DEPRECIATION OBJECTIVES

LESSON – 6
DEPRECIATION
OBJECTIVES
After studying this unit you should be able to
• define the meaning of depreciation
• explain the objectives of providing depreciation
• discuss the casues of depreciation
• describe the methods of depreciation
• prepare the depreciation accounts under different methods.
STRUCTURE
6.1 Introduction
6.2 Characteristics of Depreciation
6.3 Causes of Depreciation
6.4 Methods of allocating of depreciation
6.4.1 Straight Line Method of Depreciation
6.4.2 Written down value method of depreciation
6.5 Change in method of depreciation.
6.5.1 Prospective change in depreciation
6.5.2 Change in Depreciation with Retrospective effect
6.6 Annuity Method
Unit Questions
6.1 INTRODUCTION
Generally, the term ‘depreciation’ is used to denote decrease in value but in accounting, this term is used to denote decrease in the book value of a fixed asset. Depreciation is the permanent and continuous decrease in the book value of a fixed asset due to use, effluxion of time, obsolescence, expiration of legal rights or any other cause. According to the Institute of Chartered Accountants in England and Wales, ‘Depreciation represents that part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally out of use by him. Provision against this loss of capital is an integral cost of conducting the business during the effective commercial life of the asset and is not dependent on the amount of profit earned’.

6.2 CHARACTERISTICS OF DEPRECIATION
a) It is related to fixed assets only.
b) It is a fall in the book value of an asset.
c) The fall in the book value of an asset s due to the use of the asset in business operations, effluxion of time, obsolescence, expiration of legal rights or any other cause.
d) It is a permanent decrease in the book value of an asset.
e) It is a continuous decrease in the book value of an asset.


6.3 CAUSES OF DEPRECIATION
The main causes of depreciation include the following:
a) Physical wear and tear When the fixed assets are put to use, the value of such assets may decrease. Such decrease in the value of assets is said to be due to physical wear and tear.

b) With the passage of time When the assets are exposed to the forces of nature like weather, winds, rains, etc. the value of such assets may decrease even if they are not put to any use..

c) Changes in economic environment The value of an asset may decrease due to decrease in the demand of the asset. The demand of the asset may decrease due to technological changes, changes in the habits of consumers etc.

d) Expiration of legal rights When the use of an asset (e.g. patents, leases) is governed by the time bound arrangement, the value of such assets may decrease with the passage of time.

NEED FOR PROVIDING DEPRECIATION
To ascertain true results of operations
To present true and fair view of the financial position
To ascertain the true cost of production
To comply with legal requirements
To accumulate funds for replacement of assets
6.4 METHODS OF ALLOCATING DEPRECIATION
There are several methods of allocating depreciation over the useful lives of the assets. Those most commonly employed in industrial and commercial enterprises are the Straight Line Method (SLM) and the Written Down Value Method(WDV).

