Depreciation Accounting
Financial Accounting Notes
Part C: Depreciation and Provisions
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Table
of Contents |
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1. Meaning and Features of Depreciation 2. Objectives and Causes of charging depreciation 3. Factors affecting amount of depreciation 4. Methods of Charging depreciation 5. Assets Disposal Account 6. Change in the method of Charging Depreciation 7. Meaning and Difference of Provisions and Reserves |
Depreciation
Depreciation: The word
depreciation is derived from a Latin word “Depretium” where “De” means decline
and “pretium” means price. Thus, the word “Depretium” stands for decline in the
value of assets. It stands for gradual and continuous decline. In simple words,
Depreciation may be defined as permanent decrease in the value of assets due to
Use and /or the lapse of the time.
According to
Carter, “Depreciation may be defined as the permanent and gradual decrease in
the Value of assets from any cause.’’
Depletion: Depletion implies removal of
available resources e.g. Coal from Coal mine, Oil out of Oil well.
Amortisation: The process of writing off
intangible assets such as goodwill, patents, and trademarks etc. is called
amortisation.
Dilapidation: The term Dilapidation reduces to
damage done to a building or other property during tendency.
Obsolescence: When an asset becomes out dated
due to new or improved technology or invention, this is called Obsolescence.
Characteristics or Features of Depreciation
a)
Depreciation may
be physical and Functional.
b)
It is a non cash
expenses.
c)
It is a charge
against Profit.
d)
Depreciation is
charged in respect of fixed assets only.
Objectives or causes for providing depreciation
a)
To find out
correct cost of goods manufactured.
b)
To find out
correct profit for the year.
c)
To provide for
replacement of assets.
d)
To find out
correct financial position.
e)
To reduce tax
burden.
Causes of Depreciation
The causes of
decline on the book value of fixed assets may be divided into two categories:
1)
Physical:
Physical causes may be as follows
a)
Wear and tear
b)
Destruction
2)
Functional:
Functional causes may be as follows
a)
Obsolescence
b)
Inadequacy
c)
Effluxion of time
d)
Depletion
e)
Exhaustion
Factors on which the calculation of
depreciation depends:
For
determining the amount of depreciation on fixed assets, following factors
should be considered:
a) Cost of asset: Original cost of asset
including expenses incurred at the time of purchase is the amount on which the
amount of depreciation is calculated.
b) Estimated working life of the assets: Working
life of any asset is to be taken into consideration while calculating the amount
of depreciation. In case of SLM method, the amount of depreciation is
calculated by dividing the cost of assets less scrap value by estimated working
life of the assets.
c) Scarp value: Estimated salvage/residual/ scarp
value which is estimated to be realised when asset is sold is to be deducted
from the cost of asset to find out the amount of depreciation.
d) Provision for repairs: Provision for repairs
and renewals required to keep the asset in good condition is also taken into
consideration while calculating the amount of depreciation.
e) Addition and subtraction: Any addition to the
asset or sale of part of asset during the life of the asset is also taken into
consideration while calculating the amount of depreciation.
f) Obsolescence: In present technological world,
change in technology can cause huge depreciation in the value of asset. So
obsolescence is also a key factor while calculating the amount of depreciation.
Methods of Charging Depreciation
Methods of
Depreciation classified under the following groups:
(1)Uniform charge methods: (a) fixed
installment method. (b) Depletion method (c) Machine hour rate method
(2)Declining charged method: (a) Diminishing
balance method (b) Sum of years Digit method. (c)Double Declining method
(3)Others method: (a)Group Depreciation method
(b)Annuity method (c)Inventory system of Depreciation (d)Insurance policy
method
But out of the methods mentioned above, two methods are more
popular – Straight line method and Written down value method.
Straight
Line method or Fixed installments method: This method of charging depreciation
is each to understand and simple to calculate. Under this method depreciation
is charged on original cost of the assets on uniform basis every year. The
value of the assets can be reduced to ‘O’ under this method.
Merits:
(1) It is simplest to understand and easy to
apply.
(2)The value of the assets can be reduce to
zero under this method.
Demerits:
(1) Under this method, same amount of
Depreciation is charged from year to year, irrespective of use of the assets.
(2)With the passage of time efficiency of
assets decreases but the amount of Depreciation remains the same.
Diminishing
Balance method: Under this method a fixed rate of depreciation
is charged each year on the diminishing value of the assets till the amount is
reduced to scrap value. This method involves more calculation as compared to
SLM and value of assets cannot be reduced to zero under this method.
