Chapter 10. The Nature of Depreciation – Financial Accounting

Chapter 10

The Nature of Depreciation

LEARNING OBJECTIVES

After studying this chapter, you will be able to

  1. Define Depreciation

  2. Know the Characteristic Features of “Depreciation”

  3. Understand the Accounting Concept of Depreciation

  4. Know the Salient Features of Depreciation

  5. Understand the Causes of Depreciation

  6. Know the Need for Depreciation

  7. Understand the Factors that Affect Depreciation

  8. To Calculate Depreciation for the Period for Which Depreciation is to be Charged Depending on Different Types of Problems

  9. Understand Methods of Accounting Entries for Recording Depreciation

  10. Understand Methods of Providing (Allocating) Depreciation

  11. Understand the Meaning, Formula, Merits, Demerits and Applicability of Straight Line Method

  12. Calculate the Rate and Amount of Depreciation Under Straight Line Method

  13. Understand the Meaning, Formula, Merits, Demerits and Suitability of Written Down Value Method

  14. Distinguish Between Straight Line Method and Written Down Value Method

  15. Compute Machinery Account and Ascertain Profit/Sale on Asset

  16. Understand the Accounting Treatment for Creating Provision for Depreciation and Accumulated Depreciation

  17. Understand the Procedure for Change in the Method of Depreciation as per Accounting Standard (AS) – 6

  18. Complete and Prepare Machinery Account, When There is a Change in the Method of Depreciation

  19. Understand the Concept of Annuity Method and Accounting Treatment Under This Method

  20. Understand the Main Features of Sinking Fund Method

  21. Differentiate Annuity Method and Sinking Fund Method

  22. Understand the Sum-of-the-Years’-Digits Method

  23. Choose a Method of Depreciation

  24. Answer: Is Depreciation a Source of (Income) Funds?

  25. Understand the Meaning, Objectives, Examples of Accounting Treatment and Disclosure Relating the “Provisions”

  26. Understand the Meaning and Objectives of “Reasons” and to Distinguish Between “Provision” and “Reserve”

  27. Understand Different Types of Reserves and Their Meanings

  28. Understand the Term “Provision for Repairs and Renewals” and Its Accounting Treatment

  29. Understand the Salient Features of Accounting Standard (AS) – 6

Introduction

To understand “what depreciation means” we have to expose the intricacies inherent in this word by way of the following detailed facts associated with the term. Every going concern acquires different types of assets broadly categorized into Fixed Assets and Current Assets. It is a fact that fixed assets are generally used for a longer period (i.e., more than one accounting period) and they are not for resale without using in the business activities). Despite the fact that fixed assets have longer life, they cannot be held perpetually in a concern. Fixed assets will have to loose their value over a period of time. At this stage one may say that the fall in value or quality of fixed assets may be connected with the term “Depreciation.” But the word Depreciation denotes many more factors.

OBJECTIVE 1: DEFINITION OF DEPRECIATION

According to the Institute of Chartered Accountants of India, “Depreciation is a measure of the wearing out or other loss of value of a depreciable asset arising from use, time or obsolescence. Depreciation is allocated so as to charge a fair proportion of the cost in each accounting period during the Expected Useful Life of the Asset. Depreciation includes amortization”. This is the Accounting Standard (AS) – 6.

According to the Institute of Chartered Accounts of England, “Depreciation represents that part of the cost of a fixed asset to its owner which is not recoverable when the asset is finally out of use by him. Provision against this loss of capital is an integral cost of conducting the business during the effective commercial life of the asset and is not dependent on the amount of profit earned”.

A careful analysis of the definition throws light on its character and extends its coverage by inclusion of some more terms like obsolescence, depletion and amortization.

OBJECTIVE 2: CHARACTERISTIC FEATURES OF “DEPRECIATION”

First, we shall look into its characteristic features:

  • “Loss of value of depreciable asset” is an important phrase in the definition that explodes its character. Loss of value means fall in value – book value is reduced (its cost minus depreciation) – such a fall or reduction or decrease in value of fixed assets may be termed as “Deprecation”.
  • It is a fall or decrease in the book value of depreciable fixed assets.
  • It is related to tangible fixed assets.
  • The fall in book value of asset is due to constant use of such asset in business activities.
  • The fall or loss of value or reduction in book value of tangible depreciable fixed assets is gradual, continuous and permanent.
  • As the definition covers “depletion, obsolescence, amortization” – explanation of these terms will also throw some light – what deprecation means really.
  • Depletion: This term is used in relation to natural resources like oil wells, deposits in mines, quarries and so on. It indicates exhaustion of natural resources. Such assets value will be reduced due to constant use and such reduction in the value of assets is referred to as “Depletion”.
  • Obsolescence: This term refers to the decline in economic value of assets. This may be due to invention of new techniques or equipment, market decline, change in fashion, inadequacy of existing fixed asset to meet increased demand and so on.
  • Amortization: This term refers to loss of economic value of intangible assets such as patents, trademarks, goodwill and copyrights. Some of them have limited period of life. So they have to be written off and removed from the list of assets. The process of writing off of intangible assets is called amortization.
OBJECTIVE 3: ACCOUNTING CONCEPT OF DEPRECIATION

According to American Institute of Certified Public Accountants. “Depreciation Accounting is a system of accounting which aims to distribute cost or the basic value of tangible capital assets loss salvage, if any, over the estimated useful life of the unit (which may be group of assets) in a systematic and rational manner. It is a process of allocation and not of valuation.

  • Depreciation accounting is the process of allocating the cost of the fixed tangible assets, less its salvage value over its serviceable life.
  • Depreciation is an expense that is to be charged against the revenues of different years over the asset is to be used.
  • It is immaterial whether the business makes profit or loss.
  • The amount to be allocated each year should be systematic and rational.
  • Deprecation accounting does not refer to the decline in value of current assets resulting from obsolescence.
  • Depreciation is not the process of valuation, even if the market value of an asset increases, depreciation is to be recorded.

On the basis of above discussion (i.e., based on definition of depreciation and meaning of depreciation accounting) the following salient features come into light on “Depreciation.”

OBJECTIVE 4: SALIENT FEATURES
  • Depreciation is gradual but continues fall in the book value of fixed assets.
  • Deprecation is caused due to depletion, obsolescence and amortization of fixed assets.
  • Deprecation is related to tangible fixed assets.
  • Deprecation is not connected with current assets.
  • Depreciation in accounting is a process of allocating the cost (as an expense) in each of the accounting period in which the asset is used.
  • Depreciation has no relationship with the market value of assets.
  • Deprecation cost is not an exact amount, it is to be estimated.
  • Depreciation is a charge against the profits.
  • Total deprecation cannot exceed its depreciable value (cost − scrap value) or original cost in case the scrap value is nil.
OBJECTIVE 5: THE CAUSES OF DEPRECIATION

The causes for the decline in the usefulness of asset may be due to physical and functional factors.

5.1 Physical Features

Physical loss of an asset is due to

  1. Wear and Tear: When the fixed assets are put into constant use, due to wear and tear, they may be rendered useless in course of time. Wear and tear may be due to friction, breakage and corrosion.
  2. Passage of time: Assets are affected when they are exposed to forces of nature – wind, rain, snow, heat of the sun, etc. – and with the passage of time the value of asset may get diminished even if they are not put in use.
  3. At times, natural calamities like earthquake, tsunami and factors like fire, flood and events of accident may cause the decline in the value of assets.

5.2 Functional Factors

  1. Inadequacy: It may not be able to match the demand – if the demand expands, its value is declined.
  2. Obsolescence: New inventions and technological advancement may be the cause of the decline.
  3. Depletion: Exhaustion of natural resources.
  4. Expiry of legal rights relating to copyright, patent, leases and so on. will also be a factor.
OBJECTIVE 6: NEED FOR DEPRECIATION

The need for charging a reasonable amount of depreciation arises for the following purpose or objectives.

1. True Results of Operations: It is necessary to charge the depreciation against income in each accounting period. Otherwise, the result of operations will not be fair and true.

2. True and Fair View of Financial Position: In the absence of depreciation charge, assets have to be shown at their original cost every year in the final accounts. In order to show true and fair final position, assets will have to be shown at cost less depreciation.

3. Proper Cost of the Product: Depreciation forms part of production like other expenses. In the absence of depreciation charge, cost records may not reveal true account of cost of production. To ascertain the proper cost of the product, it is imperate to provide for prescribed depreciation.

4. Funds for Replacements of Assets: A portion of profit is to be set aside in the form of depreciation every year which facilitates the task of replacement of assets at the end of its life. Without any additional financial burden, assets can be replaced in such accumulated depreciation provisions.

5. Legal Requirements: Legal requirements can be complied with, (as in case of companies) by way of charging depreciation on assets.

6. Allocation of Cost of Fixed Assets: The main objective of depreciation accounting is to allocate the cost of fixed asset to respective accounting periods which benefit from the use of the asset which can be achieved by charging depreciation.

7. Impact on Tax-Liability: Rate of depreciation is influenced by the tax-laws and thereby helps the tax liability to a certain extent.

OBJECTIVE 7: FACTORS AFFECTING AMOUNT OF DEPRECIATION

The amount of annual deprecation is based on the following factors:

1. Historical Cost: The cost includes all costs incurred in acquiring the depreciable fixed assets on its acquisition, installation and commissioning (e.g., invoice price, legal charges, freight, transport and so on.)

2. Estimated Useful Life: This depends on the intensity of use, standard of maintenance and the replacement policy of the management.

3. Estimated Residual Value (Scrap Value) (Salvage Value): The salvage value means the estimated amount that may be recovered on its sale or exchange for a new asset at the end of its useful service life.

OBJECTIVE 8: DEPRECIATION ON ASSETS

Following alternatives may be adopted to charge depreciation on assets purchased during the year:

Type Period for which depreciation is to be charged

(A) If the rate of depreciation is expressed as … % without the words of per annum (p.a.)

 

(i) When date of purchase or sale is not given

Depreciation is to be calculated for the full accounting period

(ii) When date of purchase or sale is given

Depreciation is to be computed on the basis of time factor unless the examination problem requires otherwise

(B) If the rate of deprecation … % with the words p.a. is given (e.g. 12% p.a.)

 

(i) If the date of the acquisition is given

(i) Depreciation is charged for the period beginning with the date acquisition and ending with the date of closing period

(ii) If the date of acquisition is NOT given

(ii) Assumption I: Assume that the asset was purchased in the beginning and charge the depreciation for a full year

Assumption II: Assume that the asset was purchased in the middle of the year and charge the depreciation for half of the year

Assumption III: Assume that the asset was purchased at the end of the accounting period and no depreciation is to be charged

[Students are asked to put a note in any such case.]

OBJECTIVE 9: ACCOUNTING TREATMENT

Following are the two alternative methods of accounting entries for recording depreciation:

  • By charging to asset account directly.
  • By creating Provision for Depreciation/Accumulated Depreciation Account.

9.1 Method 1: By Charging to Asset Account Directly

This accounting procedure is applicable to all the methods of depreciation except Sinking Fund Method.

Under this method of recording depreciation, it is directly credited to the “respective asset account” with the result that the respective asset account appears in the Balance Sheet at its book value or cost value less depreciation for the accounting period.

9.2 Method 2: By Creating Provision for Depreciation

Under this method, the asset account is not at all affected by the depreciation amount. Asset appears in the books (Ledger and Balance Sheet) at its original cost until sold or discarded.

The amount stands in the credit side of the Provision for Depreciation Account depicts the total amount of depreciation accumulated to date. When the asset is sold, that accumulated amount in the Provision for Depreciation Account is transferred to the respective asset account and closed.

Difference between these two methods of accounting:

Directly Charged to Asset A/c Provision for Depreciation

1 The asset is shown in the Balance Sheet at its cost or book value less depreciation relating to that accounting period.

1 The asset always appears at its original cost in the Ledger and the Balance Sheet.

2 Total amount of depreciation cannot be ascertained from a single Balance Sheet.

2 Total amount of depreciation written off up to date can be ascertained even from the last single Balance Sheet.

3 It is difficult to assess, whether the asset is new or old or when purchased, in the absence of any accounting information.

3 It is very easy to find out the age of asset with the help of cost of asset and accumulated depreciation.

Journal entries which will have to be passed under the method (charging direct to the asset):

  1. To record the purchase of asset:

     

     

    Asset A/c

    Dr.

     

    To Cash/Bank A/c

     

     

    (Being the Asset purchased.)

     

     

  2. To provide depreciation:

     

     

    Depreciation A/c

    Dr.