6.4.1 ‘Straight Line Method’ of Depreciation
Meaning Under the straight line method, a fixed and equal amount in the form of depreciation, according to a fixed percentage on the original cost, is written off during each accounting period over the expected useful life of the asset. The amount and rate of depreciation is calculated as under:
Amount of Depreciation=
Rate of Depreciation= x 100
Merits The main merits of this methods are as follows:
a) It is easy to understand.
b) It is easy to calculate the amount and rate of depreciation.
c) Under this method, the book value of the asset becomes zero or equal to its scrap value at the expiry of its usefullife.
d)
Demerits The main demerits of this methods are as under:
The total charge (i.e. depreciation plus repairs and renewals) in later years is more as compared to that in earlier years since, the amount of repairs and renewals goes on increasing as the asset grows older whereas the amount of depreciation remains constant year after year.
It does not take into consideration the interest on the capital invested in the asset.
Example 1: On January 1, 1997, X Ltd, purchased a second-hand machine for Rs.52,000 and spent Rs.2,000 as shipping and forwarding charges, Rs.5,000 as import duty, Rs.500 as carriage inwards, Rs.1,500 as repair charges, Rs.500 as installation charges, Rs.400 as brokerage of the middleman and Rs.100 for an iron pad. It was estimated that the machine will have a scrap value of Rs.2,000 at the end of its useful life which is 20 years. On 20 Sept. 1997 repairs & renewals amounted to Rs.2,000. On only 1, 1999, this machine was sold for Rs.30,600. Prepare the Machinery Account for the first three years.
Solution:
Total Cost of Machinery = Purchase price + Expenses to be capitalized
= Rs.52,000 + Rs.2,000 + Rs.5,000 + Rs.500 + Rs.1,500 + Rs.500+ Rs.400+ Rs.100
= Rs.62,000
Amount of Depreciation p.a. =
= = Rs.3,000
Dr. Machinery Account Cr.
Date Particulars Rs Date Particular Rs
01.01.97 To Bank A/c (Cost)
To Bank A/c(Expenses) 52,000
10,000 31.12.97 By Depreciation A/c
By Balance c/d 3,000
59,000
62,000 62,000
01.01.98 To Balance b/d 59,000 31.12.98 By Depreciation A/c
By Balance c/d 3,000
56,000
59,000 59,000
01.01.99 To Balance b/d 56,000 01.07.99 By Depreciation A/c
By Bank A/c
By P&L A/c(Loss) 1,500
30,600
23,900
56,000 59,000

Working Notes:
Book value as on date of sale = Rs.56,000 – Rs.1,500 = Rs.54,500
Loss on sale = Book Value as on date of sale – Sale proceeds
= Rs.54,000 – Rs.30,600 = Rs.23,900
The amount spent on repairs & renewals on 30.9.97 is of revenue nature and not of capital nature and hence, not debited to Machinery Account.

Example 2: X Ltd. has imported a machine on July 1, 1993 for Rs.1,28,000, paid customs duty and freight Rs,64,000 and incurred erection charges Rs. 48,000. Another local machinery costing Rs.80,000 was purchased on January 1, 1994. On July, 1 1995 a portion of the imported machinery (value one third) got out of order and was sold for Rs.27,840. Another machinery was purchased to replace the same for Rs.40,000. Depreciation to be calculated at 20% p.a. Show the Machinery Account for 1993, 1994 and 1995.
Solution:
Dr. Machinery Account Cr.
Date Particulars Rs Date Particular Rs
01.07.93
01.07.93
01.07.93 To Bank A/c
To Bank A/c
To Bank A/c 1,28,000
64,000
48,000 31.12.93 By Depreciation A/c
(for ½ year)
By Balance c/d 24,000

2,16,000
2,40,000 2,40,000
01.01.94
01.01.94 To Balance b/d
To Bank A/c 2,16,000
80,000 31.12.94 By Depreciation A/c
By Balance c/d 64,000
2,32,000
2,96,000 2,96,000
01.01.95
01.07.95 To Balance b/d
To Bank A/c 2,32,000
40,000 01.07.95
01.07.95

01.07.95

31.12.95 By Bank A/c
By Depreciation A/c
(on machinery sold)
By P&L A/c
(loss on sale)
By Depreciation A/c
By Balance c/d 27,840
8,000

20,160

52,000
1,64,000
2,72,000 2,72,000
Working Notes:
i) In the absence of information about depreciation method to be used, straight line method of depreciation has been used. Alternatively, written down value method of depreciation may be assumed.
ii) Calculation of Loss on Sale of Mahicnery

A Original Cost of machinery as on 1.7.93 (Rs.2,40,000 x 1/3)
B Less: Depreciation for 2 years from date of purchase to date of sale
C Less: Value as on date of sale [A – B]
D Less: Sale Proceeds
El Loss on sale of machinery [C – D] Rs
80,000
32,000
48,000
27,840
20,160

