Depreciation

DEPRECIATION

Depreciation-Depreciation is a permanent, continuing and gradual shrinkage in the book value of a fixed asset.

Objectives of providing depreciation

1. Correct income measurement

2. True financial position of business

3. Funds for replacement of new assets

4. Ascertainment of true cost of production

Methods of charging depreciation

1. Straight Line Method- Under this method depreciation is charged on original cost of the assets every year. Original cost includes purchase price, carriage on asset, installation cost and all other expenses regarding asset till it is installed. If the rate of depreciation is not given, depreciation is calculated as follows-

Depreciation= Purchase Price + carriage + Installation Cost- Scrap Value (Residual Value)\ Life

Of assets (No. of years)

Features- 1. Depreciation is charged on the original cost of the asset.

2. Amount of depreciation remains same every same every year.

3. Value of assets may become nil at the end of the life of the assets.

4. Calculation of depreciation is easy.

2. Diminishing Balance Method-Under this method depreciation is charged on the book value or written down value of assets i.e. the value cost less depreciation till last year.

Features-1. Depreciation is charged on book value of assets.

2. Amount of depreciation reduces every year.

3. Value of assets never becomes nil.

4. Calculation of depreciation is complex.

Journal Entries

1. For Purchase of assets Assets A\C Dr. To Cash\ Bank\ Creditors 2. For charging depreciation Depreciation A\C Dr. Assets A|C 3. For transfer of depreciation Profit &Loss A\C Dr. To Depreciation

4. For sale of assets Cash\ Bank\ Debtors A\C Dr. To Assets A\C 5. For loss on sale of assets Profit &Loss A\C Dr. To Assets A\C 6. For Profit on sale of assets Assets A\C Dr. To Profit & Loss A\C

Other Methods

3. Sum of year’s digits method- in this method charge for depreciation for an accounting period is calculated in proportion of the remaining life of the asset at the beginning of every accounting period. Depreciation goes on decreasing every year.

Formula-

4. Sinking Fund Method-

Under this method annual depreciation is not deducted from asset but sinking fund is created with the annual depreciation. Apart from it amount of annual depreciation is invested every year outside the  business. At the end investment is sold and the proceed is utilized to purchase a new asset to replace the old one.

Journal Entries

First Year	Second Year	Last Year
For annual contribution Depreciation A\C Dr. To Sinking Fund A\C 2. For transfer of depreciation Profit & loss A\C Dr. To Depreciation A\C 3. For investing amount of depreciation Sinking Fund Investment A\C Dr. To Bank A\C	For interest received Bank A\C Dr. To Interest on SFI A\C For transfer of interest Interest on SFI A\C Dr. To Sinking Fund A\C	For sale of investment Bank A\C Dr. To SFI A\C For profit SFI A\C Dr. To Sinking Fund A\C For loss Sinking Fund A\C Dr. To SFI A\C For sale of asset Bank A\C Dr. To Asset A\C For transfer of sinking fund to asset account Sinking Fund A\C Dr. To Asset (old) A\C
Note- All three entries as in case of the first year will also be passed.

Balance of Old Asset A\C represents profit ( credit side being higher) or loss ( debit side being higher) which is transferred to P\L A\C.

For purchase of new asset

Asset (new) A\C Dr.

To Bank A\C

5. Provision for Depreciation Method- Under this method depreciation is not deducted from asset a\c but it is credited to provision for depreciation a\c. Under this method asset is maintained at cost price. At the time of sale asset a\c is credited with the cost of asset sold

Journal Entries

For providing depreciation

1. Depreciation A\C Dr. To Provision for Depreciation A\C 2. For transfer of depreciation Profit & Loss A\C Dr. To Depreciation A\C 3. For transfer of asset to asset disposal a\c Asset Disposal A\C Dr. To Asset A\C

4. For transfer of accumulated depreciation on asset sold to asset disposal a\c Provision for Depreciation A\C Dr. To Asset Disposal A\C 5. For sale of asset Bank A\C   Dr. Profit & Loss A\C (if sold at loss)Dr. To Asset Disposal A\C To Profit & Loss A\C (if sold at profit)

Note- Asset Disposal A\C may alternatively not be opened; in that case, sale of asset will be credited to Asset A\C which will finally disclose the profit or loss.

6. Machine Hour Method- Depreciation is calculated after estimating the total number of hours that a machine would work during the year.

Depreciation= Cost X Total Machine Hours In a Year\Total Machine Hours in Life Time of the Machine

7. Depletion Method-This method is used in case of mines, quarries etc. containing only a certain quantity of product.

Depreciation= Cost X Total Quantity Extracted \ Total Quantity Stored

8. Production Units Method-Under this method depreciation is determined based on the total production during the year.

Depreciation= Total Cost- Scrap Value= Total Production during the year\ Total estimated production

9. Provision for Repairs and Renewals- Under this method estimated amount of depreciation of entire life of the asset is added to the cost of asset and then based on this figure depreciation is calculated.

Change in the methods of depreciation

1. Prospective Method- Under this method change is effective when and from decision of change is decided.

2. Retrospective Method- Under this method change takes place from the very first year.

Steps-1. First compute depreciation under new method.

2. Then compute depreciation under old method.

3. Deduct depreciation calculated in step 2 from the depreciation calculated in step 2; if there is any surplus that should be debited to P\L A\C and if there is any deficit that should be credited to P\L A\C.