     

    To Asset A/c

     

     

    (Being the depreciation provided.)

     

     

  3. To close depreciation account:

     

     

    Profit and Loss A/c

    Dr.

     

    To Depreciation A/c

     

     

    (Being the Depreciation transferred to Profit and Loss A/c.)

     

     

  4. To record sale of asset:

     

     

    Cash/Bank A/c

    Dr.

     

    To Asset A/c

     

     

    (Being the asset sold.)

     

     

  5. To record profit/loss on sale:
    1. in case of profit:

       

       

      Asset A/c

      Dr.

       

      To Profit and Loss A/c

       

       

      (Being the transfer of profit on sale.)

       

       

    2. in case of loss:

       

       

      Profit and Loss A/c

      Dr.

       

      To Asset A/c

       

       

      (Being the transfer of loss on sale.)

       

OBJECTIVE 10: METHODS OF PROVIDING (ALLOCATING) DEPRECIATION

There are several methods of allocating depreciation. They are

  • Straight Line Method
  • Diminishing Balance Method
  • Annuity Method
  • Sinking Fund Method
  • Insurance Policy Method
  • Machine Hour Rate Method
  • Units of Output or Production or Depletion Method
  • Revaluation Method
  • Sum-of-the-Years’-Digits Method
  • Group Depreciation Method

The most commonly used methods are

  1. Straight Line Method
  2. Diminishing Balance Sheet

10.1 Straight Line Method: (or) Fixed (or) Equal Installment Method: Meaning, Formula, Merits, Demerits and Suitability

10.1.1 Meaning

Under this method:

  1. a fixed and equal amount (in the form of depreciation)
  2. according to a fixed percentage on original cost
  3. is written off each accounting year
  4. over the expected useful life of the asset

Under this method, the depreciation charge is not affected by the extent of the use of the asset, its age or efficiency.

10.1.2 Formula

  1. Amount of Depreciation = Original Cost − Residual value/Expected Useful Life of the Asset
  2. Rate of Depreciation = Amount of Depreciation/Original Cost × 100

While applying the formula, the following hints will be of much use to the students:

  1. Book Value (as on date of sale) = Original Cost − Total Depreciation (till date).
  2. Profit = Sale Proceeds − Book Value (as on date of sale).
  3. Loss = Book value (as on date of sale) − Sale Proceeds.
  4. In case of an exchange of asset,
    Sale price is the amount at which the vendor agrees to acquire the old asset (trade in allowance).
  5. In case of destruction of an insured asset, Sale price is the Claim admitted by the insurance company with the sale value if any.

10.1.3 Merits of this Method

  1. It is easy to comprehend and recognize by AS–6.
  2. It is easy to calculate the amount and rate of depreciation, and comparison is easy.
  3. The book value of the asset becomes zero or equal to its scrap value at the expiry of its useful life.

10.1.4 Demerits

  1. Total Charge − (Depreciation + Repairs + Renewals) does not commensurate with depreciation over the years. It is not in confirmity with the age of the asset.
  2. Interest on capital (invested in the asset) is ignored.
  3. It does not provide for the replacement of the asset on the expiry of its useful life.

10.1.5 Applicability

This method can yield rich dividends for those assets which have less repair charge and less chances of obsolescence. This method is suitable for patent, copyright, trademark, lease and so on.

 

Model: Depreciation under Straight Line Method

Illustration: 1

Calculate the rate of depreciation under Straight Line Method:

 

Purchase Price of Machine

=

Rs 4,00,000

Expenses to be Capitalized

=

Rs 2,00,000

Estimated Residual Value

=

Rs 2,00,000

Expected Useful Life

=

5 years

Solution

Step 1: Calculation of Total Cost of Asset

 

Remember

 

 

Total Cost of Asset = Purchase Price + Expenses to be Capitalized

 

 

=

Rs 4,00,000 + Rs 2,00,000

 

 

=

Rs 6,00,000

Step 2: Calculation of amount of depreciation per year

 

Remember

 

 

Amount of Deprecation

 

 

=

Total Cost of Asset – Estimated Scrap Value/Expected Useful Life

 

 

=

Rs 6,00,000 – Rs 2,00,000/5 years = Rs 4,00,000/5

 

 

=

Rs 80,000

Step 3: Calculation of Rate of Depreciation

 

Remember

 

 

Rate of Depreciation = Amount of Depreciation/Total Cost of Asset × 100

 

 

=

Rs 80,000/ Rs 5,00,000 × 100 = 16%.

 

Model: Calculation of amount of depreciation for the first year of purchase if rate of depreciation is not given

Illustration: 2

A machine is purchased for Rs 4,00,000. Expenses incurred on it Rs 1,00,000. The residual value at the end of its expected useful life of 4 years is estimated at Rs 2,00,000. Calculate the amount of depreciation for the first year ending on Mar 31, 2009 if it is purchased on:

  1. Apr 1, 2008
  2. July 1, 2008
  3. Oct 1, 2008
  4. Jan 1, 2009

Solution

Step 1: Total cost of asset is to be calculated

 

 

 

(Total) Cost of Asset = Purchase Price + Expenses

 

=

Rs 4,00,000 + Rs 1,00,000

 

=

Rs 5,00,000

Step 2: Amount of depreciation per year is calculated

Amount of Depreciation per year

 

 

=

Total Cost of Asset – Estimated Residual Life/Expected Useful Life

 

=

Rs 5,00,000 – Rs 2,00,000/4 = Rs 75,000 per year

Step 3: Amount of depreciation for the first year of purchase

Case (a): Date of purchase Apr 1, 2008

From Apr 1, 2008 to Mar 31, 2009: 12 months

∴ Amount of depreciation for 12 months, i.e. 1 year = Rs 75,000

(as per Step 2)

Case (b): Date of purchase: July 1, 2008

From July 1, 2008 to Mar 31, 2009 = 9 months

Amount of deprecation for 12 months = Rs 75,000

∴ Amount of depreciation for 9 months = Rs 75,000×9/12 = Rs 56,250

Case (c): Date of purchase = Oct 1, 2008

From Oct 1, 2008 to Mar 31, 2009 = 6 months

Amount of Depreciation for 6 months = 6/12×75,000 = Rs 37,500

Case (d): Date of purchase: Jan 1, 2009

From Jan 1, 2009 to Mar 31, 2009 = 3 months

Amount of Depreciation = 3/12 × 75,000 = Rs 18,750.

 

Model: Calculation of Amount of Depreciation for the First Year of Purchase – Rate of Depreciation is Given

Illustration: 3

A machine is purchased for Rs 8,00,000. Expenses incurred on its cartage and installation Rs 1,00,000. Calculate the amount of depreciation @ 10% p.a. as per Straight Line Method for the first year ending on Mar 31, 2009, if the machine is purchased on

  1. Apr 1, 2008
  2. July 1, 2008
  3. Oct 1, 2008
  4. Jan 1, 2009

Solution

Step 1: Calculation of total cost of asset

Total Cost of Asset = Purchase Price + Expenses

 

 

=

Rs 8,00,000 + Rs 1,00,000

 

=

Rs 9,00,000

Step 2: Amount of depreciation

 

 

=

Total Cost of Asset × Rate/100 × Period/12 months

Case (a): Purchase is on Apr 1, 2008

Period = from Apr 1, 2008 to Mar 31, 2009 = 12 months

Amount of depreciation for 12 months = Rs 9,00,000 × 10/100 × 12/12

= Rs 90,000

Case (b): Purchase is on July 1, 2008

Period = from July 1, 2008 to Mar 31, 2009 = 9 months

Amount of depreciation for 9 months = Rs 9,00,000 × 10/100 × 9/12

= Rs 67,500

Case (c): Purchase is on Oct 1, 2008

Period = From Oct 1, 2008 to Mar 31, 2009 = 6 months

∴ Amount of depreciation for 6 months = Rs 9,00,000 × 10/100 × 6/12

= Rs 45,000

Case (d): Purchase is on Jan 1, 2009

Period = From Jan 1, 2009 to Mar 31, 2009 = 3 months

Amount of depreciation for 9 months = Rs 9,00,000 × 10/100 × 3/12

= Rs 22,500

 

Model: Calculation of Profit/Loss on Sale of Asset

Illustration: 4

A company purchased a second-hand machine on Apr 1, 2007 for Rs 1,50,000 and spent Rs 50,000 on its repairs. Depreciation is to be provided @ 10% as per Straight Line Method. The machine was sold for Rs 1,00,000. Accounting year is financial year. Calculate the profit/loss on sale of machine, on Mar 31, 2009.

Solution

Step 1: Total Cost of Asset = Purchase Price + Expense

 

 

=

Rs 1,50,000 + Rs 50,000 = Rs 2,00,000

Step 2: Depreciation

Period = from Apr 1, 2007 to Mar 31, 2009 = 24 months

Amount of Depreciation for 24 months

 

 

=

Rs 2,00,000 × 10/100 × 24/12

 

=

Rs 40,000

Step 3: Book value as on date of sale

(Step 1 – Step 2) = Rs 2,00,000 – Rs 40,000

        = Rs 1,60,000

Step 4: Sale proceeds = Rs 1,00,000

Step 5: Book Value − Sale Proceeds

      Rs 1,60,000 – Rs 1,00,000

      = Rs 60,000 (Profit)

Hence, profit on Sale = Rs 60,000.

 

Model: Passing Journal Entries and Preparation of Depreciation A/c and Machinery Account

Illustration: 5

On Apr 1, 2006 X Ltd purchased a second-hand machine for Rs 1,60,000 and spent Rs 40,000 on its cartage and installation. The residual value at the end of its expected useful life of 4 years is estimated at Rs 80,000. On Sep 30, 2008. This machine is sold for Rs 1,00,000. Depreciation is to be provided according to Straight Line Method.

You are required to pass Journal entries in the books of X Ltd and prepare Machinery Account and Depreciation Account for the first three years assuming that the accounts are closed on Mar 31, each year.

Solution

Stage I First, rate of depreciation is calculated

  1. Total cost = Rs 1,60,000 + Rs 40,000 = Rs 2,00,000
  2. Amount of Depreciation per year = Total Cost – Estimated Residual value/Expected Useful Life

    = Rs 2,00,000 – Rs 80,000/4 = Rs 30,000

  3. Rate of Depreciation = Amount of Depreciation/Total Cost of Asset × 100

    = Rs 30,000/Rs 2,00,000 × 100 = 15%

Stage II Next, profit/loss on sale of asset is to be computed

 

   

Rs

(i)

Total Cost of Asset (Rs 1,600,000 + Rs 40,000)

2,00,000

(ii)

Less: Depreciation from the date of purchase to date of sale (Rs 2,00,000 × 15/100 × 30/12)

75,000

(iii)

Book value as on date of sale (i) – (ii)

1,25,000

(iv)

Less: Sale proceeds

1,00,000

(v)

Loss on Sale of Asset

25,000

Note: Depreciation for the period from Mar 31, 2008 to date of sale of asset Sep 30, 2008 has to be computed.

Amount of depreciation for the period from Apr 1, 2008 to Sep 30, 2008

i.e. for 6 months = Rs 2,00,000 × 15/100 × 6/12

                             = Rs 15,000

Stage III Passing of Journal entries in the books of X Ltd

 

Journal of X Ltd

Machinery Account

Depreciation Account

10.2 Written Down Value Method (or) Diminishing Balance Method (or) Reducing Balance Method: Meaning, Formula, Merit, Demerit and Suitability

10.2.1 Meaning

The depreciation is calculated on the reducing balance (Asset Cost Less Depreciation) and not on original cost. Under this method, a fixed rate (percentage) is applied to the original cost in the first year and to the book value in subsequent years. The book value of the asset means the balance of asset cost but not yet depreciated. The deprecation is deducted from the cost of the asset and the balance is termed as Written Down Value (WDV). In the next year, the fixed rate is applied to the WDV and not to the original cost. Under this method, the rate of deprecation remains the same but the amount of depreciation goes down decreasing.

The WDV at the end of the estimated useful life of the asset will equal the estimated salvage value.

10.2.2 Formula: Rate of Depreciation (WDV Method)

 

R

=

R

=

Rate of depreciation in %

N

=

Useful life of the asset

S

=

Scrap value at the end of useful life of the asset

C

=

Cost of the Asset.

