Unit 3: Depreciation Accounting

Course Facilitator: Prof.Radhakrishna

 Content
• Meaning, Depreciation methods – Straight
Line Method(SLM), Written Down Value
Method (WDV), Annuity Method, Sinking Fund
and Revaluation Method (problems with
adjustments on SLM ,WDV and annuity
method only).
 Meaning and Definition: Depreciation
• The term depreciation refers to fall in the value or utility of
fixed assets which are used in operations over the definite
period of years.
• In other words, depreciation is the process of spreading the
cost of fixed assets over the number of years during which
benefit of the asset is received.
• According to the Institute of Chartered Accountant of India,
"Depreciation is the 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.
 Characteristics of Depreciation
• Depreciation is decline in the value of fixed asset (except
land). Decline in the value of asset is permanent in nature.
Once reduced, it cannot be restored to its original value.
• Depreciation is a gradual and continuous process because
value of asset is reduced, either with use of asset or due to
expiry of time.
• It is not a process of valuation of asset. It is the process of
allocating cost of an asset to its effective life.
• Depreciation reduces the book value and not the market
value of the asset.
• Depreciation is used in respect of tangible fixed assets only.
It is not used for wasting and intangible assets such as
amortisation of goodwill, depletion of natural resources etc.
 Causes of Depreciation
• Usage
• Passage of Time
• Obsolescence
• Exhaustion or Depletion
 Objectives of Providing Depreciation

• To ascertain true value of assets and financial

position.
• To make provision for replacement of worn
out assets.
• To calculate correct amount of profits or loss.
• To compute cost of production.
• To comply with legal provisions.
• To avail of tax benefits.
 Depletion and Amortisation
• Depletion: refers to cost allocation for natural
resources such as oil and mineral deposits.
• Depletion is an accounting concept used most
often in mining, timber, petroleum, or other
similar industries. The depletion deduction
allows an owner or operator to account for the
reduction of a product's reserves.
• Amortisation: relates to cost allocation for
intangible assets such as patents, copyrights, etc.
FACTORS AFFECTING THE DEPRECIATION
Illustration
 Methods of Depreciation
• 1. Fixed instalment or Straight line or Original cost
method.
• 2. Diminishing Balance Method or Written down
value method or Reducing Instalment method.
• 3. Annuity Method.
• 4. Depreciation fund method or Sinking fund
amortization fund method.
• 5. Insurance policy method.
• 6. Revaluation method.
Fixed Instalment or Straight line or Original Cost Method
Example
Advantages
 Disadvantages
• Under this system, the burden on the P&L a/c in
respect of depreciation and repairs of an asset is
not uniform year after year.
• Calculation of depreciation becomes difficult,
when there are frequent additions.
• The interest on capital invested on the asset is
completely ignored.
• No fund is created for the replacement of the old
asset.
Fixed Instalment or Straight line or Original Cost Method

