the end of which it will fetch Rs 5,000. Additions are made on 1 st January, 2009 to the value
of Rs 20,000 (Residual value Rs 2,000). More additions are made on July 1, 2010 to the value of Rs 10,000
(Breakup value Rs 1,000). The working life of both the additional Plants and Machinery is 20 years.
Show the Plant and Machinery account for the first four years, if depreciation is written off according to
Straight Line Method. The accounts are closed on 31 st December every year.
4. On 1st July 2008 Raj & Co. purchased machinery worth Rs 40,000. On 1 st July, 2010 it buys additional
machinery worth Rs 10,000. On 30th June, 2011 half of the machinery purchased on 1 st July, 2008 is sold for Rs
9,500. The company writes off 10% on the original cost. The accounts are closed every year on 31 st December.
Show the machinery account for four years, Accounts is closed on December 31, every year.
5. Kaushal Traders purchased second hand machinery on 1st January, 2010 for Rs 23,000 and spent Rs 2,000 on its
repairs. It was decided to depreciate the machinery at 20% every year, according to diminishing balance
method. Prepare the machinery account from 2010 to 2012 and show profit or loss as it was sold on 31st
December, 2012 for Rs 10,800. The accounts are closed on December 31 every year.
6. A company whose accounting year is the calendar year purchased on 1 st April, 2008 machinery costing Rs
30,000. It further purchased machinery on 1 st October, 2008 costing Rs 20,000 and on 1st July, 2009 costing Rs
10,000. On 1st January, 2010 one – third of the machinery which was installed on 1st April, 2008 became
 obsolete and was sold for Rs 3,000. Show how the machinery account would appear in the books of company.
The depreciation is charged at 10% p.a. on written down value method.
7. A manufacturing concern, whose books are closed on 31 st December, purchased machinery for Rs 50,000 on
1.1.2008. Additional machinery was acquired for Rs 10,000 on 1.7.2009 and for Rs 16,061 on 1.1.2012. Certain
machinery purchased for Rs 10,000 on 1.1.2008 was sold for Rs 5,000 on 30.6.2011.
Give the machinery account for 5 years. Depreciation is written off at 10% per annum on written down value
method.
8. On January 1, 2010, Karim Printing Press purchased a printing machinery costing Rs 50,000. Its scrap value is
Rs 2,000 and expected life is 10 years. It is decided to depreciate printing machinery by written down value
method for initial 3 years. Calculate the rate of depreciation, under this method and show the written down
value (book value) at the end of the year.
9. A company purchased a plant for Rs 20,000 on January 1, 2010. The plant was subjected to depreciation @
10% according to straight line method. It was sold on December 31, 2011 for Rs 15,000. Additional Plant was
purchased on January 1, 2012 for Rs 10,000. Pass requisite journal entries and prepare Plant Account,
Depreciation A/c and Provision for Depreciation A/c for 3 years. Also show Plant in the Balance Sheet.
10. On 1st January, 2011, M/s Swaminathan and Bros. purchased 5 washing machines for Rs 15,000 each. They
sold on January 1, 2012 one machine for Rs 12,500. They have decided to write off depreciation @ 10% on
straight line method. Prepare washing machines A/c, Washing Machine Disposal Account and Provision for
Depreciation A/c for two years. Accounts are closed on 31 st December, every year.
11. On 1.1.2009 X Ltd. purchased from Y Ltd. plant costing Rs 4,00,000 on Instalment basis payable as follows:
On 1.1.2009 1,00,000
On 1.7.2009 1,00,000
On 1.1.2010 1,00,000
On 1.1.2011 1,00,000
The company spent Rs 10,000, on transportation and installation of the plant. It was decided to provide for
depreciation on straight line method. For this purpose, the useful life of the plant was estimated at 5 years. It
was also estimated that at the end of useful life, realizable value of the plant would be Rs 12,000 (Gross) and
dismantling cost of the plant, to be paid by the company, was estimated at Rs 2,000. The plant was destroyed by
fire on 31.12.2012 and an insurance claim of Rs 50,000 was admitted by the insurance company.
Prepare plant account, Accumulated Depreciation Account, Plant Disposal Account and Loss on sale of plant
assuming that the company closes its books on 31 st Dec. every year.
12. B. Bedi purchased a machine by cheque for Rs 90,000 on 1 st January, 2008. Its probable working life was
estimated at 10 years and its probable scrap value at the end of that time as Rs 10,000. It was decided to write-
off depreciation by equal annual instalments. You are required to pass necessary journal entries for 1 st two years
and show necessary accounts and the Balance Sheet:
a. When no Provision for Depreciation Account is maintained.
b. When Provision for Depreciation Account is maintained.
13. Roy Bros., a firm, purchased machinery by cheque for Rs 1,00,000 on 1st January, 2008. The estimated scrap
value of the machinery is Rs 34,868. At the end of each year, depreciation is provided at the rate of 10% per
annum by the diminishing balance method. Show Machinery Account and Balance Sheet for the first two
financial years which is ending on December, 31st every year:
a. When no Provision for Depreciation Account is maintained; and
b. When Provision for Depreciation Account is maintained.
14. M/s Suba Pharmaceuticals has imported a machine on 1 st July, 2006 for Rs 1,60,000, paid customs duty and
freight Rs 80,000 and incurred erection charges Rs 60,000. Another local machinery costing Rs 1,00,000 was
purchased on January 1, 2007. On 1st July, 2008, a portion of the imported machinery (value one-third) got out
of order and was sold for Rs 34,800. Another machinery was purchased to replace the same for Rs 50,000.
Depreciation is to be calculated at 20% p.a. on the straight-line method. Show the Machinery Account for 2006,
2007 and 2008.
15. On 1st January, 2005, machinery was purchased by X for Rs 50,000. On 1st July, 2006, additions were made to
the extent of Rs 10,000. On 1st April, 2007, further additions were made to the extent of Rs 6,400.
On 30th June, 2008, machinery, original value of which was Rs 8,000 on 1 st January, 2005, was sold for Rs
6,000. Depreciation is charged @ 10% p.a. on original cost.
Show Machinery Account for the years from 2005 to 2008 in the books of X. X closes his books on 31 st
December.
16. Gautam & Co., whose books are closed on 31.12.2006, purchased a machine for Rs 1,50,000 on 1st January
2006. Additional machinery was acquired for Rs 50,000 on 1 st July 2006. Certain machinery, which was
purchased for Rs 50,000 on 1st July, 2006 was sold for Rs 30,000 on 30 th June, 2008. Prepare Machinery
Account and Accumulated depreciation Account for all the years upto the year ending 31 st December, 2008
taking into account depreciation @ 10% p.a. on straight-line method.
17. On 1.1.2005, X purchased roasting machine for Rs 60,000 and grinding machine for Rs 40,000. On 1.1.2006, he
purchased one oil expeller for Rs 1,00,000. On 1.1.2007, the roasting machine got out of order and a new
roaster was purchased costing Rs 1,20,000, after surrendering the old one and paying cash of Rs 90,000. On
1.1.2008, the oil expeller purchased on 1.1.2006 was destroyed by fire and the insurance company paid Rs
60,000 only. Show Machinery Account for 2005, 2006, 2007 and 2008, charging depreciation @ 10% p.a. on
the W.D.V. method.