10.2.3 Merits

  1. Higher depreciation, charged in the earlier years of the asset (i.e., the machine in the most efficient condition result in increased production) is in conformity with larger revenues, is a practical approach.
  2. The obsolescence view is looked into as major part of depreciation is charged in the earlier years and in the end there will not be much difficult to replace assets.
  3. In later years, any machinery warrants higher maintenance and repair expenses and lower depreciation charge in later years ease the financial burden of the companies.
  4. As the asset will never be written off completely, the management can keep a track on the asset.
  5. All items, including additions are added together and depreciated on the same rate. As such recalculation need not be done.
  6. This method is recognized by AS–6 and recognized by tax authorities.

10.2.4 Demerits

  1. Under this method, the formula is a complicated one and more mathematical competence is needed.
  2. Interest on the amount invested in assets is ignored.
  3. It takes much time (i.e., more years) to write off the assets completely. As such early replacement of asset is not possible.
  4. Assets having a very short useful life, may affect the profit results, as (charged) depreciation rate is high in the earlier years.
  5. This method is neither based on the use of the asset nor distributed evenly throughout the useful life of the asset.

10.2.5 Suitability

This method is suitable where

  1. The amount of repair/renewable charges are high in later years.
  2. Obsolescence is more frequent.

10.2.6 Distinction Between Straight Line Method and Written Down Value Method

Points of Distinction Straight Line Method (SLM) Written Down Value Method (WDV)

1. Basis

Depreciation is charged at a fixed rate on the original cost of the asset.

Depreciation is charged at a fixed rate on original cost in the first year and on the WDV (Cost — Total Depreciation) in the subsequent years.

2. Amount of Depreciation

The amount of depreciation remains constant (same) throughout the life of asset.

The amount of depreciation goes on decreasing from year to year.

3. Effect on Net Profit

Net Profit will be affected in later years since the maintenance charges may increase, depreciation being the same amount.

Net Profit will not be affected in later years since the depreciation amount decreases.

4. Formula and Calculation

Easy to calculate depreciation as the formula is simple.

Difficult to compute depreciation, as the formula requires mathematical skill

5. Book Value

At the end of useful life of the asset, book value is nil or equal to scrap value.

The book value will never be zero or equal to scrap value.

6. Suitability

Suitable where

(i) repair charges are less

(i) obsolescence is less.

Suitable where

(i) repair charges are high

(i) obsolescence is more frequent.

7. Tax Authority’s Recognition

This method is not recognised by Income Tax Authorities

This method is recognised by Income Tax Authorities

Illustration: 6

A machine was purchased on Apr 1, 2007 for Rs 50,000. The cost of installation and other expenses are Rs 3,000. Its scrap value at the end of its useful life will be Rs 5,000. Write up the Machine Account for the first two years under (i) WDV Method and (2) SLM charging 20% depreciation, assuming financial year is followed:

Solution

First, under SLM, amount of depreciation for a year (12 months) is calculated.

 

Annual Depreciation

=

Total Cost – Scrap value/Useful Life of Asset

 

=

Rs 50,000 + Rs 3,000 – Rs 5,000

 

=

Rs 48,000 × 20/100 × 12/12

 

=

Rs 9,600

 

Machinery Account (Under Straight Line Method)

Machinery Account (Diminishing Balance Method)

Now, the differences between these two methods can be easily understood.

  1. The depreciation is charged on the original cost of the asset under Straight Line Method, whereas under WDV Method, even though it is charged on the original cost in the first year, in the subsequent years it is charged at WDV (Cost less Depreciation).
  2. The amount of depreciation remains the same, i.e. Rs 9,600 for every year under SLM, whereas it varies and decreases, i.e. Rs 10,600 in the first year and Rs 8,480 in the second year.
  3. Further the amount of depreciation is high in the first under WDV is Rs 10,600 compared to Rs 9,600 under SLM.
  4. Amount of depreciation is less even lesser than under SLM, i.e. Rs 8,480 under WDV Method, whereas it is Rs 9,600 under SLM.

The differences between these two methods can be illustrated in a better way as follows:

Illustration: 7

M/s Renu Sugars Ltd purchased a machine costing Rs 50,000 or Jan 1, 2004. The depreciation is to be charged @ 20% p.a. Write up the Machine Account for five years ending on Dec 31, 2008 under Straight Line Method and WDV Method:

Solution

 

Machine Account

Purchase of Assets (or Additions) and Depreciation

Illustration: 8

From the following information of Vas Ltd prepare Machinery Account for three years ending Mar 31, 2009, by providing depreciation @ 20% p.a. under Straight Line Method

Date Transactions Rs

Apr 1, 2006

Purchased a second hand machinery I

1,20,000

Apr 1, 2006

Repairs on it

   30,000

Oct 1, 2006

Purchased a new machinery II

3,00,000

Apr 1, 2007

Spent repairs on machine II

     3,000

Sep 30, 2008

Sold machinery I

   67,500

Sep 30, 2008

Purchased a new machinery III

4,50,000

Solution

Step 1:  Profit or Loss on Sale of Asset is calculated

 

 

 

  Rs

1.

Total Cost of Asset (Rs 1,20,000 + Rs 30,000)

1,50,000

2.

Less:  Depreciation on I from date of purchase to date of sale
(Rs 1,50,000 × 20/100 × 30/12)

75,000

3.

Book value as on date of sale (1–2)

  75,000

4.

Less: Sale proceeds of Machine I

67,500

5.

Loss on sale (3–4)

   7,500

Step 2:

 

Machinery Account

Illustration: 9

From the following information of Ra & Co Ltd, prepare Machinery Account for three years ending Mar 31, 2009 by charging depreciation @ 20% p.a. applying WDV Method.

Date Transactions Rs

Apr 1, 2006

Purchased a second hand machinery I

1,20,000

Apr 1, 2006

Spent for repairs

30,000

Oct 1, 2006

Purchased a new machine II

3,00,000

Apr 1, 2007

Spent for repairs on new machine II

3,000

Sep 30, 2008

Sold machine I

67,500

Sep 30, 2008

Purchased a new machine III

4,50,000

Illustration figures are the same as that of the previous illustration but the Method of Deprecation differs here.

Solution

Step 1: Calculation of Profit/Loss on Sale of Machine:

 

    Rs

1.

Total Cost of Asset (Rs 1,20,000 + Rs 30,000)

1,50,000

2.

Less: Depreciation for 2006– 2007 (20% of Rs 1,50,000)

30,000

3.

Book value as on Apr 1, 2007 (1–2)

1,20,000

4.

Less: Depreciation for 2007–2008 (20% of Rs 1,20,000)

24,000

5.

Book value as on Apr 1, 2008 (3–4)

96,000

6.

Less: Depreciation upto date of sale from Apr 1, 2008 to Sep 30, 2008: 6 months 20% of Rs 96,000 for 6/12

9,600

7.

Book value (6–7) as on Sep 30, 2008

86,400

8.

Less: Sale proceeds

67,500

9.

Loss on Sale (7–8)

18,900

Step 2:

 

Preparation of Machinery Account

Important Note: Amount spent on repairs on Apr 1, 2007 is of revenue nature and as such it is not debited to Machinery Account.

Note: There exists no difference in recording Journal entries under WDV. The procedure and accounting entries are similar to that of the procedure adopted under Straight Line Method.

Journal entries are same under both methods (i.e., Straight Line Method and Diminishing Value Method (WDV).

So this part is not repeated here.

Illustration: 10

On July 1, 2005, Shree Ltd purchased a second-hand machinery for Rs 40,000 and spent Rs 6,000 on re-conditioning and installing it. On Jan 1, 2006, the firm purchased machinery worth Rs 24,000. On June 30, 2007, (the machinery purchased on Jan 1, 2006) was sold for Rs 16,000. On July 1, 2007, another new machinery was purchased on installment basis, payment for which was to be made as follows:

 

June 30, 2008

Rs 10,000

July 1, 2008

Rs 12,000

June 30, 2009

Rs 11,000

Payments in 2008 and 2009 include interest of Rs 2,000 and Rs 1,000 respectively.

The company writes off depreciation @ 10% on original cost. The accounts are closed every year on Mar 31. Show the Machinery Account for three years ending Mar 31, 2008.

 

[B.Com (Hons) – Modified]

Solution

Note: As there is no specific instruction regarding the method of depreciation, Straight Line Method is followed.

Calculation of Depreciation: In order to avoid confusion, let the machinery purchased on July 1, 2005 be noted as Machine I (assumption), and the one purchased on Jan 1, 2006 as Machine II, and the other one purchased on July 1, 2007 as Machine III – for easy calculation of depreciation.

Step 1: For the year 2005–2006 (Apr 1, 2005 to Mar 31, 2006)

 

(i) Date of purchase July 1, 2005: Machine I

Rs 40,000

Add: Expenses

  Rs 6,000

 

Rs 46,000

From July 1, 2005 to Mar 31, 2006: 9 months

∴ Depreciation on Machine I = Rs 46,000 × 10/00 × 9/12 = Rs 3,450

 

(ii) Machine II was purchased on Jan 1, 2006 = Rs 24,000

From Jan 1, 2006 to Mar 31, 2006 = 3 months

∴ Depreciation on Machine II = Rs 24,000 × 10/100 × 3/12 = Rs 600

Step 2: For the year 2006–2007 (From Apr 1, 2006 to Mar 31, 2007)

Note: There is no addition (purchase) or sale during this period. So depreciation has to be computed for 1 year for both the machines.

  1. Depreciation for Machine I

    Rs 46,000 × 10/100 × 12/12 = Rs 4,600

  2. Depreciation for Machine II

    Rs 24,000 × 10/100 × 12/12 = Rs 2,400

Step 3: For the year 2007–2008 (from Apr 1, 2007 to Mar 31, 2008)

  1. Depreciation for Machine II

    This was sold on June 30, 2007

    Depreciation for the period, i.e. from Apr 1, 2007 to June 30, 2007

    ∴ Depreciation = Rs 24,000 × 10/100 × 3/12 = Rs 600

  2. Depreciation for Machine I

    (This means for a year.)

    ∴ Depreciation = Rs 46,000 × 10/100 × 12/12 = Rs 4,600

  3. On July 1, 2007, Machine III was purchased

    Depreciation for the period from July 1, 2007 to Mar 31, 2008

    = Rs 33,000 × 10/100 × 9/12

    = Rs 2,475

Step 4: Note: Interest is not to be added to the cost of asset for depreciation calculation. At this stage, profit or loss on sale of machinery has to be computed.

 

 

 

  Rs

1.

Original cost (as on date of purchase Jan 1, 2006)

24,000

2.

Less: Depreciation for this (Machine II)
(Rs 24,000 × 10/100 × 3/12) + Rs 2,400 + Rs 600 (2006–07) (2005–06)

3,600

3.

Book value (1–2) as on date of sale (June 30, 2007)

20,400

4.

Less: Sale proceeds

16,000

5.

Loss (3–4)

4,400

Hence, there is a loss of Rs 4,400 on the sale of Machine II.

Step 5: Now all these figures have to be transferred to “Machinery Account” which has to be prepared as follows:

 

Machinery Account

Important Note: Machine is brought under Hire-Purchases Scheme, payment by installment spreads over a number of years. But total cost (i.e., sum of all the installments) has to be taken into account for computing depreciation and at the same time excluding interest amount as already noted.

Illustration: 11

On Apr 1, 2006, Siva Ltd agreed to purchase a machine on hire-purchase basis from Dev Ltd. The cash price of the machine was Rs 6,00,000. The company was required to pay Rs 3,00,000 down and the balance in three annual installments of Rs 1,00,000 each plus interest @ 12% per annum. First installment was paid on Mar 31, 2007. Show Machine Account for all the three years in the books of Siva Ltd, which depreciated machine @ 15% per annum using Diminishing Balance Method. Assume the books of accounts are closed every year on Mar 31.

 

(C.S. Foundation – Modified)

Solution

Note: Asset is bought under hire purchase system and payment is made in installments. For calculating depreciation, installment is ignored and the total, i.e. cash price has to be taken into account. Interest need not be added to the cost of the asset.

 

Machinery Account

Illustration: 12

On Jan 1, 2005, a machine was purchased by Vasu Dev for Rs 60,000. On July 1, 2006 additions were made to the extent of Rs 12,000. On Apr 1, 2007, further additions were made to the extent of Rs 7,680. On June 30, 2008, a machine, the original value of which was Rs 9,600 on Jan 1, 2005, was sold for Rs 7,200. He closed books on Dec 31 every year.

Show the Machine Account for four years from 2005 to 2008 in the books of Vasu Dev, if depreciation is charged @ 10% under Original Cost Method.

 

B. Com (Hons) – Modified

Solution

Depreciation has to be calculated by Straight Line Method calculation.