6.4.2 ‘Written Down Value Method’ of Depreciation
Meaning Under the Written Down Value method, depreciation according to a fixed percentage calculate upon the original cost (in the first year) and written down value, (in subsequent years) of an asset, is written off during each accounting period over the expected useful life of the asset. Under this method, the rate of depreciation remains constant year after year whereas the amount of depreciation goes on decreasing. The rate of depreciation is calculated as under:
x100
Where R=Rate of Depreciation (in %), n = Useful life of the asset(in years)
S=Scrap value at the end of useful life of the asset
C=Cost of the asset
Merits The main merits of this method are as under:
a) The total charge (i.e., depreciation plus repairs renewals) remains almost uniform year after year, since in earlier years the amount of depreciation is more and the amount of repairs and renewals is less, whereas in later years the amount of depreciation is less and the amount of repairs & renewals is more.
b) This method is logical in the sense that as the asset grows older, the amount of depreciation also goes on decreasing.
Demerits The main demerits of this method are as under:
a) It is difficult to calculate the rate of depreciation
b) It does not take into consideration the interest on capital invested in the asset
c) It does not provide for the replacement of the asset on the expiry of its useful life
Example 3: On January 1, 1993, X Ltd, purchased a second-hand machine for Rs.58,000 and spent Rs.2,000 on its erection. On July 1, 1995, this machine was sold for Rs.28,000. Prepare the Machinery Account of the first 3 years according to the Written Down Value taking the rate of depreciation at 10% p.a.
Solution:
Dr. Machinery Account Cr.
Date Particulars Rs Date Particular Rs
01.01.93 To Bank A/c
To Bank A/c
(Erection charges) 58,000

2,000 31.12.93 By Depreciation A/c

By Balance c/d 6,000


54,000
60,000 60,000
01.01.94 To Balance b/d 54,000 31.12.94 By Depreciation A/c

By Balance c/d 5,400


48,600
54,000 54,000
01.01.95 To Balance b/d 48,600 01.07.95 By Depreciation

By Bank A/c
By P & L A/c (Loss) 2,430


28,600
17,570
48,600 48,600
Working Notes:
i) Book value as on date of sale=Rs.48,600- =Rs.46,170.
ii) Loss on Sale = Book Value – Sale proceeds = Rs.46,170 – Rs.28,600 = Rs.17,570
Example 4: On 1st January, 1992 X Ltd purchased a machinery for Rs.58,000 and spent Rs.2,000 on its erection. On 1st July, 1992 an additional machinery costing Rs.20,000 was purchased. On 1st July, 1994 the machine purchased on 1.1.92 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 taking the rate of depreciation at 10% p.a.
Dr. Machinery Account Cr.
Date Particulars Rs Date Particular Rs
01.01.92
01.01.92

01.07.92 To Bank A/c
To Bank A/c
(Erection charges)
By Bank A/c 58,000

2,000
20,000 31.12.92 By Depreciation A/c
(Rs.6,000 + Rs.1,000)
By Balance c/d 7,000

73,000
80,000 80,000
01.01.93 To Balance b/d 73,000 31.12.93 By Depreciation A/c
By Balance c/d 7,300
65,700
73,000 73,000
01.01.94
01.07.94 To Balance b/d
To Bank A/c 65,700
40,000 01.07.94




31.12.94 By Bank A/c (sale)
By Depreciation
(on machine sold)
By P & L A/c
(Loss on sale)
By Depreciation A/c
(Rs.1,710 + Rs.2,000)
By Balance c/d 28,600

2,430

17,570

3,710
53,390
1,05,700 1,05,700
01.01.95 To Balance b/d 53,390 31.12.95 By Depreciation A/c
By Balance c/d 5,339
48,051
53,390 53,390
Working Note: Calculation of Loss on Sale of Machinery (purchased on 1.1.1992)

