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Accounting for Fixed Asset

Accounting for Fixed Asset

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Published by sappuk

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Published by: sappuk on Apr 07, 2010
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08/06/2013

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What is depreciation?
 
Causes of depreciation:
Depreciation is a rational
estimate of a decline in the usefulness
(fall in the value) of an asset dueto consumption, use, passage of time, technological changes etc.
 Decline in the usefulness of anasset may be caused by the following factors:
1.
 
P
hysical wear and tear 2.
 
With the passage of time3.
 
Obsolescence4.
 
Expiration of legal rights
Obj
ectives of depreciation
Every business enterprise needs to make a suitable policy on depreciation of the fixed assets. Thecharging of depreciation on fixed assets is necessary because of the following objectives:
1.
 
o allocate depreciable cost:2
.
 
o ascertain
rue and Fair Profit or Loss:3
.
 
o show
rue and Fair Financial Position:4
.
 
o provide funds for Replacement:5
.
 
o compute
ax Liability:
.
 
o determine Product Cost for Managerial Decision-Making:
B
asic factors for calculation of depreciation
C
alculation of amount of depreciation depends on the following three factors:
Cost of an asset:
 
C
ost of an asset includes the money or its equivalent paid for its acquisition andother cost which are necessary to put the asset in to operation. These other expense include legalcharges, installation cost etc.
 Net Residual Value or Salvage:
Residual value refers to estimated net realizable value of anasset at the end of its useful life. It is also called scrap value or salvage.
 E 
stimated useful life of an asset:
it refers to that period for which it will work economically andefficiently. It is very difficult job to estimate useful life of an asset. It depends on number of complex factors such as use of an asset, maintenance of an asset, replacement policy, andtechnological changes etc. useful life of an asset can be expressed in following ways
 
 D
epreciable cost = cost of an asset ± net residual value
 
(a)
 
 Number of units, (b) Number of working hours (c)
C
alendar years
M
ethods for calculating depreciation
:
There are various methods for calculating amount of depreciation which are as follows:1.
 
F
ixed Installment
M
ethod
:Under this method, depreciation amount is calculated by dividing depreciable cost of the asset bythe estimated life of the asset. Formula for calculating depreciation amount is as under:It is called fixed installment method because the amount of depreciation remains fixed or samefrom year to year. It is also referred to as µstraight line method¶ or µconstant charge method¶.
nder this method depreciation is generally calculated at a fixed percentage on the original cost of the asset 
.
 
A
dvantages:
The main merits of this method are:1.
 
It is easy to understand2.
 
It is easy to calculate.3.
 
Under this method, the book value of the asset becomes Zero or equal to its scrap value atthe expiry of its useful life
D
isadvantage:
The main demerits of this method are as under:1.
 
It does not provide for the replacement of the asset on the expiry of its useful life.2.
 
It does not take into consideration the interest on the capital invested in the asset.
S
uita
b
ility of this method
: It is suitable if:a)
 
Repair and maintenance expenses are almost same for each accounting period, b)
 
Utility of asset does not decrease with passage of time.2.
 
D
iminishing
B
alance
M
ethod:
 Under this method depreciation is calculated at a fixed percentage of written down value of theasset. This method implicitly assumes that benefit accruing to business by utilization of assetkeeps on decreasing as the asset gets old. As the value of asset goes on decreasing from year toyear, the amount of depreciation charged to different accounting year decreases with passage of time (but the rate of depreciation remains same).
 
 
Where µn¶ = Number of years of asset lifeAs the amount of depreciation is based on written down value of the asset, it is also referred to as
µW 
ritten down Value Method 
.
 
Another term used for this method is µReducing BalancingMethod¶.
A
dvantages:
use of this method results in following advantages:1.
 
It makes proper allocation of cost because more depreciation is charged in the earlier yearswhen its utility is more as compared to later years when it becomes less useful2.
 
Equal amount is charged to profit and loss account. This is so because amount of repair andmaintenance increases and amount of depreciation decreases with the passage of time.3.
 
As major portion of depreciable cost is recovered in earlier years, technological changeswhich make existing assets obsolete and require replacement will not pose much problem.
D
isadvantages:
it suffers from the following drawbacks1.
 
As depreciation is calculated at fixed percentage of written down value, depreciable cost of asset cannot be fully written off.2.
 
It does not take into consideration the interest on the capital invested in the asset.3.
 
It does not ensure liquid funds at the time of replacement of an asset.4.
 
It is very difficult to calculate the rate of depreciation.
S
uita
b
ility:
This method is suitable for those assets in relation to which:a)
 
The amount of repairs and renewals goes on increasing as the asset grows older  b)
 
The possibilities of obsolescence are more.c)
 
This method is suitable for plant and machinery, building and furniture etc.3.
 
A
nnuity
M
ethod:
Under this method the annual depreciation charges would beascertained with the help of Annuity Table. This method gives importance to interest factor.Other methods do not take into account the interest factor while calculating depreciation.Fixed interest rate is charged on the opening balance of each year and then the cost of assettogether with interest thereon is written off equally over the life of the asset.
G
enerally, manual calculation of rate is not very easy and logarithm tablesare used for this purpose. Moreover, if residual value is zero, rate of depreciation cannot be calculated.

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