Step 1: For the year 2005 (Jan 1, 2005 to Dec 31, 2005) that machine remains throughout the year

∴ Depreciation = Rs 60,000 × 10/100 × 12/12 = Rs 6,000

Step 2: For the year 2006: (From Jan 1, 2006 to Dec 31, 2006):

 

Before addition:

Rs

Depreciation = Rs 60,000 × 10/100 × 12/100

6,000

Addition on July 1, 2006 = (From July 1, 2006 to Dec 31, 2006)

 

Depreciation = Rs 12,000 × 10/100 × 6/12

600

Total Depreciation for the year 2006

6,000

Step 3: For the year 2007:

 

Rs

Before addition: (for 1 year)

 

(i) Depreciation = Rs 60,000 × 10/100 × 12/12

6,000

(ii) Depreciation = Rs 12,000 × 10/100 × 12/12

1,200

Addition on Apr 1, 2007 (from Apr 1, 2007 to Dec 31, 2008)

 

(iii) Depreciation = Rs 7,680 × 10/100 × 9/12

576

Total Depreciation for the year 2007

7,776

Step 4: For the year 2008:

 

(i) Sale on June 30, 2008 = (June 30, 2008 to Dec 31, 2008)

Rs

    Rs 9,600 × 10/100 × 6/12

480

(ii) Balance (60,000 – 9,600) = 50,400 × 10/100 × 12/12

5,040

    10% on Rs 12,000 machine for 1 year

1,200

    10% on Rs 7,680 machine for 1 year

768

 

7,008

Step 5: Calculation of profit/loss on sale of machine:

 

 

 

  Rs

1.

Cost of machine sold on June 30, 2008

9,600

2.

Loss: Depreciation for 2005

960

3.

Book value on Dec 31, 2005

8,640

4.

Less: Depreciation for 2006

960

5.

Book value on Dec 31, 2006
As Straight Line Method applied no change occurs in depreciation value

7,680

6.

Less: Depreciation for 2007

960

7.

Book value on Dec 31, 2007

6,720

8.

Less: Depreciation upto June 30, 2008 only

480

9.

Book value on the date of sale

6,240

10.

Sale value on the date of sale

7,200

11.

Profit (10 – 9) (Rs 7,200 – Rs 6,240)

960

Step 6: Preparation of Machinery Account:

 

Machinery Account

10.3 Provision for Depreciation/Accumulated Depreciation: Passing of Entries and Preparation of Accounts

Under this method of recording depreciation, depreciation is to be credited to Provision for Depreciation Account.

As a result, the asset account is not affected by the amount of depreciation. The respective asset appears in the books (Ledger and Balance Sheet) at its original cost value. However, the amount in the credit side of the Provision for Depreciation Account shows the total amount of depreciation accumulated to date (till sold or discarded).

Journal entries to be passed are:

  1. To Provide Depreciation

     

    Depreciation A/c

    Dr.

    To Provision for Depreciation A/c

     

     

  2. To Close Depreciation Account:

    Profit and Loss A/c

    To Depreciation A/c

  3. Disposal of the (respective) Asset:
    1. For transfer of original cost of asset disposed off

       

      Asset Disposal A/c

      Dr.

      To Asset A/c

       

    2. For transfer of accumulated depreciation

       

      on asset disposed off

       

      Provision for Depreciation A/c

      Dr.

      To Asset Disposal A/c

       

       

    3. For Sale proceeds:

       

      Cash/Bank A/c

      Dr.

      To Asset Disposal A/c

       

       

    4. For transfer of balance in Asset Disposal Account:
      1. When Profit:

         

        Asset Disposal A/c

        Dr.

        To Profit and Loss A/c

         

         

      2. When Loss:

         

        Profit and Loss A/c

        Dr.

        To Asset Disposal A/c

         

Illustration: 13

On Jan 1, 2006, Raj Ltd purchased a machinery for Rs 6,000,000. On July 1, 2008, a part of the machinery purchased on Jan 1, 2006 for Rs 40,000 was sold for Rs 22,500 and a new machinery at a cost of Rs 79,000 was purchased. The company has adopted the method of providing 1% p.a. depreciation on the original cost of the machinery. Prepare the necessary ledger accounts – Provision for Depreciation Account is maintained.

Solution

Step 1: Profit/loss on sale of machinery is to be calculated:

 

 

 

  Rs

1.

Cost of Machinery (as on Jan 1, 2006)

40,000

2.

Less: Depreciation for the period from Jan 1, 2006 to July 1, 2008: 30 months Rs 40,000 × 10/100 × 30/12

10,000

3.

Book value as on July 1, 2008 (1 – 2)

30,000

4.

Less: Sale proceeds

22,500

5. Loss on Sale (3 – 4) 7,500

Step 2: Calculation of depreciation on machines (other than sold)

 

 

 

Rs

1.

On Machine I (Rs 6,00,000 – Rs 40,000)

5,60,000

 

(Purchased)    (Sold)

 

 

    Depreciation for 1 year: Rs 5,60,000 × 10/100

56,000

2.

On new Machine II:

 

 

    Period from July 1, 2008 to Dec 31, 2008: 6 months

 

 

    Depreciation Rs 79,000 × 10/100 × 6/12

3,950

 

    Total (for 2008)

59,950

Step 3

 

Machinery Account

Step 4

 

Provision for Depreciation Account

Step 5

 

Machinery Disposal Account

10.4 Procedure for Change in the Method of Depreciation

Accounting Standard–6 of ICAI stipulates that the depreciation method selected should be applied consistently. It has to facilitate easy comparison of results of operation from period to period. AS–6 (Revised) permits change of method only from the back date (retrospectively) on existing machines.

In order to comply with any statutory requirements or Accounting Standards of ICAI, change from one method of depreciation to another method can be adopted.

In case, a change in the method of depreciation is needed, depreciation must be “Recalculated” from the date of asset coming into use.

Due to recalculation, Surplus (Excess) or Deficiency (Shortage) may be the outcome. Surplus is to be credited to Profit and Loss A/c (or Depreciation A/c) and Deficiency is to be debited to Profit and Loss A/c (or Depreciation).

This can be explained with the help of the following illustration.

Illustration: 14

On Jan 1, 2005 X Ltd purchased machinery costing Rs 75,000 and provided depreciation @ 10% p.a. on Straight Line Method basis. At the end of 2009, the company decided to change the method of depreciation from Straight Line Method to Diminishing Value Method, retrospectively, the rate of depreciation remains unchanged. Prepare the Machinery Account upto the year 2008.

Solution

 

Step 1:

Calculation of total depreciation under old method:

 

 

Period from Jan 1, 2005 to Dec 31, 2008: 36 months (3 years)

Rs

 

Depreciation = Rs 75,000 × 10/100 × 36/12

22,500

 

*1. Total depreciation under Straight Line Method

18,000

Step 2:    Calculation of total depreciation under new method:

 

 

(Diminishing Value Method)

 

1.

Cost of Machinery as on Jan 1, 2005

75,000

2.

Less: Depreciation for 1 year (2005)

7,500

 

          (Rs 75,000 × 10/100 × 12/12)

67,500

3.

Book value on Jan 1, 2006

 

4.

Less: Depreciation for 1 year (2006)

 

 

          (Rs 67,500 × 10/100 × 12/12)

6,750

5.

Book value on Jan 1, 2007

60,750

6.

Less: Depreciation for 1 year (2007)

 

 

          (Rs 60,750 × 10/100 × 12/12)

6,075

7.

Book value on Jan 1, 2008

54,675

 

*2. Total depreciation under new method

 

 

          (Rs 7,500 + Rs 6,750 + Rs 6,075

20,325

Step 3: Calculation of the difference between the total depreciation under old method (Straight Line Method) and the total depreciation under new method (Diminishing Value Method).

 

 

 

Rs

*1.

Total Depreciation under SLM (Old Method)

(refer Step 1)

22,500

*2.

Total Depreciation under WDV (New Method)

(refer Step 2)

20,325

3.

Difference (Surplus or Excess)

2,175

Step 4:    Pass Journal entries.

 

 

Machinery A/c

Dr. 2,175

 

 

To Profit and Loss A/c

 

2,175

 

(Being the excess on the method of depreciation credited to Profit and Loss A/c)

Step 5:    Depreciation for the current accounting year

 

 

Rs 54,675 × 10/100 × 12/12

 

 

Book Value on Jan 1, 2008

 

 

(refer Step 2)

Rs 5,468

 

(rounded off to the nearest rupee)

 

Step 6:    Preparation of Machinery Account:

 

Machinery Account

Illustration: 15

Shree Ltd purchased on Jan 1, 2004, certain machinery for Rs 97,000 and spent Rs 3,000 on its execution. On July 1, 2004 additional machinery costing Rs 50,000 was purchased. On July 1, 2006, the machinery purchased on Jan 1, 2004 was auctioned for Rs 50,000 and on the same date a new machinery was purchased at a cost of Rs 75,000. Depreciation was provided annually on Dec 31 @ 10% p.a. on the original cost. No depreciation need be charged during the year of sale of machinery for that part of the year when the machine was used. In 2008, however, the company has changed the method of depreciation to WDV Method @ 15% p.a. from the Straight Line Method. Show the machinery account for the period from 2004 to 2008.

 

[B.com (Hons) – Modified]

Solution

Let the machine purchased on Jan 1, 2004 be called as Machine I, additional machinery on July 1, 2004 be Machine II and the new machinery purchased on July 1, 2006 be Machine III for computing depreciation without any confusion.

Step 1:    Calculation of total depreciation for Machine II, under both the methods worked out as:

 

  Machine II Straight Line Method
Rs (10%)
Written Down Method
Rs (15%)

 

Cost as on July 1, 2004

50,000

50,000

 

(Addition)

 

 

Less:

Depreciation for the period

 

 

 

From July 1, 2004 to Dec 31, 2004

2,500

3,750

 

for six months: (year 2004)

 

 

 

Book value on Dec 31, 2004

47,500

46,250

Less:

Depreciation for 1 year (2005)

5,000

6,938

 

Book value on Dec 31, 2005

42,500

39,312

Less:

Depreciation for 1 year (2006)

5,000

5,897

 

Book value on Dec 31, 2006

37,500

33,415

Less:

Depreciation for 1 year (2007)

5,000

5,012

 

Book value on Dec 31, 2007

32,500

28,403

 

Total Depreciation

17,500

21,597

Step2:

 

  Machine III Straight Line Method
Rs (10%)
Written Down Method
Rs (15%)

 

Cost (as on July 1, 2006)

75,000

75,000

Less:

Depreciation from July 1, 2006 to

 

 

 

Dec 31, 2006: 6 months

3,750

5,625

 

Book value on Dec 31, 2006

71,250

69,375

Less:

Depreciation for 1 year (2007)

7,500

10,406

 

Book value on Dec 31, 2007

63,750

58,969

 

Total Depreciation

11,250

16,031

Step3:    Computation of Surplus or Deficiency:

 

 

Total depreciation on Machine II and III:

Rs

(i)

Under WDV Method

 

 

(Rs 21,597 + Rs 16,031)

37,628

(ii)

Under Straight Line Method

 

 

(Rs 17,500 + Rs 11,250)

28,750

 

Difference between (i) and (ii) (Excess)

8,878

Step4:    Computation of Depreciation for 2008

 

 

Book value of both machines (II and III)

 

 

(WDV: Ref Step 2)

96,250

 

(Rs 63,750 + Rs 32,500)

 

Less:

Difference (Excess)

8,878

 

 

87,372

Less:

15% Depreciation

13,106

 

(under WDV)

74,266

 

Machinery Account

As per AS–6, the change in the method of depreciation must be effective with retrospective effect on the existing machine. The position will be as:

* Calculation of loss on sale:

Rs

 

Cost

=

1,00,000

Less:

Depreciation

=

20,000

 

 

 

80,000

Less:

Sale proceeds

=

50,000

 

Loss

=

30,000

Illustration: 16

X Ltd bought a truck on Jan 1, 2005 for Rs 1,20,000 and a sum of Rs 40,000 was spent for various accessories on July 1, 2006 another vehicle was purchased for Rs 1,04,000. On July 1, 2007, the first truck was sold for Rs 1,20,000. On the same date another truck was purchased for Rs 1,00,000. On July 1, 2008 the second vehicle was sold for Rs 92,000. Rate of depreciation was 10% p.a. on the original cost annually on Dec 31. In 2007, the method of depreciation was changed to Diminishing Value Method, on the balance existing on Dec 31, 2007, the rate being 15% p.a. Prepare Truck Account for 2005, 2006, 2007 and 2008.