A Original cost
B Less: Depreciation for 1992
C Book Value as on 1.1.93 (A – B)
D Less: Depreciation for 1993
E Book Value as on 1.1.94 (C – D)
F Less: Depreciation for 1994 [(for 6 months) upto date of sale]
G Book Value as on 1.7.94 (E – F)
H Sale Proceeds
I Loss on Sale (G – H) Rs
60,000
6,000
54,000
5,400
48,000
2,430
46,170
28,600
17,570

6.5 Change in method of Depreciation
According to Accounting Standard – 6 of Para 21 (Revised), Depreciation method selected should be applied consistently from one period to another period. The standard recommends that change of method should be made only if the adoption is required by statute or for compliance with an accounting standard or if it is considered that the change would result in a much better presentation of financial statements.
A change in method contemplated by this standard is that depreciation should be recalculated in accordance with the new method from the date of the asset coming into use. So the change permitted by the Institute is with restrospective effect only. The deficiency or surplus arising from the change should be adjusted in the accounts in the year in which the depreciation method is changed. Such a change should be treated as a change in accounting policy and its effect should be quantified and disclosed. The point to be borne in mind is that the revised accounting standard comes into effect for financial statements commencing on or after April 1, 1995.
The decision to change the method of depreciation with immediate effect with the object of providing better information to the users of accounting reports. There is one more possibility for change in depreciation charged. The estimated useful life and the residual value is revised, then the written down value may be required to be revalued and the depreciation should be based on this revalued amount. This situation arises only when the information required to revise the accounting estimate was not available earlier. This is a rare possibility.
So change in method of depreciation may be effected in (a) Prospective way, or (b) Retrospective way. Both methods are discussed below.

6.5.1 Prospective change in Depreciation
This method is simple because the change in the method of charging depreciation is effected from the current on written down value.
Example
On 5-4-2001, XYZ Limited purchased a machine for Rs.10,000 and provided depreciation at 10% p.a. At the end of the accounting year, the company decided to change the method of depreciation from straight line method to written down value method. Prepare the machinery account for the two years. The rate of depreciation remains the same.
Solution.
Dr. MACHINERY ACCOUNT Cr.
Date Particulars Amount Date Particulars Amount
2001
April 1

2002
April 1

To Bank A/c


To Balance Rs.
10,000
10,000

9,000
.
9,000 2002
March 31

2003
March 31
By Depreciation A/c
By Balance

By Depreciation A/c
By Balance Rs.
1,000
9,000
10,000
900
8,100
9,000

6.5.2 Change in Depreciation with Retrospective Effect
In this method depreciation already recorded in the previous years are to be adjusted. The S.D.V. on the date of change is to be adjusted for over depreciation or under depreciation charged. The steps to be taken are as follows.
Step 1: Calculate total depreciation from the date of restrospective effect to the date of change by adopting new method of depreciation.
Step 2: Calculate total depreciation under the existing method upto the date of change.
Step 3: Pass the journal entries for the difference between them as specified below.
a) If the depreciation of Step 1 is greater than that of Step 2
Profit and Loss Account Dr.
To Asset A/c
(Adjustment entry for under charging of depreciation)
b) When total depreciation of Step 1 is less than that of Step 2
Assets A/c Dr.
To Profit and Loss A/c
(Entry for adjusting depreciation over charged)
Step 4: Charge depreciation from the date of change by applying the new method
Example
A firm purchased a machine for Rs.80,000 on 1-4-2000. It was depreciated at 10% on written down value method.
On 31-3-2002, they decided to change the method of depreciation to SLM from 1-4-2002. Prepare machinery account for all the years upto 1-4-2003.
Solution.
Dr. MACHINERY A/c Cr.
Date Particulars Amount Date Particulars Amount
2000
April 1

2001
April 1

2002
April 1
To Bank A/c


To Balance


To Balance Rs.
80,000
80,000

72,000
72,000

64,800
64,800 2001
March 31

2002
March 31

2003
March 31
By Depreciation A/c
By Balance

By Depreciation A/c
By Balance

By P and L A/c
(under charged)
By Depreciation A/c
By Balance Rs.
8,000
72,000
80,000
7,200
64,800
72,000
800

8,000
56,000
64,800
Note:

WDV SLM
Depreciation charged
I year
II year Rs.
8,000
7,200 Rs.
8,000
8,000
15,200 16,000
/ Depreciation underchanged = 16,000 – 15,000 = Rs.800.