Journal Entries:
• Depreciation account Dr.
To Asset account
(Being the depreciation of the asset)
• Profit and loss account Dr.
To Depreciation account
(Being the amount of depreciation charged to Profit and Loss account)
• These entries will be passed at the end of each year so long as the asset lasts.
In the last year, the scrap will be sold and with the amount that realised by
the sale the following entry will be passed:
• Cash account Dr.
To Asset account
(Being the sale price of scrap realised.)
 Illustration
• The original cost of the asset is Rs. 2,50,000.
The useful life of the asset is 10 years and net
residual value is estimated to be Rs. 50,000.
Calculate the amount of Depreciation.
 Diminishing Balance Method or Written
Down Value Method
• Under this method the asset is depreciated at
fixed percentage calculated on the debit
balance of the asset which is diminished year
after year on account of depreciation.
• Under this method, depreciation is charged on
the book value of the asset.
 Advantages
1. This method is accepted by Income Tax
Authorities.
2. Impact of obsolescence will be reduced at
minimum level.
3. Fresh calculation is not required when additions
are made.
4. Under this method the depreciation amount is
gradually decreasing and it will affect the
smoothing out of periodic profit.
 Disadvantages
1. Residual Value of the asset cannot be correctly
estimated.
2. It ignores interest on investment on opportunity
cost which will lead to difficulty while.
3. It is difficult to ascertain the true profit because
revenue contribution of the asset are not
constant.
4. The original cost of the asset cannot be brought
down to zero.
 Illustration
• The original cost of the asset is Rs. 2,00,000
and depreciation is charged @ 10% p.a. at
written down value, then what is the amount
of Depreciation charged and written down
value of asset for year 1, 2 and 3.
Distinction Between SLM & WDV
 Annuity Method
• Under annuity method of depreciation the cost of asset is regarded as
investment and interest at fixed rate is calculated thereon.
• Had the proprietor invested outside the business, an amount equal to
the cost of asset, he would have earned some interest. So as a result of
buying the asset the proprietor loses not only cost of asset by using it,
but also the above mentioned interest. Hence depreciation is calculated
in such a way as will cover both the above mentioned losses.
• The amount of annual depreciation is determined from annuity table.
• Annuity method is particularly applicable to those assets whose cost is
heavy and life is long and fixed, e.g. leasehold property, land and
building etc.
•
Example
Example
 Advantages
1. This method takes interest on capital invested
in the asset into account.
2. It is regarded as most exact and precise from
the point of view of calculations; and is
therefore most scientific.
 Disadvantages
1. The system is complicated.
2. The burden on profit and loss account goes on increasing
with the passage of time whereas the amount of
depreciation charged each year remains constant. The
amount of interest credited goes on diminishing as years
pass by, the ultimate consequence being that the net
burden on profit and loss account grows heavier each
year.
3. When the asset requires frequent additions and
extensions, the calculation have to be changed
frequently, which is very inconvenient.
 Depreciation Fund Method
• Depreciation fund method is also known as sinking fund method
or amortization fund method. Under this method, a fund know as
depreciation fund or sinking fund is created.
• Each year the profit and loss account is debited and the fund
account credited with a sum, which is so calculated that the
annual sum credited to the fund account and accumulating
throughout the life of the asset may be equal to the amount
which would be required to replace the old asset.
• The asset appears in the balance sheet year after year at its
original cost while depreciation fund account appears on the
liability side.
• This Method is mainly used for Long Leases on Mines.
 Advantages
1. The most important advantages of this
method is that it makes available a sum of
money for the replacement of the asset,
which has become useless. If separate
provision was not made, the sum required to
purchase the new asset will have to be drawn
from the business which might effect the
financial position of the concern adversely.
 Disadvantages
1. The burden on profit and loss account goes on
increasing as years pass by since the amount of
depreciation every year remains same but the
amount spent on repairs goes on increasing as the
asset becomes old.
2. It can also be said that the work of investing money
is complicated.
3. Prices of securities may fall at the time when they
are to be realized as a result of which loss may have
to be suffered.
 Insurance policy method
• Insurance policy method is a slight
modification of the depreciation fund method
or sinking fund method.
• Under this method the amount represented
by the depreciation fund, instead of being
used to buy securities, is paid to an insurance
company as premium.
 Advantages
1. The advantage of insurance policy method is
that risk of loss on the sale of investment and
the trouble and expense of buying
investment are avoided.
 Disadvantages
1. Disadvantage lies that the interest received
on the premiums paid is comparatively very
low.
 Revaluation Method
• This method is specially designed to revalue the assets in the
case of livestock, loose tools, patents etc. This method also
termed as Appraisal Method. The calculation of depreciation
of these assets is valued at the end of the accounting year by
comparing the opening value of the asset of the additional if
any, the difference is treated as depreciation.
• The loss on revaluation is debited to Profit and Loss Account
or Depreciation Account and credited to Asset Account.
• The method is normally adapted to charge depreciation on
numerous inexpensive fixed assets like small tools, live stock,
patents, copy rights and other assets of such nature which are
constantly changing and their period of life is most uncertain.
 Example
• For example, if the value of tools at the beginning
of the year was $8,000, during the year tools
worth $6,000 were purchased more and when at
the end revaluation was undertaken it amounted
to $ 11,000. The amount of depreciation for the
year shall be as under:
=($8,000 + $6,000) - $11,000
=$14,000 - $11,000
= $3,000
 Example
• On 1st July 2003, a firm has loose tools worth Rs 10,000.
During the year they purchased tools of Rs 6 000 On
December 2003, the loose tools valued at Rs 13,500.
• On 1st June 2004, loose tools of Rs 8,000 were purchased.
During the year, tools worth Rs 1,000 were stolen by the
workers. The remaining tools valued at Rs 20,000.
• During the year 2005, tools worth Rs 800 were broken and
sold as scrap for Rs 150. In the same year tools for Rs 800
purchased. Dec. 2005, tools were valued at Rs 18,500.
Prepare Loose Tools Account and Depreciation Account for
three years.
 Advantages
• This method is very simple and the amount of
loss can be ascertained very easily.
 Disadvantages
• As every year revaluation is desired it presents
various problems.
• Amount of depreciation is always unequal.
• The valuation of asset is very time consuming.