 

B.Com (Hons.) – Modified

Solution

Step 1: Accounting Standard–6, stipulates that change in method and rate should take place with retrospective effect.

But in this problem, instructions are given accordingly the change in method and rate will have to take place from Dec 31, 2007.

Step 2: Calculation of depreciation for 2005:

    Cost as on Jan 1, 2005 (Rs 1,20,000 + Rs 40,000) = Rs 1,60,000

    Period: (from Jan 1, 2005 to Dec 31, 2005): 1 year

    Depreciation for 2005 = Rs 1,60,000 × 10/100 × 1 = Rs 16,000

Step 3: Calculation of depreciation for 2006:

  1. Truck I: period = 1 year (Jan 1, 2006 to Dec 31, 2006)

    Depreciation for Truck I for 2006 = Rs 16,000

  2. Truck II: Cost as on July 1, 2006: Rs 1,04,000

    Period (from July 1, 2006 to Dec 31, 2006) = 6 months

    Depreciation for Truck II for 2006 = Rs 5,200

    (Rs 1,04,000 × 10/100 × 6/12)

Step 4: Calculation of depreciation for 2007

Note:

  1. Rate has to be changed from 10% to 15%.
  2. Method has to be changed from Straight Line Method to Diminishing Value Method.
    1. For Truck II

      Book Value as on Jan 1, 2007 = Rs 98,800

      (Rs 1,04,000 – Rs 5,200)

                                ↓

      (Depreciation for 2006)

      Period: from Jan 1, 2007 to Dec 31, 2007 = 1 year

      Depreciation for 2007 = Rs 14,820

      (Rs 98,800 × 15/100 × 12/12)

    2. For Truck III

      Cost as on July 1, 2007: Rs 1,00,000

      Period from July 1, 2007 to Dec 31, 2007: ½ year

      Depreciation for 2007 = Rs 7,500

      (Rs 1,00,000 × 15/100 × ½)

Step 5: Depreciation for the year 2008:

  1. For Truck II:

    Book value on Jan 1, 2007: Rs 98,800

    Less: Depreciation for 2007: Rs 14,820

    Book value on Jan 1, 2008: Rs 83,980

    Depreciation (Jan 1, 2008 to July 1, 2008) = Rs 83,980 × 15/100 × 6/2 = Rs 6,299

  2. At this stage itself Profit/Loss on sale may be computed.
        Rs

    1.

    Depreciated value of Truck II date of sale (July 1, 2008)

    77,681

     

    (Rs 83,980–Rs 6,299)

     

    2.

    Sale proceeds

    92,000

     

    Profit (Rs 92,000–Rs 77, 681)

    14,319

     

           (2–1)

     

     

  3. For Truck III

     

    Book value cost as on July 1, 2007

    1,00,000

    Period from July 1, 2008 to Dec 31, 2007 = 6/12 years

     

    Depreciation 1,00,000 × 15/100 × 6/12 (2007)

    7,500

    Book value as on Jan 1, 2008

    92,500

    Less: Depreciation @ 15% for 1 year (for 2008)

    13,875

    Book value as on Jan 1, 2009

    78,625

     

Step 6

Truck Account

Illustration: 17

On Apr 1, 2004, a new plant was purchased for Rs 40,000 and a further sum of Rs 2,000 was spent on its installation. On Oct 1, 2006 another plant was acquired for Rs 25,000. Due to fire on Jan 5, 2007 the first plant was totally destroyed and was sold for Rs 1,000 only. On Jan 20, 2008 a second hand plant was purchased for Rs 30,000 and a further sum of Rs 5,000 was spent for bringing the same to use on Mar 15, 2008. Depreciation has been provided @ 10% p.a. on straight line basis. It was a practice to provide depreciation for full year on all acquisitions made at any time during any year and to ignore depreciation on any item sold or disposed of during the year. None of the assets were measured. The accounts are closed annually to Mar 31. It is now decided to follow the rate at 20% p.a. on Diminishing Balance Method with retrospective effect in respect of the existing items of plant and to make necessary adjustment entry on Apr 1, 2008.

You are required to prepare

  1. A Plant Account
  2. Provision for Depreciation A/c

B.Com (Hons.) – Modified

Solution

Here, all accounts, i.e. Provision for Depreciation, Sale of Asset and change in method with retrospective effect from part of the problem and one by one is to be prepared as follows:

Step 1: Preparation of Provision for Depreciation Account:

 

Provision for Depreciation Account

Step 2: Calculation of Depreciation under Diminishing Value Method

 

 

 

Rs

1.

Plant purchased on Oct 1, 2006 cost

25,000

 

Less: Depreciation for (2006–2007): 1 year

5,000

 

(Rs 25,000 × 20/100 × 1)

 

 

Book value

20,000

 

Less: Depreciation for (2007–2008): 1 year

4,000

 

(Rs 20,000 × 20/100 × 1)

______
16,000

 

Total Depreciation for this plant = Rs 5,000 + Rs 4,000 = Rs 9,000

 

2.

Plant purchased (Jan 20, 2008)

 

 

Cost

35,000

 

(Rs 30,000 + Rs 5,000)

 

 

Less: Depreciation for 2007 – 08

7,000

 

(Rs 35,000 × Rs 20/100 × 1)

______
28,000

 

Depreciation for this second-hand plant

7,000

 

Total provision for depreciation for both plants

16,000

 

*Provision already made (SLM)

8,500

 

Difference: Provision – Additional Depreciation Needed

_____
7,500

Step 3

Plant Account

Illustration: 18

Machinery Account of Parul Ltd showed a debit balance of Rs 97,200 on Jan 1, 2006, depreciation @ 10% p.a. is charged. On July 1, 2006, a part of the machinery purchased for Rs 30,000 on Jan 1, 2004, was sold for Rs 21,000 and on the same date a new machinery was purchased for Rs 60,000. On Dec 31, 2006, the company decided to change the method of depreciation from WDV Method to Straight Line Method with effect from Jan 1, 2004, depreciation remaining at 10% p.a.

Prepare necessary ledger accounts.

Solution

In case, sale or disposal of a part of the asset occurs, new account – Asset Disposal Account may be prepared. As such, book value of the sold or discarded asset may be transferred to Asset Disposal Account.

Step 1: As debit balance of Machinery Account is given in the question, cost price on that date has to be computed as:

 

 

 

Rs

Let the original cost on Jan 1, 2004 be taken as

100

Then,

Less: Depreciation @ 10% for 2004

10

 

WDV on Jan 1, 2005 will be

90

 

Less: Depreciation @ 10% for 2005

9

 

WDV on Jan 1, 2006

81

If WDV is Rs 81, original cost will be Rs 100.

 

[Original cost for Rs 97,200 = 100/81 × Rs 97,200

 

 

       = Rs 1,20,000

1,20,000

 

 

Rs

Step 2: Less: Machinery sold on July 1, 2006

30,000

          (cost as on July 1, 2004)

 

      Cost of machinery in hand

90,000

          (on July 1, 2004)

 

      Add: Cost of machinery purchased

60,000

          (on July 1, 2006)

 

      Acquisition cost of machinery still in hand

_______
1,50,000

Step 3: Depreciation on machinery at SLM for

 

      2004 and 2005 @ 10% on Rs 90,000

18,000

          (Rs 9000 + Rs 9000)

 

      Less: Depreciation already charged @ 10%

 

      on WDV on Rs 90,000 for 2004 = Rs 9,000

 

      and on Rs 81,000 for 2005 = Rs 8,100

17,100

          (Rs 9,000 + Rs 8,100)

 

      Difference due to change in method

___
900

Step 4: Calculation of WDV of machinery to be transferred to new account – Machinery Disposal Account:

 

 

 

 

Rs

Original Cost

30,000

 

Less:

Depreciation for 2004

3,000

 

 

 

27,000

 

Less:

Depreciation for 2005

2,700

 

 

 

______
24,300

 

Less:

Depreciation upto July 1, 2006 for 6 months

1,215

 

 

 

______
23,085

Step 5

Machinery Account

Note: No specific instructions are given in the question. Accordingly, change in method of depreciation is applicable at the end of accounting period, i.e. for the year 2006 only.

Step 6

 

Machinery Disposal Account

10.5 Annuity Method: Meaning and Features

  1. The different methods of computing depreciation fail to take into account the “interest on capital” invested in fixed assets.
  2. This system rectifies this factor.
  3. Under this system, interest is to be calculated at a specified rate on the opening of the asset account and added to the book value every year and credited to interest account.
  4. Journal entry:

    Asset Account Dr.

    To Interest A/c

  5. Simultaneously, a fixed amount is to be charged as a depreciation expense on a straight line basis.
  6. The underlying factor under this system is that the amount of depreciation to be charged every year must be so calculated as to reduce that asset together with interest accumulated thereon to its salvage value at the end of the useful life of the asset.

This can be best explained by way of an illustration as follows:

Illustration: 19

X takes a lease of land for Rs 1,00,000. The annual depreciation is charged on the basis of Annuity Method presuming the rate of interest at 6% p.a. The annuity table shows that the annual amount necessary to write off Re 1 in 4 years at 6% p.a. is Rs 288591. Prepare the Lease Account.

Solution

To write off Re 1 together with interest at 6% over 4 years = Re .288591

the annual charge (This is shown in the question itself.

Annuity Table shows all data.)

To write off Rs 1,00,000 plus interest, the annual charge = Rs 1,00,000 × .288591

Rs 28,859

Now, a table is to be prepared to show the amounts of interest and depreciation to be charged to Income Statement or Profit and Loss Account.

Table showing the amounts of interest and depreciation to be charged to Income Statement and Profit and Loss Account.

  1. Depreciation is to be Debited to Income Statement.
  2. Interest is to be Credited to Income Statement.
  3. Note from the table, Cost of the Asset Rs 1,00,000 plus interest Rs 15,436 = Total Depreciation Rs 1,15,436.
  4. From the table, you can note that the charge against profit Increases every year.

Lease Account

10.5.1 Advantages

  1. It involves accurate calculation.
  2. Interest is taken into account in this method, whereas all the other methods neglect this aspect.

10.5.2 Demerits

  1. Calculation will become more difficult in case of frequent additions of assets.
  2. Under this method, the amount of interest and depreciation are treated together, which may not yield good result.

10.5.3 Suitability

  1. It is suitable for large amounts of capital investments oriented business.
  2. This is most suitable for long-term leases.

10.6 Sinking Fund Method (or) Depreciation Fund Method: Meaning, Merits, Demerits and Suitability

10.6.1 Meaning

  1. The fund created to provide a definite amount at a certain future date for the specific purpose of replacement of asset at the end of its useful life may be termed as Sinking Fund.
  2. The procedure adopted to create such fund is referred to as “Sinking Fund Method” or “Depreciation Fund Method”
  3. Under this method, provision is made for the replacement of asset.
  4. This method requires the calculation of a basic sum of money which, if invested every year, would together with interest earned will be equal to the cost of asset.

    Such amount which has to be set aside every year by way of depreciation is calculated by using Sinking Fund tables.

10.6.2 Merits

  1. This method not only provides depreciation, but also makes provision for replacement of asset at the end of its useful life.
  2. As separate sum of money is earmarked, there will not be any financial stress while replacement of assets.

10.6.3 Demerits

  1. Income is charged with the same amount of depreciation. Such a combination of depreciation and replacement may not yield the desired result.
  2. It ignores the proportionate amount to be spent for maintenance in later years of the assets.

10.6.4 Suitability

Suitable for concerns which aim to treasure some part of amount for futuristic activities:

10.6.5 Differences between Annuity Method and Sinking Fund Method

Basis of Difference Annuity Method Sinking Fund Method

1. Separate Fund Account

Annual amount is not set aside as a separate fund account

Annual amount is set aside as a separate fund account

2. Charge of interest

Interest is charged from the end of first year itself

Interest is charged only at the end of second year

3. End result

The total depreciation is more than the depreciation cost of the asset (as interest is added to the cost of the asset)

The total depreciation is less than the depreciable cost of the asset (as interest is deducted from the cost of the asset)

4. Outside investment

Funds are not invested in outside securities

Funds set aside are invested in outside securities

5. Realization of interest

Interest is not actually realized

Interest is actually realized, as it is received from investment in outside securities.

6. Accounting treatment

Interest is credited to Profit and Loss A/c by debiting to Asset account

Interest is credited to Sinking Fund Account

7. Effect on Profit and Loss Account

As depreciation is fixed, interest is decreasing – effect on Profit and Loss A/c will result in a rise

As depreciation and interest being uniform, there will be one effect on Profit and Loss Account

10.6.6 Accounting Treatment for Sinking Fund Method

 

Stage I:

At the end of First Year

 

Step 1:

(a) Find the amount of depreciation to be provided from the Sinking Fund tables. That has to be recorded at the end of the first accounting period as:

 

 

Depreciation A/c

Dr.

