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FINANCIAL ACCOUNTING
Fixed Assets Accounting & Depriciation
By
Siddharth S. Kanungo
Introduction
Are you familiar with the distinction between current assets and fixed assets?
Current assets: Current assets are those assets which are held (i) in the form of cash (ii) for their conversion into cash (iii) for their consumption in the production of goods or rendering of services in the course of business. Example: Cash, Bank balance, Stock of raw materials, Stock of finished goods, Stock of work-in-progress, Debtors, Bills receivables etc.
Fixed assets: Fixed assets are those assets which are held for use in the production of goods or rendering of services however, these are not sold in the normal course of business. Example: Land, building, Machinery, Motor vehicles, Goodwill, Patent, Copyright, Trademark etc.
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Classifying Costs
Yes
No
Expense
No Investment
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Financial accounting recognizes the fact that the monetary value of fixed assets decreases due to their use in the production of goods or rendering of services. This decrease in value is depreciation. Most fixed assets lose their value over time. In other words, they depreciate and must be replaced once the end of their useful life is reached. For example, a machine costs Rs. 1,000 and is expected to wear out after ten years of use. We can reduce its balance sheet value by Rs. 100 each year. Therefore, depreciation is a non-cash expense that reduces the value of a fixed asset as a result of wear and tear, age, or obsolescence.
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Accounting Standard 6
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. Depriciable asset: Depreciable assets are assets which (i) are expected to be used during more than one accounting period (ii) have a limited useful life (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: Useful life is either (i) the period over which a depreciable asset is expected to be used or (ii) the number of production or similar units expected to be obtained from the use of the asset. Depreciable amount: Depreciable amount of a depreciable asset is its historical cost, or other amount substituted for historical cost in the financial statements, less the estimated residual value.
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Initial Cost
Residual Value
Depreciable Cost
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Causes of Depreciation
(1) Wear and Tear: An asset depreciates on account of continued use e.g. building, plant, machinery etc. Such depriciation depends upon quantum of use of an asset. (2) Depletion: Some assets depreciate in proportion to the quantum of production, e.g. mines, quarry etc. With the raising of coal etc. from coal mine, the total deposit reduces gradually and after some time it will be fully exhausted. Then its value will be nil. (3) Obsolescence: Some assets, though in proper working order, may become obsolete. For example old machine becomes obsolete with the invention of more economical and sophisticated machine, whose productive capacity is generally higher and cost of production is lesser. (4) Passage of time: Some assets diminish in value on account of sheer passage of time, even though they are not used e.g. lease hold property, patents, copyrights etc. (5) Accidents: Assets may be destroyed by abnormal reasons such as fire, earth quake, flood etc. In such a case the destroyed asset may be written-off as loss and a new one purchased.
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Assignment What are the accounting entries under each of the above two methods in situations like (1) Purchase of asset (2) Providing depriciation (3) Closing the depriciation account (3) Sale of asset (4) Profit / loss on sale of asset
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Reducing Balance
Straight Line
Source: Accounting Trends & Techniques, 56th. ed., American Institute of Certified Public Accountants, New York, 2002.
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(2) Estimated useful life of asset (This is the number of years that the asset is expected to be used)
(3) Residual Value or Scrap Value or Salvage Value of the asset (This is the value of the asset at the end of its life.) (4) Method of calculating depreciation (Straight line method or reducing balance method.) (5) Rate of depreciation (The rate at which depriciation is charged annually over the useful life of the asset.)
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Example
Particulars Purchase price of the asset Useful life in years Approximate salvage Value Amt. (Rs.) 24000 5 years 2000
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Yr. 1 2 3 4 5
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Yr.
1 2 3 4 5
Book Value Depr. Accum. Depr. Book If we use this approach in Year 5, we will end the year with a Value Expense at End book at Beginning 1,866. Remember, the residual value at End value of Rs. at Cost end of Yr. 5 is expected to be Rs. of Yr. so we must Yr. of Year for Yr. of the 2,000, modify our approach. STOP! 24,000 24,000 9,600 9,600 14,400 24,000 14,400 5,760 15,360 8,640 24,000 8,640 3,456 18,816 5,184 24,000 5,184 2,074 20,890 3,110 24,000 3,110 1,244 22,134 1,866
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Yr.
1 2 3 4 5
Cost
24,000 24,000 24,000 24,000 24,000
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Yr.
1 2 3 4 5
Cost
24,000 24,000 24,000 24,000 24,000
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Comparison
Total Depriciation Charged under Straight Line Method 4,400 + 4,400 + 4,400 + 4,400 + 4,400 = 22000 Total Depriciation Charged under Reducing Balance Method 9,600 + 5,760 + 3,456 + 2,074 + 1,110 = 22000
Total depreciation charged on an asset over its useful life remains the same irrespective of the method adopted.
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Discussion
Which method of charging depreciation should a company adopt? Is there a "best" method for charging depreciation? Each method has its advantages and disadvantages. Companies might do well to choose different methods for different asset types. There is no one single method that is correct for all asset types. The answer lies in understanding that depreciation is a process of allocation of cost not valuation of asset. Depreciation charged in the profit and loss account can be viewed as the cost of using the asset over the period that the profit and loss account covers. As per this understanding, the pattern of depreciation for an asset should attempt to match the pattern of benefits derived from that asset. Where the benefits from an asset are likely to be constant over its useful life, the straight line method of depreciation would be appropriate as it results in a constant annual depreciation charge. Where the benefits from an asset are likely to reduce over its useful life, the reducing balance method of depreciation would be appropriate as it results in a high annual depreciation charge in early years.