Merits:
(1) The amount of depreciation decreases
continuously with the decrease in the life of assets.
(2) High amount of Depreciation is provided in
earlier year thus reducing the impact of Obsolescence
Demerits:
(1) The book value of assets can never be
zero.
(2)The determination of a suitable rate of
Depreciation is also difficult.
Difference between fixed installment
and reducing installment method are given below:
(1)The rate and amount of depreciation remains
the same each year under fixed installment method. The rate remains the same,
but amount of Depreciation reduces each year under reducing balance method.
(2)Depreciation is calculated on original cost
under fixed installment method. Depreciation is charged on the diminishing
value of assets under reducing Balance Method.
(3)The book value of assets reduces to zero
under straight line method. The book value of assets can never be zero under
reducing balance method.
Asset Disposal Account
When, a part of machinery is disposed off or
discarded, it is better to open a machinery disposal account. The book value
less depreciation of the discarded portion should be debited to this account
and credited to the asset account. But if the asset is maintained at original
cost and a separate provision for depreciation account is maintained, then
machinery disposal account should be debited with the cost of the discarded
portion of the asset and credited with depreciation provision applicable to
this asset. The amount realized or the estimated realizable value is credited
to the machinery disposal account and the balance of this account will show
profit or loss and is transferred to Profit and Loss Account. Following entries
are passed in such a case on sale of an asset:
a) Assets
Disposal A/c
To Assets
A/c [With original cost
of asset]
b) Bank A/c
To Asset
Disposal A/c [With amount realized
from the sale of asset]
c) Provision
for Depreciation A/c
To Asset
Disposal A/c [With accumulated depreciation on the asset sold]
d) Profit
& Loss A/c
To Asset Disposal A/c [For transfer of loss on sale
of asset]
Note. Reverse entry in case there is profit.
Change of Method
Sometimes the method is changed either from
straight line method to diminishing balance method or from diminishing balance
method to straight line method with effect from the particular year or with
retrospective effect. If the change is from particular year, then there will be
no problem but simply to change the method of depreciation. But if the change
is to be effective with retrospective effect, then calculations are required to
be made.
Step in recording a change in the Method of
Depreciation with retrospective effect:
Step 1: Calculate the total depreciation
already provided on the existing assets from the back date under the existing method.
Step 2: Calculate
the total depreciation on the existing asset from the back date under the new
method and rate till date.
Step 3: Calculate
the difference between the total depreciation under existing method (as per
Step 1) and under the new method (Step 2).
Step 4: Adjust
the short depreciation (excess of Step 2 over Step 1) by debiting Profit &
Loss Accounting and Crediting the Asset Account /Provision for Depreciation
Account.
Or
Adjust the excess depreciation (Excess of Step
1 over Step 2) by debiting Asset Account/Provision for Depreciation Account and
Crediting Profit & Loss Account)
Step 5: Charge
depreciation from the current accounting year and onwards by adopting new
method.
Provisions and Reserves
Provisions: The term ‘provision’ means an amount,
which is: written off, or retained, by way of providing for depreciation,
renewals, diminution in the value of assets; or retained by way of providing
for any unknown future liability of which the amount cannot be determined with
reasonable accuracy.
Examples
of provisions are: Provision for depreciation; Provision for bad and doubtful debts; Provision for taxation; Provision for
discount on debtors; and Provision for repairs and renewals.
Reserves: A part of
the profit may be set aside and retained in the business to provide for certain
future needs like growth and expansion or to meet future contingencies such as
workmen compensation are called reserves. Unlike provisions, reserves are the
appropriations of profit to strengthen the financial position of the business.
Reserve is not a charge against profit as it is not meant to cover any known
liability or expected loss in future.
Examples of reserves are: General reserve; Workmen compensation
fund; Investment fluctuation fund; Capital reserve; Dividend equalization
reserve; Reserve for redemption of debenture.
Difference
between Provisions and Reserves:
a)
Provision is a
charge on profits and reduces the amount of net profits. Whereas Reserves is an
appropriation of profits and reflects undistributed profits.
b)
Provision is to
be made even if there are no profits. On the other hand, Reserve is created
only when there are profits.
c)
Provision
creation is compulsory. But Reserves creation is at the discretion of
Management.
d)
Dividend cannot
be paid out of provisions. But dividend can be paid out of reserves.
e) Provisions are utilised for specific purpose for which it has been created. But, reserves can be utilised for any purpose.
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