 

To Sinking (Depreciation Account)

 

Step 2:

(b) The amount so transferred to Depreciation Fund is invested in outside securities (purchasing instruments)

 

 

Depreciation (Sinking)Funds Investment Account

Dr.

 

To Bank A/c

 

Stage II:

At the end of second year and subsequent years (except last year)

 

Step 1:

(a) When interest is received on investments

 

 

Bank A/c

Dr.

 

To Depreciation Fund A/c

 

Step 2:

(b) On setting aside the annual amount:

 

 

(same as in stage 1 (a))

 

 

Depreciation A/c

Dr.

 

To Depreciation Fund A/c

 

Step 3:

(c) On investing the amount set aside (with interest)

 

 

(same as in Stage 1 (b))

 

 

Depreciation Fund Investment A/c

Dr.

 

To Bank A/c

 

(Note: Here the amount to be invested = Amount set aside + Amount of interest received on previous investments)

Stage III:

Last Year

 

Step 1:

(a) On sale of investments (realization of investment fund)

 

 

Bank A/c

Dr.

 

To Depreciation Fund Investments A/c

 

Step 2:

(b) For transfer of profit/loss on realization of depreciation fund investments:

 

 

(i) When Profit:

 

 

Depreciation Fund Investment A/c

Dr.

 

To Depreciation Fund A/c

 

 

(ii) When Loss:

 

 

Depreciation Fund A/c

Dr.

 

To Depreciation Fund Investments A/c

 

Step 3:

(c) For sale of old asset (scrap)

 

 

Bank A/c

Dr.

 

To asset A/c

 

Stage V: Treatment in Balance Sheet

  1. Depreciation Fund Account appears on the Liabilities side of the Balance Sheet under the head “Reserves and Surplus” – till the asset is disposed off.
  2. Depreciation Fund Investment Account appears on the Assets side of the Balance Sheet under the head “Investments” till realization of investments.
Model: Calculation of amount of Depreciation (to be provided)

Illustration: 20

A machine costing Rs 10,00,000 is expected to have an estimated useful life of 4 years and scrap value of Rs 71,800 at the end of useful life. The Sinking Fund table shows that Re 0.215470803 invested at the end of each year at 10% compound interest will amount to Re.1 at the end of 4 years and Re.1 p.a. at 10% compound interest amount to Rs 4.641 in 4 years.

Calculate the amount of depreciation to be provided for.

Solution

Method I

Step 1:Cost of Machine – Scrap Value
                               Rs 10,00,000 – Rs 71,800
                             = Rs 9,28,200

 

Step 2: Rs 9,28,000 × 0.215470803
                             = Rs 1,99,999.9965
                             = Rs 2,00,000

 

Method II

Step 1: Cost – Scrap
                               Rs 10,00,000 – Rs 71,800
                             = Rs 9,28,200

 

Step 2: Rs 9,28,200 ÷ 4.641
                             = Rs 2,00,000

10.6.7 Calculation of the amount of Investments to be made

Case (a): When specific investments are to be made in multiples of same specific denomination (e.g. Rs 10; Rs 20 and so on) (will be given in the problem), then only that amount which is fully divisible by the given denomination will be invested.

Example: Suppose the amount available for investment is Rs 1,05,129.08 and the investments are to be made in the multiple of Rs 10, then only Rs 1,05,120 will be invested and the balance Rs 9.08 will be kept separately in Depreciation Fund Cash A/c. This will be adjusted at the end of the time of making investments during the next accounting period.

Case (b): When no specific instruction is given:

  1. In case of Non-cumulative Depreciation Fund: The amount of profit set aside has to be invested, i.e. Interest on Depreciation Fund Investments is credited to Profit and Loss A/c and interest is not reinvested.
  2. In case of Cumulative Depreciation Fund, interest + profit has to be invested, i.e. Interest on Depreciation Fund Investments is credited to Depreciation Account and interest is reinvested.

Case (c): In any case, no investment should be made in the last year.

Calculation of the amount of interest on depreciation fund investments:

Illustration: 21

From the following particulars calculate the amount of investments to be made and interest to be received by assuming investments are to be equal to entire profits set aside.

 

    Profit to be set aside

= Rs 60,000

        Interest Rate

= 10%

    Year of Realization of Investments

= 4th year.

 

Solution

Note: Entire profit is to be set aside. No specific instruction is given, i.e. amount available is to be made in multiple of specific amount. So, the entire amount is to be taken into account.

This can be best shown in the following table:

Table showing the calculation of the amount of investment to be made and interest to be received:

Note

  • Generally, the closing balance at the end a year will be the opening balance of next year.
  • Interest is calculated at the opening balance of the year, i.e. from the second year (Column = 2).
  • Profit set aside is constant (Column = 3).
  • Investments (entire) interest + Profit set aside are shown in column 4 (2 + 3).
  • Closing balance represents the sum of opening balance and investments to be made in column 5 (1 + 4).
  • No interest is computed for 1st year.
  • No investment is made in the last year (IV year).

Illustration: 22

From the following figures calculate the amount of investment to be made and interest to be received (by considering investments to be made in the nearest multiple of Rs 100)

 

    Profit to be set aside

= Rs 41,602.89

        Interest Rate

= 10%

    Year of Realization of Investments

= 4th year.

Solution

Draw the columns as in previous illustration:

Note: In the illustration, investments are to be made in the nearest multiple of Rs 100, investment amount is worked out in multiples of 100 and the fraction is left out. Take the case if in II year – Profit to be set aside + Interest = Rs 41,602.89 + Rs 4,160 = Rs 45762.89. This is to be divided by 100:45,762.89/100.

(Rs 45,700 in full, i.e. multiple of 100 – 457 × 100) the fraction of Rs 62.89 is to be kept separately in Depreciation Fund Cash A/c and not to be shown in the account.

This is the difference to be noted by students.

Illustration: 23

Vasant bought a machine on Apr 1, 2003 for a sum of Rs 2,00,000 having useful life of five years. It is estimated that the plant will have a scrap value of Rs 32,000. He decided to charge depreciation according to Depreciation Fund Method. Sinking Fund Table shows that Re. 0.180975, if invested yearly @ 5% p.a. produces Re. 1 at the end of five years. The depreciation fund investments are expected to earn interest @ 5% p.a. At the end of fifth year, the investments were sold for Rs 1,30,000 and the scrap realized Rs 34,000.

You are required to prepare Plant Account. Depreciation Fund Account and Depreciation Fund Investments Account for five year period.

 

B.Com (Hons) – Modified.

Solution

Step 1: Calculation of amount to be provided for depreciation fund every year:

(Remember Method I in Illustration 20)

 

Cost – Scrap

=

Rs 2,00,000 − Rs 32,000

 

=

Rs 1,68,000

Multiply this by the figure from Sinking Fund Table

 

=

(Rs 1,68,000) × 0.180975

 

=

Rs 30,403.60

 

=

Rs 30,404 (rounded off)

 
=

 
Rs 30,404

Step 2: Calculation of the amount of investments to be made and interest to be received for 5 years. Table showing investments to be made each year and interest to be received.

Step 3: Preparation of Depreciation Fund Account:

 

Depreciation Fund A/C

*To be transferred from Depreciation Fund Investment A/c.

**Plant A/c may be transferred from Plant A/c but it may be calculated simply: (Rs 2,00,000 (Cost) – Rs 34,000 (Scrap)) = Rs 1,66,000

Note: Interest is transferred from table column 3.

Step 4: Preparation of Depreciation Fund Investment A/c

 

Depreciation Fund Investment Account

Note: (1) Bank A/c → represents two components:

  1. Investment to be made
  2. Interest to be received.

To enter the figure for the years from 2005 to 2007, refer to the table Step 2 and directly transfer the figure under column “Investments to be made”.

Column 5: Students need not work out again thereby saving time.

(2) Bank A/c → For the year – (on credit side) 2008 represents the value of investments sold at the end of 5th year.

Step 5: Preparation of Plant Account

 

Plant Account

Step 6: Preparation of Depreciation Account

 

Depreciation Account

10.6.8 Sum-of-the-years’-digits method

  1. This method is simple and easier than WDV Method.
  2. This method is based on the assumption that loss of economic usefulness of an asset is high during the early years of an asset.
  3. When the asset is new, depreciation is charged more. Charge less depreciation when the assets get older.
  4. It will enable to suit matching of costs and revenues.

The depreciation is computed as follows:

Depreciable cost of an asset is Rs 1,00,000; useful life of that asset is 4 years. Calculate amount of depreciation to be provided for the period.

Solution

Useful Life of the Asset = 4 years

Sum-of-the-Years’-Digit = 1 + 2 + 3 + 4 = 10

I year  =  Depreciation  =  4/10 × 1,00,000  =  Rs 40,000

II year  =  Depreciation  =  3/10 × 1,00,000  =  Rs 30,000

III year  =  Depreciation  =  2/10  × 1,00,000  =  Rs 20,000

IV year  =  Depreciation  =  1/10  × 1,00,000  =  Rs 10,000

Under this method, more amount is charged in the I year, i.e. Rs 40,000 and less towards the end, i.e. Rs 10,000.

OBJECTIVE 11: CHOICE OF DEPRECIATION METHOD

Depreciation expenses differ from method to method. Choice of selecting a suitable depreciation method is not easy. The decision is based on the inherent characteristic features of an asset.

Accelerated depreciation methods may be of much use in case of the following:

  • Quality of the asset decreases with its age years roll, assets may loose its effective working capacity – Maintenance costs grow.
  • Introduction of new equipment due to Research and Development may adversely affect the effective usage of existing equipment.
  • The other Straight Line Method may be suitable for assets like buildings, furniture, patents, leases, etc. and for assets which do not warrant frequent repairs and renewals.
  • Choice of a method of depreciation affects the amount of net income because quite often the management employs depreciation as an instrument of financial policy of the entity. Hence, selection of a method depends on the management too.
  • Choice of the method affects the Balance Sheet because the amount of depreciation enhances the accumulated depreciation which in turn will affect the book value of assets.
  • Role of Accountants play a significant role in the selection of a method.

So, all these factors, characteristic features of assets, maintenance costs of assets, wear and tear of equipment and machinery, renewal cost of equipment, expected useful life of the assets, allocation of cost (matching principles of cost and revenue), net book value of assets, accountant’s role and management Policy have to be analyzed to choose the method of depreciation, which indeed is an uphill task.

OBJECTIVE 12: IS DEPRECIATION A SOURCE OF INCOME OR EXPENSE?

The notion that depreciation is a source of fund or working capital is a misconception which leads to a big controversy

Generally, funds are generated by revenues from sales. But depreciation is a non-cash expense. Depreciation does not require the use of funds or working capital. So, the view that depreciation is a source of funds is erroneous.

Journal entry to record depreciation:

     Depreciation Expense A/c    Dr.

       To Accumulated Depreciation A/c

Hence, the debit account is an expense account and the credit account is contra fixed account, according to accounting principles. It is crystal clear from this that depreciation is a source of expense and not a source of fund.

But viewed from other angle, depreciation is considered to be a source of fund, when funds from operations are calculated. In such situation, depreciation is added which tempts to treat it as a source of fund. But a careful analysis will reveal that the funds provided by operations will remain unaffected by the charge on depreciation.

It may by concluded that this conception is only a misconception. As per accounting principles, under no circumstances depreciation is a source of fund or working capital.

OBJECTIVE 13: PROVISION: MEANING, EXAMPLES, OBJECTIVES, ACCOUNTING TREATMENT AND DISCLOSURE

13.1 Meaning

The term “Provision” refers to

  1. Any amount set aside or retained by way of providing for depreciation, renewals or diminutions in value of assets.
  2. The amount retained by way of providing any known liability for which the amount of liability cannot be determined with substantial accuracy.

13.2 Examples of Provisions

  1. Provision for Doubtful Debts
  2. Provision for Depreciation
  3. Provision for Repairs and Renewals
  4. Provision for Taxation
  5. Provision for Fluctuations in Investments
  6. Provision for Discount on Debtors.

A provision may be

  1. in respect of loss in the value of asset,
  2. in respect of a claim which is disputed but which have to be paid,
  3. in respect of depreciation and so on.

It should be noted here that if a liability is determined in specific value and in advance, then for such known liability, provision need not be created; instead that particular liability can be created, e.g. Liability for Salary.