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Discussion (Cont.)
In practice it may be difficult to assess the pattern of benefits derived from an asset. In such cases the straight line method may often be chosen simply because it is easy to understand and calculate. It should be noted that, whichever method of depreciation is selected, the total depreciation to be charged over the useful life of an asset will be the same. It is simply the allocation of the total depreciation charge between accounting periods that is affected by the choice of method. Once a particular method of depreciation has been chosen for an asset, the method should be applied consistently over its life. It is not permissible to switch from one method to another unless there are sufficient reasons.
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Change in Method
On 1st January 2008 a company purchased two machines A & B, costing Rs. 50,000 each. Depriciation was provided on the machines at 10% pa under Straight Line method. At the end of 2011, the company decided to change the method of depriciation from Straight Line to Written Down Value. The rate of depriciation remaining the same, you are required to prepare the Machinery Account and show necessary calculations upto 2011.
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Total depriciation under new method = Rs. 10,000 + 9,000 + 8,100 = 27,100
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Step 4: Journal entry to adjust excess depriciation in the year 2011 when the change of method was effected.
Machinery A/c To Profit & Loss A/c Dr. 2,900 2900
Date 01.01.2008
Particulars By Depriciation By Balance c/d By Depriciation By Balance c/d By Depriciation By Balance c/d By Depriciation By Balance c/d
01.01.2009
01.01.2010
01.01.2011 31.12.2011
Rs. 10000 90000 100000 10000 80000 90000 10000 70000 80000 7290 65610 72900
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Asset Revaluation
A machine purchased for Rs. 130,000 was originally estimated to have a useful life of 30 years and a residual value of Rs. 10,000. The asset has been depreciated for 10 years using the Straight Line Method. Calculation of annual depreciation (Rs. 1,30,000 Rs. 10,000)/30 years = 4000 per year Total depreciation charged in 10 years = 10 X Rs. 4,000 = Rs. 40,000 Book Value of the asset after 10 years = 1,30,000 40,000 = 90,000 During the 11th year, it is estimated that the remaining useful life is 25 years (rather than 20) and that the revised estimated residual value is Rs. 5,000. Calculation of revised annual depriciation (Book value Revised residual value)/Revised estimated remaining life = (Rs. 90,000 Rs. 5000)/25 years = Rs. 3400
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Disclosures
If any depreciable asset is disposed of, discarded, demolished or destroyed, the net surplus or deficiency, if material, should be disclosed separately. The following information should be disclosed in the financial statements: (i) the historical cost or other amount substituted for historical cost of each class of depreciable assets (ii) total depreciation for the period for each class of assets (iii) the related accumulated depreciation. The following information should also be disclosed in the financial statements along with the disclosure of other accounting policies: (i) depreciation methods used (ii) depreciation rates or the useful lives of the assets, if they are different from the principal rates specified in the statute governing the enterprise.
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Remember
Change in depreciation amount due to change in method is to be given retrospective effect but in all other cases (like Change in Cost, Life, Revaluation etc.) change in depreciation is given prospective effect.
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Minimum Depriciation
The Department of Company Affairs, Govt. of India, dictates that the rates goven in the Schedule XIV to the Indian Companies Act, 1956 should be considered as minimum rates and therefore company cannot charge depriciation at rates lower than specified in the schedule in relation to the assets. However, if on technical evaluation, higher rates of depreciation are justified, the higher rates should be applied. Where rates other than Schedule XIV rates are applied, appropriate disclosures in the notes to the accounts would be required.
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Depriciation for Items Below Rs. 5000/As per Schedule XIV, individual items of fixed assets below Rs. 5000/- should be depriciated at 100%. For example, an item of furniture such as a chair or table is capable of being used independently, therefore each chair or table will have to be provided 100% depriciation if its individual value does not exceed Rs. 5000/-. The 100% provision cannot be provided by arguing that the furniture can be used only as a set, i.e. A set of chairs, which in aggregate cost more than Rs. 5000/-. Where the aggregate actual cost of individual items of plant and machinery costing Rs. 5000/- or less comstitutes more than 10% of total actual cost of plant and machinery, normal schedule XIV rates should be used. (Note No 8 of the Schedule XIV of the Indian Companies Act, 1956.)
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Query
ABC Limited acquired a huge piece of land on a 999 year lease from the Government for Rs. 999 lakhs. As per the terms of the lease, the land along with any construction thereon will revert to the Government after the expiry of 999 years. Since the said period of 999 years is very long and is akin to owning the land, the company does not wish to amortise the consideration. Is this acceptable under the applicable accounting rules and regulations of India?
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Response
Accounting Standard 19 Leases does not apply to lease agreement to use lands. Accounting Standard 6 Depreciation, does not apply to land unless it has a limited useful life for the enterprise. In other words, if the life of land is limited then the provisions of Accounting Standard 6 would apply. In the given case, the lease tenure of 999 years though very long is still limited. Therefore, Accounting Standard 6 would apply. Therefore, each year ABC Limited will have to charge Rs. 1 lakh to the income statement as amortization expenses.
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Thank You!