6.6 Annuity Method
The annuity method considers that the business, besides losing the original cost of the asset also loses interest, on the amount used for buying the asset, which he would have earned in case the same amount would have been invested in some other form of investment. Thus, the asset account is debited with interest, which is ultimately credited to Profit and Loss Account and is credited with amount of depreciation which remains fixed year after year. The annual amount of depreciation is determined with the help of Annuity table. The amount of total depreciation is determined by adding the cost of the asset (i.e., purchase price )and interest thereon at an expected rate. The journal entries under this method are:
a) Asset A/c … Dr.
To Bank
(For purchase of asset)
b) Asset A/c … Dr.
To Interest
(For charging interestto asset)
c) Depreciation A/c … Dr.
To Asset
(For depreciation charged on asset)
Appraisal. (i) This method takes into account interest on capital invested in the asset.
(ii) The method is most scientific as it considers the amount of depreicaiton from Annuity table.
(iii) Too much calculation work becomes cumbersome.
(iv) In case the asset requires frequent additions or extensions, the calculations have to be revised quite often thus overburdening calculation work.
(v) Like the straight line method, it also has tendency to inequalise the charge to profit and loss account in respect of depreciation and repairs put together because the amount of depreciation remains fixed over the life of the asset.
(vi) Annuity method is much suited to those assets that require considerable investment and where frequent additions are not made. It is not suited for plant and machinery where additions are usually made quite often.
Example
Manish & Co. acquires a lease costing Rs.1,00,000 on April 1, 1993 for a term of five years. You find from the Annuity Table that in order to write off the lease on the annuity method at 12% per annum interest, the amount to be written off annually works out to be Rs.0.2774096 for every rupee. Prepare the Lease Account for all the five years and show the annual charge to Profit and Loss Account during each of these five years. Books are closed on 31st March every year.
Solution. Books of Manish & Co.
Dr. LEASE ACCOUNT Cr.
Date Particulars Rs. Date Particulars Rs.
1993
April 1
1994
Mar 31


1994
April 1
1995
March 31


1995
April 1
1996
March 31


1996
April 1
1997
March 31


1997
April 1
1998
March 31

To Bank

To Interest
(1,00,000x12/100)

To Balance b/d

To Interest
(84,259 x 12/100)


To Balance b/d

To Interest
(66,629x12/100)


To Balance b/d

To Interest
(46,884x12/100)


To Balance b/d

To Interest
(24,769x12/100)
10,000

12,000
_______
1,12,000
84,259

10,111
______
94,370

66,629

7,996
______
74,625

46,884

5,626
_____
52,510

24,769


2,972
27,741 1994
March 31




1995
March 31




1996
March 31




1997
March 31




1998
March 31
By Depreciation

By Balance c/d



By Depreciation

By Balance c/d



By Depreciation

By Balance c/d



By Depreciation

By Balance c/d



By Depreciation
27,741

84,259
_______
1,12,000

27,741

66,629
______
94,370

27,741

46,884
______
74,625

27,741

24,769
______
52,510

27,741

______
27,741
Notes: 1 Annual charge on account of depreciation has been computed as under:
Rs. 1,00,000 x 0.2774096
= Rs. 27,740,96
This has been rounded off to Rs.27,741
2. Interest debited to the Asset Account every year has also been rounded off to the nearest rupee.
3. For depreciation every year, the journal entry will be:
Depreciation A/c … Dr.
To Asset A/c
For interest every year, the journal entry
will be:
Asset A/c … … Dr.
To Interest A/c
Both Depreciation A/c and Interest A/c, being nominal accounts, are ultimately transferred to Profit and Loss A/c every year by passing the following journal entries.
(i) For Depreciation:
Profit and Loss A/c … …. Dr.
To Depreciation A/c
(ii) For Interest:
Interest A/c …. ….Dr.
To Profit and Loss A/c
Thus, each year Profit and Loss A/c will be debited with depreciation and credited with interest.
The following statement shows the net charge to Profit and Loss Account.
STATEMENT SHOWING AMOUNT CHARGEABLE TO P&L A/C
Year Depreciation (Debited) Interest (Credited ) Net charge against profits