13.3 Objectives

Main object of creating a provision is to make good the loss in the value of assets or losses or expenses, the amount of which cannot be determined with considerable accuracy.

13.4 Accounting Treatment

Provision is a charge against the Profits.

It is created by debiting the Profit and Loss Account.

13.5 Disclosure

It may be disclosed in any one of the following ways:

  1. Provision is shown on Assets side by deducting from the respective assets.
  2. Provision may also be shown on the Liabilities side under the subhead “Provisions”.
OBJECTIVE 14: RESERVES

14.1 Meaning

The term “Reserves” generally refers to profits retained in the business not having any of the characters of a provision.

Any sum appropriated or set aside out of the profit of a business not intended to cover up any liability, loss or reduction in valuation of assets may be referred to as “Reserve”.

Reserve also means accumulated or undistributed profits.

14.2 Objectives

  1. To strengthen the financial position of the business entities.
  2. To provide funds for the acquisition of a new plant and modernization and expansion of existing plant.
  3. To comply with the legal requirement.
  4. To meet any unforeseen financial crunch.
  5. To equalize the dividend during the periods of inadequate profits.

14.3 Distinction Between Provision and Reserve

Basis of Distinction Provision Reserve

1. Main objective

It is created for a specific purpose and should be used only for that specific purpose

It is not created for a specific purpose and may be general in nature

2. Effect on profit

It reduces net profits

It reduces only divisible profits

3. Dividend distribution

It cannot be utilized for distribution of dividends

Unutilized reserves can be utilized for distribution of dividends

4. Legality

It is created to meet legal requirements

In this case, there are no legal requirements needed

5. Vice versa transfer

It cannot be transferred to General Reserve

It can be transferred to Provisions

6. Charge vs. appropriation

It is a charge to Profit and Loss Account. It can be created even if there are no profits

It is an appropriation of profit and can be created only when there is sufficient profits

7. Nature of investment

It is never invested outside the business

It can be invested outside the business

8. Disclosure in Profit and Loss A/c

It is shown on the Debit side of Profit and Loss A/c

It is shown on the Debit side of Profit and Loss Appropriation A/c

9. Balance Sheet

It is shown by deducting from the respective item

It is shown under the head “Reserves and Surplus” on the Liabilities side of Balance Sheet

14.4 Types of Reserves

Reserves may be classified into Capital Reserve and Revenue Reserve.

14.4.1 Capital Reserve

Any reserve which is created out of capital and is not to be utilized for distribution of profit (among the owners of the business by way of drawings, dividends, etc) is referred to as Capital Reserve.

Examples: Provision on the issue of shares and debentures, profit on issue of forfeited shares, profit on sale of a business or a part of business, any profit on sale of fixed assets and so on.

14.4.2 Revenue Reserve

Any reserve which is available for distribution of profit among the owners of business entities is referred to as Revenue Reserve.

Example: General Reserve, Debenture redemption reserve, Investment fluctuation reserve, staff welfare reserve and so on.

The Revenue reserve may further be classified into (1) General Reserve and (2) Specific Reserve.

14.4.3 General Reserve

The name itself leads to a concept that this type of reserve is not to be created for any specific purpose. It means that this reserve is to be created for any general purpose of the concern.

14.4.4 Specific Reserve

The specific reserves are to be created for a specific purpose only. It can be utilized for that specific purpose only.

14.4.5 Difference Between Capital Reserve and Revenue Reserve

Type of Distinction Capital Reserve Revenue Reserve

Type of transaction

It may be due to internal transaction or external transaction

It may always be formed due to internal transaction only

Distribution of profit

It is not utilized for distribution of profit

It is utilized for distribution of profit

Creation

It is not created by appropriation of profit

It is always created by retaining profit

Pre-incorporation period

It may be created from pre incorporation profit

It is never created from pre-incorporation period

Nature

It is always specific

It is general or specific

OBJECTIVE 15: PROVISION FOR REPAIRS AND RENEWALS: MEANING AND ACCOUNTING TREATMENT

Any business entity will be in dire need of a certain amount to meet out repairs and maintenance for the fixed assets. It is normal in any business concern, the amount needed will be less in the initial years, but will be heavy at the end of useful life of fixed assets. In order to ensure a uniform charge for such purpose, many concerns create a reserve known as Provision for Repairs and Renewals.

  • A fixed amount determined in advance is added to this Provision for Repairs and Renewable Account by debiting Profit and Loss Account.

    Entry: Profit and Loss Account                                    Dr.

           To Provision for Repairs and Renewable Account

  • But the amount actually spent on repairs and renewals is charged to the Provision Account (not to Profit and Loss A/c.)
  • Entry: Provision for Repairs and Renewable Account         Dr.

         To Repairs and Renewable A/c

  • The credit balance in this Provision Account will appear on the Liabilities side of Balance Sheet.
  • Any balance in this Provision Account is transferred to Profit and Loss A/c (on sale or disposal of asset)

Illustration 24

Raj has created a repairs and renewal provision on Mar 31, 2006 by charging Rs 6,000 each year. During the three years ended Mar 31, 2007, 2008 and 2009, actual repairs amounted to Rs 4,956, Rs 5,310 and Rs 6,006, respectively. Show repairs and renewals account for three year period.

 

B.Com (Hons) – Modified.

Solution

 

Repairs and Renewals Account

OBJECTIVE 16: ACCOUNTING STANDARD (AS)–6

The Institute of Chartered Accountants of India, keeping in view with international accounting principles, revised (AS)–6.

This standard AS–6 deals with the concept: Depreciation

Depreciation is defined as “a 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. Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the Expected Useful Life of the Asset. Depreciation includes amortization of assets whose useful life is predetermined”.

16.1 Salient features of AS–6 (Revised)

1. Accounting for Depreciation:

  1. Existing Assets: The depreciable amount of existing assets = Cost of the asset (historical not market value) – salvage (scrap value) value.
  2. Revision of estimate useful life of an asset: In case, if there is a necessity to revise the estimated life of an asset, the unamortized depreciable amount will have to be charged over the remaining useful life.
  3. Addition (or) extension to an existing asset of capital nature: In such cases, two factors will have to be considered:
    1. such an addition should retain separate identity,
    2. it can still be used after the disposal of existing assets.

    Then, depreciation is to be determined independently on the basis of an estimate of its own useful life.

    In other cases, the depreciation has to be determined on the basis of remaining useful life of the existing asset plus addition or extension as an integral part.

  4. AS–6 provides that the commonly employed methods of depreciation are Straight Line Method and Reducing Balance Method. It further stipulates that the selection of method would depend on the type of assets and nature and use of assets.

    For depreciable assets having no material value, depreciation is to be allocated fully in the accounting period in which the said asset is acquired.

  5. Further, it stipulates that the Depreciation Method selected should be applied consistently.
  6. Change from one method to other method should be made only if:
    1. such a change is required by a statute
    2. it complies with an accounting standard
    3. it would result in desired result and better presentation of financial statements.

    When such a change in method of depreciation occurs, depreciation should be calculated in accordance with new method with retrospective effect

    The deficiency surplus arising from such retrospective computation should be adjusted into the Profit and Loss Account of the year in which depreciation is changed.

    This fact must be disclosed as a change in accounting policy.

  7. Where a historical cost of a depreciable asset has undergone a change due to increase or decrease in the long-term liability on account of exchange fluctuations, price adjustments, changes in duties or similar factors, the depreciation on the revised unamortized depreciable amount should be provided prospectively over the remaining useful life of the asset.
  8. Revaluation of depreciable assets:
    1. Provision for depreciation should be based on the revalued amount and on the estimate of remaining useful Life of such asset.
    2. In case, the revaluation has a material effect on the amount of depreciation, the same should be disclosed separately in the year in which such revaluation is made.
  9. If any depreciable asset is disposed off, discarded, demolished or destroyed, Net Surplus (or) Deficiency, If Natural, should be disclosed separately.
    1. Finally, this AS – 6 requires the disclosure of cost (historical or any cost) of the asset, depreciation for the period for each class of assets and accumulated depreciation
    2. Depreciation method used, rate, Useful Life of Assets are also to be disclosed in the financial statements along with the disclosure of accounting policies.

Summary

  • Depreciation is a measure of the wearing out, or other loss of value of depreciable asset arising from use, time or obsolescence. Depreciation is allocated so as to change a fair proportion of the cost in each accounting period during the Expected Useful Life of the Asset. Depreciation includes amortization, depletion and obsolescence.
  • Depreciation accounting is the process of allocating the cost of the fixed tangible assets less its salvage value over its serviceable life. It is a process of allocation and not of valuation.
  • Features: (i) Depreciation is a gradual but continuous fall in the book value of fixed assets. (ii) It is related to tangible fixed assets. (iii) It is a charge against profits. (iv) It is a process of allocating costs. (v) It has no relationship with market value. (vi) It is only an estimation. (vii) Total depreciation cannot exceed original cost.
  • Causes of Depreciation: Physical features: (i) wear and tear, (ii) passage of time and (iii) natural calamities. Functional factors: (i) inadequacy to match demand, (ii) depletion, (iii) obsolescence and (iv) expiry of legal rights.
  • Need for Depreciation: (i) to ascertain true result of operations, (ii) to show true and fair view of financial position, (iii) exact cost of the product, (iv) to comply with legal requirements, (v) allocation of cost of fixed assets and (vi) impact on tax liability.
  • Factors that affect depreciation: (i) historical cost, (ii) estimated useful life and (iii) estimated residual (scrap) value.
  • Accounting treatment: (i) by charging to Asset Account directly and (ii) by creating provision for depreciation.
  • Methods of Providing (Allocating) Depreciation:
    1. Straight Line Method: A fixed and equal amount according to a fixed percentage on original cost is written off each accounting year over the Expected Useful Life of the Asset. For actual method of calculation refer Illustrations 15.
    2. WDV Method: Depreciation is computed on the reducing balance (Asset Cost Less Depreciation) and not on original cost. The rate of depreciation remains the same but the amount of depreciation goes down decreasing. For actual method of computation refer Illustrations 69, 12, 20 and 22.
  • Accounting treatment to create provision for depreciation and accumulated depreciation (refer Illustration 13).
  • Change in the method of depreciation is permitted as per AS–6 (Revised). Depreciation has to be calculated from the date of asset coming into use. Surplus or Deficiency that arises due to recalculation is to be credited to or debited to Profit and Loss account, respectively. For detailed workings refer to Illustrations 1418.
  • Annuity Method: Under this method, the amount of depreciation to be charged every year must be so calculated as to reduce that asset together with interest accumulated thereon to the salvage value at the end of the useful life of the asset. For detailed working refer to Illustration 19.
  • Sinking Fund Method: This method requires the calculation of a basic sum of money which, if invested every year, would together with interest earned will be equal to the cost of the asset. Such amount which has to be set aside every year by way of depreciation is calculated by using Sinking Fund Table. For detailed working of this method refer to Illustrations 2023.
  • Sum-of-the-Years’-Digits Method: Under this method, depreciation is charged more in the first year and less in the later years.
  • Choice of depreciation methods: Choice of selecting a suitable depreciation is not easy. It mostly depends on the inherent characteristic features of an asset.
  • Is depreciation a source of fund? The question leads to a big controversy and debate. The most acceptable answer to the question is that depreciation is not a source of fund.
  • Provision: This term refers to any amount set aside or retained by way of providing for depreciation, renewals or diminutions in value of assets. It is a charge against profits. It is created by debiting Profit and Loss Account.
  • Reserves: This term refers to profits retained in the business not having any of the characters of Provision. It is an appropriation of profit and can be created only when sufficient profit is available. It is shown on the debit side of Profit and Loss Appropriation Account and under the head “Reserves and Surplus” on the liabilities side of the Balance Sheet.
  • Types of Reserves: Capital Reserve and Revenue Reserve. Revenue Reserve may be classified into General Reserve and Specific Reserve.
  • Salient features of AS–6 relating to depreciation (refer the text).

Key Terms

Amortization: The gradual and systematic writing off of an asset or an account over a reasonable period is referred to as “Amortization.”

Annuity: A series of periodic cash flows may be called so. Annuity method takes care of the interest on investments and added to the cost of the asset to compute depreciation.

Depreciation: A measure of the wearing out or loss of value of a depreciable asset arising from use, efflux of time or obsolescence.

Obsolescence: The reduction of utility of an asset that results from the development of a better machine or process.

Provision: An amount written off or retained or earmarked for diminution in value of assets is known as Provision. It may also be retained for any known liability.

Reserve: Accumulated profit of a business. Reserve is an appropriation of profits.

