Amity Business School

Amity Business School

MBA Class of 2012,
Semester I
ACCOUNTING FOR MANAGEMENT
Course Code: MBAFN10101

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Depreciation means a fall in the value of an asset.

Every Fixed Asset is liable to lose its value ,once it
begin to be used for production purpose
Accounting Concept of Depreciation

Accounting concept of depreciation means to

distribute the cost of fixed asset over its estimated
life in a reasonable manner.

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Depreciation
Depreciation

Plant
Plant
Assets
Assets

Depletion
Depletion

Natural
Natural
Resources
Resources

Amortization
Amortization

Intangible
Intangible
Assets
Assets

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Causes of Depreciation

1. Wear and tear

wearing out of the asset on account of its
constant use is called wear & tear.
2. Lapse of time
With passage of time there is reduction in the
value of fixed assets .
3. Obsolescence
Due to acquisition of an improved model which
is more economic and works more quickly then
the existing machine will become obsolete.

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Objective of Charging Depreciation

1. To Ascertain the Profit or Loss Properly
2. To show the Asset at its proper Value
3. To Retain out of Profit Funds for Replacement

Basic Factors Consider for calculating the Depreciation

1. Original cost of the Asset
2. Scrap Value at the End of its Life
3. Estimated effective or Commercial life or legal life which ever is shorter

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Methods of Depreciations

1. Straight Line Method or Fixed installment Method

2. Diminishing Balance or Written Down Value Method
3. Annuity Method
4. Sinking Fund Method
5. Sum of the Digits Method
6. Insurance policy Method
7. Revaluation Method

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Straight Line Method

Under this method, an equal portion (amount) of the cost of the

Asset is allocated as Depreciation to each accounting year over a
period of its effective life. This is done so to reduce the value of the
asset equal to zero or its salvage or scrap value
This method is based on the assumption that depreciation is the Function of Time
Rather than of use and service potential of the Asset

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The Annual depreciation charge will be computed as follows

Annual Depreciation = Cost of Asset + Erection charges Scrap Value

Estimated life of the Asset

Illustration 1:
A machine is purchased for Rs 50000 & Rs 5000 is incurred as erection charges.
The machine has a life of 5 years with a salvage value of Rs 10,000.
Compute the annual depreciation.
Illustration 2:
A firm bought a machinery for Rs 38000 on 1st January 2009 and its life was
Estimated to be 8 years. Its estimated scrap value at the end of the period was
Rs 6000. Calculate the amount of depreciation.

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Question1.
Ram & Sons acquired a machine on 1st July 2008 at a cost of Rs 14000 and spent
Rs 1000 on its installation. The firm write off depreciation at 10% on the original
Cost every year. The Books are closed on 31 st December every year. Show the
Machinery Account & Depreciation Account for three years.
Question 2
On 1st January 2000, Z Ltd purchased a plant costing Rs 41000 and spent Rs 4000
On its erection. The estimated effective life of the plant is 10 year with scrap value of
Rs 5000. Calculate depreciation on the SLM for three years.

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Advantages of Fixed
installment method
It is easily understandable & is simply to
apply.
Amount of depreciation does not vary from
year to year.
Under this method the book value of asset
is reduced either to zero or scrap value as
the case may be.

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Disadvantages of fixed installment method

It does not reflect correct charge on a/c of
depreciation where effective utilization of
asset varies from year to year.
It does not recognize the reality that as an
asset becomes older the amount spent for
repairs.
Sometime in this method, book value of
asset become zero but yet the assets are
used in the business.

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Written Down Value Method

Under this Method depreciation is charged at fixed rate on the reducing balance
(i.e. cost less depreciation) every year.

Advantages of diminishing balance method

Simple to understand
Easy to follow
Ensures a fairly even charge to
profit and loss A/c
Disadvantages
Value of an asset cannot be brought down to zero
There is a difficult task to ascertain the proper rate of depreciation

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Provisions

According to The Indian Companies

Act,provision can be defined as any
amount. written off or retained by
way of providing for depreciation ,
renewal diminution in the value of
assets or retained by way of providing
for any known liability of which the
amount cannot be determined with
substantial accuracy.

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Provisions
1. It is created by debiting the profit and loss account.
2. It is created to meet a known liability or a specific contingency,
e.g.. provision for bad and doubtful debts, or provision for
depreciation etc.
3. A provision is created irrespective of whether there is profit or
loss in the business.
4. It is not available for distribution as dividend among
shareholders.
5. A provision is made for a definite amount and, therefore, a
definite sum is set aside every year to meet the known
contingency.
6. Making of a provision is a must to meet known liability or
contingency.

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Provisions
Thus provisions are the amounts set
aside out of profits and other
surpluses to provide for:1. Depreciation, Renewals or
diminution in the value of assets
2. Any known liability of which the
amount cannot be determined with
substantial accuracy.

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Provisions
Provisions are generally created for the
following:1. Provision for Depreciation
2. Provision for Bad and Doubtful
Debts
3. Provision for Discount on Debtors
4. Provision for taxation
5. Provision for Repairs and Renewals

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Reserves

This term means amount set aside

out of profits and other surplus
which are not designed to meet
any liability or diminution in
value of assets known to exist at
the date of B/S.

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Reserves
Basic purpose of creating a
reserve is to provide for
unexpected losses in future and
also retain profits within business
to provide funds for expansion of
the business.

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Reserves
1. It is created by debiting the profit and loss appropriation
account.
2. It is created to meet an unknown liability, or to
strengthen the financial position of the company or for
equalization of dividends etc.
3. A reserve is created only when there is profit in the
business.
4. It can be distributed among shareholders as dividend.
5. The reserve is created without taking into consideration
the actual amount required except in the case of
redemption of debentures when a definite sum is set
aside.
6. Creation of reserve depends upon the financial policy of
the business and discretion of its management.

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Reserve Fund
The term Reserve Fund is used for the
amount of reserve which has been invested
in outside securities.
Examples of Reserve Fund are employees
welfare fund, pension fund, gratuity fund
etc.
Profit set aside and used in the business is a
reserve. But profit set aside and invested
outside the business is a reserve fund.
Thus, the use of the term 'fund' indicates
investment of reserve outside the business.

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Distinction between provision and Reserve

Provision
1. It is made to meet a
known liability for
depreciation of
assets.
2. The amount set aside
is used only to meet
the specific purpose
for which provision
was made.
3. It is to be made even
if there are no profits.

Reserve
1. These are created to
meet unexpected
contingencies likely
to arise in future.
2. Amount can be used
for any liability or
loss.
3. It is created only
when there are
sufficient profits.