I
II
III
IV
V Rs.
27,741
27,741
27,741
27,741
27,741 Rs.
12,000
10,111
7,999
5,626
2,972 Rs.
15,741
17,630
19,745
22,115
24,769
1,38,705 38,705 1,00,000
From the above table it can be seen that the net charge to Profit and Loss Account increases year after year even though the depreciation is a fixed sum. This is because interest amount decreases year after year. However, the total net charge to Profit and Loss Account is equal to the cost of lease.

Unit Questions
1. What is Depreciation?
2. What are the features of Depreciation?
3. What is depreciation? What are its features?
4. Define Depreciation. Why is it necessary? What factors do you consider for calculating depreciation?
5. An asset is purchased for Rs.25,000. Depreciation is to be provided annually according to straight line method. The useful life of the asset is 10 years and the residual value is Rs.5,000.
Calculate the rate of depreciation and prepare asset account for first three years.
6. Machinery Account stood in the books of a company as:
Balance as at 1-1-2000 Rs.14,900. Purchase of machinery on 1-7-2000 Rs.4,400. Sale of machinery on 1-10-2000 Rs.1,000. The original cost of machinery sold was Rs.6,000. On 1-7-1999, depreciation was charged at 10% on W.D.V. Prepare machinery account in the books of the company for the year 2000. Accounts were closed on 31st December each year.

7. The balance in the machinery account stood at Rs.40,500 after providing depreciation using written down value method at 10% for two years upto 30-3-99. Onthis date it was decided to change the method to original cost from the date of purchase at 10% p.a. Prepare Machinery Account for 1997-98 to 1999-2000.

8. A business unit purchased four motor vehicles costing Rs.1,20,000 each on 1-5-1993. He expected to fetch a scrap value of 15% of the cost price of the vehicles after ten years. He depreciated the vehicles at Rs.70,000 on 31st December 1995.

9. On 1-1-99, B Ltd. purchased a machine for Rs.10,000 and provided depreciation @ 10% p.a. At the end of 2000, the company decided to change the method of depreciation from SLM to WDV restropectively. The rate remaining the same. Prepare the machinery account for the year 2000.

10. On 1.7.1978 ‘A’ Ltd. Purchased a second hand machine for Rs.20,000 and spent Rs.3000 on reconditioning and installing it on 1.1.1979 the firm purchased a new machinery worth
Rs.12,000 on 30.6.1980 the machinery purchased on 1.1.79 was sold for Rs.8,000 and on
1.7.80 a new planet was purchased at a cost of Rs.15,000 . The Company writes of
Depreciation at 10% on the original cost of the machinery each year. The accounts are closed every year ending 31st March show the machinery account for three years ending 31.3.1981.

11. On 1.1.92 on company purchased a machinery for Rs.12000 and on 30th June it purchased
additional machinery at a cost of Rs.2000 . On 31st March 1994 one of the original machine which has cost Rs.500 was found to have become obsolete and was sold for Rs.50.Dt was replaced on that date by a new machine costing Rs.800 Depreciation to be provided at the rate of 15% p.a on written down value .Show the machinery account for the first three years.

12. A lease of land was acquired on 1st Jan’2000 at a cost of Rs.30,000. It was decided to depreciate it under the annuity method at 5% interest. Annuity table shows that at 5% Re.1 over 5Years is equivalent to Rs.0.230975 annually. Write up the lease account for 5 years.

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