ZeePedia Add to Favourites   |   Contact us


Financial Accounting

<<< Previous DEPRECIATION Next >>>
 
img
Financial Accounting (Mgt-101)
VU
Lesson-17
DEPRECIATION
Depreciation is a systematic allocation of the cost of a depreciable asset to expense over its useful life. It is a
process of charging the cost of fixed asset to profit & loss account.
Fixed Assets are those assets which are:
 Of long life
 To be used in the business to generate revenue
 Not bought with the main purpose of resale.
Fixed assets are also called "Depreciable Assets"
When an expense is incurred, it is charged to profit & loss account of the same accounting period in which it
has incurred. Fixed assets are used for longer period of time. Now, the question is how to charge a fixed
asset to profit & loss account. For this purpose, estimated life of the asset is determined. Estimated useful
life is the number of years in which a fixed asset is expected to be used efficiently. It is the life for which a
machine is estimated to provide more benefit than the cost to run it. Then, total cost of the asset is divided
by total number of estimated years. The value, so determined, is called `depreciation for the year' and is
charged to profit & loss account. The same amount is deducted from total cost of fixed asset in the financial
year in which depreciation is charged. The net amount (after deducting depreciation) is called `Written down
Value'.
WDV = Original cost of fixed asset ­ Accumulated Depreciation
Accumulated Depreciation is the depreciation that has been charged on a particular asset from the time of
purchase of the asset to the present time. This is the amount that has been charged to profit and loss
account from the year of purchase to the present year.
Depreciation accumulated over the years is called accumulated depreciation.
Useful life
 Useful Life / Economic Life is the time period for machine is expected to operate efficiently.
 It is the life for which a machine is estimated to provide more benefit than the cost to run it.
GROUPINGS OF FIXED ASSETS
Major groups of Fixed Assets:
 Land
 Building
 Plant and Machinery
 Furniture and Fixtures
 Office Equipment
 Vehicles
No depreciation is charged for `Land'. In case of `Leased Asset/Lease Hold Land' the amount paid for it is
charged over the life of the lease and is called Amortization.
RECORDING OF JOURNAL ENTRIES
Purchase of fixed asset:
Debit:
Relevant asset account
Credit:
Cash, Bank or Payable Account
129
img
Financial Accounting (Mgt-101)
VU
For recording of depreciation, following two heads of accounts are used:
 Depreciation Expense Account
 Accumulated Depreciation Account
Depreciation expense account contains the depreciation of the current year. Accumulated depreciation
contains the depreciation of the asset from the financial year in which it was bought up to the present
financial year. . Depreciation of the following years in which asset was used is added up in this account. In
other words, this head of account shows the cost of usage of the asset up to the current year. Depreciation
account is charged to profit & loss account under the heading of Administrative Expenses. In the balance
sheet, fixed assets are presented at written down value. i-e.
WDV = Actual cost of fixed asset ­ Accumulated Depreciation.
Journal entry for the depreciation is given below:
Debit: Depreciation Expenses Account
Credit:
Accumulated Depreciation Account
PRESENTATION OF DEPRECIATION
Charging depreciation to any head in profit & loss account depends upon the nature of work performed by
the asset. Consider an organization has purchased computers. If computers are being used by the
management, this means that administrative work is done by computers. So, depreciation of computers will
be charged to Administrative Expenses. On the other hand, if machines working in the factory are
computerized. The value of depreciation of the computers attached with the machines will be charged to
cost of goods sold. The reason being, the computers are the part of manufacturing process & depreciation of
computers will be charged to the cost of production. Again consider the selling department of the business is
very large. Depreciation of computers used in selling department will be charged to selling expenses.
You can see that computer is a single asset and its depreciation is charged in three different heads depending
upon the nature of work done by the computer.
Depreciation for the year is charged to:
i.
Cost of Goods Sold
ii.
Administrative Expenses
iii.
Selling Expenses
In balance sheet Fixed Assets are shown at Cost less Accumulated Depreciation i.e. Written Down
Value (WDV)
METHODS OF CALCULATING DEPRECIATION
There are several methods for calculating depreciation. At this stage, we will discuss only two of them
namely:
 Straight line method or Original cost method or Fixed installment method
 Reducing balance method or Diminishing balance method or written down method.
STRAIGHT LINE METHOD
130
img
Financial Accounting (Mgt-101)
VU
Under this method, a fixed amount is calculated by a formula. That fixed amount is charged every year
irrespective of the written down value of the asset. The formula for calculating the depreciation is given
below:
Depreciation = (cost ­ Residual value) / Expected useful life of the asset
Residual value is the cost of the asset after the expiry of its useful life.
Under this method, at the expiry of asset's useful life, its written down value will become zero. Consider the
following example:
Cost of the Asset
= Rs.100,000
Life of the Asset
= 5 years
Annual Depreciation
= 20 % of cost or Rs.20,000
Written down value method
Cost of the Asset
= Rs. 100,000
Annual Depreciation
= 20%
Year 1 Depreciation
= 20 % of 100,000
= 20,000
Year 1 WDV
= 100,000 ­ 20,000
= 80,000
Year 2 Depreciation
= 20 % of 80,000
= 16,000
Year 2 WDV
= 80,000 ­ 16,000
= 64,000
Example
Cost of an asset: Rs. 120,000
Residual value: Rs. 20,000
Expected life:
Rs. 5 years
Calculate depreciation and the written down value of the asset for five years.
131
img
Financial Accounting (Mgt-101)
VU
SOLUTION
Straight line method
Depreciation = (120,000 ­ 20,000) / 5 = Rs. 20,000
Particulars
Depreciation
Written
(Rs)
Down
Value (Rs.)
100,000
Depreciable cost
(20,000)
80,000
Dep. Of the 1st year
Dep. Of the 2nd year
(20,000)
60,000
Dep. Of the 3rd year
(20,000)
40,000
(20,000)
20,000
Dep. Of the 4th year
Dep. Of the 5th year
(20,000)
0
REDUCING BALANCE METHOD
Under this method, depreciation is calculated on written down value. In the first year, depreciation is
calculated on cost. Afterwards written down value is calculated by deducting accumulated depreciation from
the cost of that asset(cost ­ accumulated depreciation) and depreciation is charged on that value. In this
method, the value of asset never becomes zero. Consider the following example:
Cost of an asset: Rs. 100,000
Expected life:
Rs. 5 years
Depreciation rate:
20%
SOLUTION
Particulars
Depreciation
Accumulated
Written
(Rs)
Depreciation
Down
(Rs.)
Value (Rs.)
Depreciable cost
100,000
Dep. Of the 1st year
20,000
20,000
80,000
100,000 x 20%
Dep. Of the 2nd year
80,000 x 20%
16,000
36,000
64,000
Dep. Of the 3rd year
12,800
48,800
51,200
64,000 x 20%
Dep. Of the 4th year
51,200 x 20%
10,240
59,040
40,960
Dep. Of the 5th year
40,960 x 20%
8,192
67,232
32,768
You see, at the end of five years, WDV of the asset is Rs. 32,768, not zero. But in case of straight line
method, the WDV, after five years was zero. So, in the opinion of some people, reducing balance method is
better than that of straight line method, but both methods are effective. It is the management that has to
decide, which method is best suited to their business.
Once an asset has been fully depreciated, no more depreciation should be recorded on it, even though the
property may be in good condition and may be in use. The objective of depreciation is to spread the cost of
an asset over the periods of its usefulness; in no case can depreciation be greater than the amount paid for
the asset. When a fully depreciated asset is in use beyond the original estimate of useful life, the asset account
132
img
Financial Accounting (Mgt-101)
VU
and the accumulated depreciation account should remain in the accounting records without further entries
until the asset is retired.
133
Table of Contents:
  1. Introduction to Financial Accounting
  2. Basic Concepts of Business: capital, profit, budget
  3. Cash Accounting and Accrual Accounting
  4. Business entity, Single and double entry book-keeping, Debit and Credit
  5. Rules of Debit and Credit for Assets, Liabilities, Income and Expenses
  6. flow of transactions, books of accounts, General Ledger balance
  7. Cash book and bank book, Accounting Period, Trial Balance and its limitations
  8. Profit & Loss account from trial balance, Receipt & Payment, Income & Expenditure and Profit & Loss account
  9. Assets and Liabilities, Balance Sheet from trial balance
  10. Sample Transactions of a Company
  11. Sample Accounts of a Company
  12. THE ACCOUNTING EQUATION
  13. types of vouchers, Carrying forward the balance of an account
  14. ILLUSTRATIONS: Ccarrying Forward of Balances
  15. Opening Stock, Closing Stock
  16. COST OF GOODS SOLD STATEMENT
  17. DEPRECIATION
  18. GROUPINGS OF FIXED ASSETS
  19. CAPITAL WORK IN PROGRESS 1
  20. CAPITAL WORK IN PROGRESS 2
  21. REVALUATION OF FIXED ASSETS
  22. Banking transactions, Bank reconciliation statements
  23. RECAP
  24. Accounting Examples with Solutions
  25. RECORDING OF PROVISION FOR BAD DEBTS
  26. SUBSIDIARY BOOKS
  27. A PERSON IS BOTH DEBTOR AND CREDITOR
  28. RECTIFICATION OF ERROR
  29. STANDARD FORMAT OF PROFIT & LOSS ACCOUNT
  30. STANDARD FORMAT OF BALANCE SHEET
  31. DIFFERENT BUSINESS ENTITIES: Commercial, Non-commercial organizations
  32. SOLE PROPRIETORSHIP
  33. Financial Statements Of Manufacturing Concern
  34. Financial Statements of Partnership firms
  35. INTEREST ON CAPITAL AND DRAWINGS
  36. DISADVANTAGES OF A PARTNERSHIP FIRM
  37. SHARE CAPITAL
  38. STATEMENT OF CHANGES IN EQUITY
  39. Financial Statements of Limited Companies
  40. Financial Statements of Limited Companies
  41. CASH FLOW STATEMENT 1
  42. CASH FLOW STATEMENT 2
  43. FINANCIAL STATEMENTS OF LISTED, QUOTED COMPANIES
  44. FINANCIAL STATEMENTS OF LISTED COMPANIES
  45. FINANCIAL STATEMENTS OF LISTED COMPANIES