Sinking Fund: A required annual payment that allows for the periodic retirement of debt.

Straight Line Method: It is a method of computing depreciation. It allocates uniform amount of depreciation amount to each full accounting period of an asset’s useful life.

WDV Method: It is another depreciation method according to which the depreciation charge is a certain percentage of the WDV of assets.

Reference

 

M.C. Shukla, T.S. Grewal and S.C. Gupta, Advanced Accountancy, Chand and Company, 2008 Edition.

J.R. Monga, Financial Accounting – Concepts and Applications, Mayor Paper Back, New Delhi, 2007– 08.

P.C. Tulsian, Financial Accounting, Pearson Education, New Delhi, 2004.

A Objective-type Questions

 

I State whether the following statements are True or False

  1. Depreciation is related to Depreciable Fixed Assets only.
  2. Depreciation is the result of fluctuations in the value of fixed assets.
  3. Depreciation is only a temporary decrease in the book value of the asset.
  4. Depreciation covers depletion, amortization, and obsolescence.
  5. In case of companies, it is compulsory to charge depreciation.
  6. When the rate of depreciation is given as 10% p.a. along with the date of acquisition, depreciation amount is computed for the entire accounting period.
  7. Depreciation is an amortized expenditure.
  8. The expressions – depreciation is to be charged at 20% and 20% p.a. denote then same thing.
  9. Historical cost of a depreciable asset affects the amount of depreciation.
  10. Estimated residual value of a depreciable asset affects the amount of depreciation.
  11. Straight Line Method is applied to have a uniform charge for depreciation and for repairs and maintenance together.
  12. The interest on the capital invested in the asset is taken into consideration under Straight Line Method.
  13. Under Straight Line Method, the book value of assets become zero or equal to its scrap value at the end of its useful life.
  14. The items of transaction relating to revenue nature are usually debited to respective assets account.
  15. Under Written Down Value Method of depreciation, the rate of depreciation remains constant, whereas the amount of depreciation goes on decreasing.
  16. WDV method takes into consideration the interest on capital invested in the asset.
  17. It takes a lengthy period to write as asset down to its break-up value, under WDV method of depreciation.
  18. Depreciation is charged at a fixed percentage on the original cost in all subsequent years.
  19. The book value of the assets does not become zero under WDV method of depreciation.
  20. Change in the Method of depreciation is made from the next accounting period.
  21. Sinking Fund Method of depreciation provides a definite amount at a certain future for replacement of assets at the end of their useful life.
  22. Depreciation Fund will appear under the head “Reserves and Surplus” on the Liabilities side of the Balance Sheet.
  23. Depreciation Fund Investment Account shall appear on the Liabilities side of the Balance Sheet.
  24. Depreciation is not provided in case of loss in an accounting year.
  25. Providing depreciation in accounts reduces the amount of profits available for dividend distribution.

Answers

 

1. True

2. False

3. False

4. True

5. True

6. False

7. True

8. False

9. True

10. False

11. False

12. False

13. True

14. False

15. True

16. False

17. True

18. False

19. True

20. False

21. True

22. True

23. False

24. False

25. True

II Fill in the blanks with suitable words

  1. Depreciation is a term used to denote decrease in the book value of _______.
  2. Depreciation is a permanent ________ in the book value of an asset.
  3. “Depletion” refers to _______ deterioration by exhaustion of natural resources.
  4. The term “Amortization” refers to _______ deterioration of intangible assets.
  5. Book value (as on date of sale) = original cost _______.
  6. Under Straight Line Method, the book value of the asset becomes _______ or to its _______ value at the end of its useful life.
  7. Under Written Down Value Method, the rate of depreciation remains ________ year after year, whereas the amount of depreciation goes on ________.
  8. Under Written Down Value Method, depreciation is charged at a fixed percentage on ________ in the first year and on ________ in subsequent years.
  9. Under Straight Line Method depreciation remains _______.
  10. Depreciation Fund Account shall appear on _______ side of Balance Sheet.
  11. Depreciation Redemption Fund Investment Account shall appear on the ________ side of the Balance Sheet.
  12. Revenue Reserves are created out of ________ available for distribution by way of dividend.
  13. Provision is a _______ against profit.
  14. Reserve is an _______ out of profit.
  15. The amount of depreciation remains constant year after year under _______.

Answers

  1. Depreciable fixed asset
  2. Decrease
  3. Physical
  4. Economic
  5. Total depreciation
  6. Zero;scrap
  7. Constant; decreasing
  8. Original cost; WDV
  9. Constant
  10. Liabilities
  11. Assets
  12. Profit
  13. Charge
  14. Appropriation
  15. Straight Line Method

B Short Answer-type Questions

  1. Define “Depreciation”.
  2. What are the characteristics of “Depreciation”?
  3. Define “Depletion.”
  4. What do you mean by “Amortization”?
  5. Explain the term “Obsolescence.”
  6. What are the causes of Depreciation?
  7. What are the main objectives of Depreciation?
  8. What are the factors that affect the amount of depreciation?
  9. Mention the two methods of recording depreciation.
  10. Mention the important methods of recording of allocating depreciation.
  11. Explain: Straight Line Method.
  12. What are the merits and demerits of Straight Line Method?
  13. For which type of business entities, the Straight Line Method is more suitable?
  14. How will you calculate the amount of depreciation under Straight Line Method?
  15. How will you calculate the rate of depreciation under the Straight Line Method?
  16. What do you mean by Written Down Value Method of depreciation?
  17. How will you calculate rate of depreciation under WDV Method?
  18. What are the merits of WDV Method?
  19. What are the demerits of WDV Method?
  20. For which type of assets, is the WDV Method considered suitable?
  21. Mention examples of assets for which WDV method is considered suitable.
  22. Distinguish between depreciation and obsolescence.
  23. Distinguish between Straight Line Method and Written Down Value Method.
  24. Pass the necessary Journal entries relating to “creation of provision for depreciation.”
  25. Elucidate the important features for recording a change in the method of depreciation.
  26. What is “Sinking Fund Method”?
  27. How will you treat:
    1. Depreciation Fund Account
    2. Debenture Redemption Fund Investment Account?
  28. What are the merits of Sinking Fund Method?
  29. What are the demerits of Sinking Fund Method?
  30. For which type of assets is the Sinking Fund Method considered more suitable?
  31. Give examples of assets for which Sinking Fund Method is considered suitable.
  32. Mention the important points to be considered while creating Depreciation Fund.
  33. Explain the term “Provision.”
  34. Give examples of “Provision.”
  35. What is the main purpose of creating “Provision”?
  36. What is the accounting treatment for “Provision”?
  37. How “provision” is treated in the final statement of accounts?
  38. What is “Reserve”?
  39. Give examples of “Reserve.”
  40. What are the objectives of a “Reserve”?
  41. Mention the two types of “Reserve.”
  42. How does a “Revenue Reserve” differ from a “Capital Reserve”?
  43. Give examples of Capital Reserves.
  44. Distinguish between “Provision” and “Reserve.”
  45. What do you mean by “Reserve for replacement of assets”?
  46. What are the factors that affect the useful life of a depreciable asset?
  47. Explain the provisions according to Accounting Standard (AS)–6-(Revised) relating to “Disclosure.”
  48. What are the important provisions envisaged in AS–6 regarding “Change in the method of depreciation”?
  49. What are the guidelines issued by (AS)–6 (revised) for
    1. Revaluation of a depreciable asset and
    2. Change in long-term liability
  50. Is depreciation affected by obsolescence and fluctuation? Give reasons for your answer.

C Essay-type Questions

  1. Define “Depreciation.” Explain its significance. Elucidate the factors that affect depreciation. Explain its effect on Profit and Loss Account as well as Balance Sheet.
  2. What is Straight Line Method? Explain its merits and suitability with a suitable illustration.
  3. Explain Written Down Value Method. Explain its salient features by way of illustrations.
  4. What do you mean by “Sinking Fund Method”? What are the merits, demerits, suitability of Sinking Fund Method?
  5. Write short notes on:
    1. Amortization,
    2. Obsolescence,
    3. Provision and
    4. Reserve
  6. “The continued existence of general reserve is dependent upon the continued existence of corresponding surplus of assets” – Comment on this statement.
  7. Explain the salient features of Accounting Standard (AS)–6 (Revised) issued by the Institute of Chartered Accountants of India.

D Exercises

 

1.Model: Computation of depreciation under Straight Line Method.
Calculate the Rate of Depreciation under SLM.

Answer: (i) 15%, (ii) 9%, (iii) 8% and (iv) 18%

2. Model: Calculation of amount of depreciation under SLM.

A machine was purchased for Rs 96,000. Expenses incurred on its cartage and installation Rs 24,000. The residual value at the end of its Expected Useful Life of 4 years is estimated at Rs 48,000. Calculate the amount of depreciation for the first year ending on Mar 31, 2009 if the machine was purchased on (i) Apr 1, 2008, (ii) July 1, 2008, (iii) Oct 1, 2008 and (iv) Jan 1, 2009.

Answer: (i) Rs 18,000, (ii) Rs 13,500, (iii) Rs 9,000 and (iv) Rs 4,500

3. Model: Calculation of profit/loss on sale of asset under SLM.

ABC Ltd purchased a second-hand machine for Rs 1,50,000 and spent Rs 30,000 on its repairs. Depreciation is to be provided @ 10% p.a. according to Straight Line Method. This machine was sold for Rs 1,35,000. Accounting year is financial year. Calculate the profit or loss on sale of machine in each of the following alternative cases:

  1. If the date of purchase is Apr 1, 2006 and date of sale is Mar 31, 2009.
  2. If the date of purchase is Apr 1, 2006 and date of sale is Sep 30, 2008.
  3. If the date of purchase is July 1, 2006 and date of sale is Mar 31, 2009.
  4. If the date of purchase is July 1, 2006 and date of sale is Sep 30, 2008.

Answer: (i) Profit Rs 9,000, (ii) NIL, (iii) Profit Rs 4,500 and (iv) Loss Rs 4,500

4. Model: Preparation of Asset Account under SLM

On Jan 1, a public limited company purchased a second-hand machine for Rs 3,12,000 and spent Rs 12,000 as shipping and forwarding charges; Rs 30,000 as import duty; Rs 3,000 as carriage inwards; Rs 12,000 as repair charges; Rs 3,000 as installation charges; Rs 2,400 as brokerage of middleman and Rs 600 for an iron pad. It is estimated that the machine will have a scrap value of Rs 12,000 at the end of its useful life which is 20 years. On Sep 30, 2006, amount spent on repairs Rs 12,000; on July 1, 2009 this machine was sold for Rs 1,89,600. You are required to prepare the Machinery Account for the first three calendar years.

Answer: Loss on sale: Rs 1,43,400

5. A cabs company purchased 5 tempos at Rs 2,00,000 each on Apr 1, 2007. The company writes off depreciation @ 20% p.a. on original cost and observes calendar year as its accounting year. On Oct 1, 2009 one of the tempos was involved in an accident and is completely destroyed. Insurance company paid Rs 90,000 in full settlement of the claim. On the same day, the company purchased a used tempo for Rs 1,00,000 and spent Rs 20,000 on its overhauling
    You are required to prepare Tempo Account for three years ending Dec 31, 2009.

Answer: Loss on sale Rs 10,000; balance Rs 4,74,000

6. On Jan 1, 2006, machineries were purchased by SUN Limited for Rs 4,00,000. On July 1, 2007, additions were made to the extent of Rs 80,000. On Apr 1, 2008, further additions were made to the extent of Rs 51,200. On June 30, 2009, one machinery, original value of which was Rs 64,000 on Jan 1, 2006, was sold for Rs 48,000. Depreciation is charged @ 10% p.a. on original cost.
   You are required to show the Machinery Account for three years from 2006 to 2009 in the books of SUN Limited, which closes its books on Dec 31st.

Answer: Profit of sale Rs 6,400; Balance Rs 3,03,840

7. On Jan 1, 2006, machinery was purchased by EXY Ltd for Rs 1,00,000. On July 1, 2007 additions were made to the extent of Rs 20,000. On Apr 1, 2008, further additions were made to the extent of Rs 12,800.
   On June 30, 2009, machinery original value of which was Rs 16,000 on Jan 1, 2006 was sold for Rs 12,000. Depreciation is charged @ 10% p.a. on original cost.
   You are required to show the Machinery Account for the years from 2006 to 2009 in the books of EXY Ltd, it closes the books on Dec 31st.

Answer: Profit on sale Rs 1,600; Closing Balance: Rs 75,960

Model: Written Down Value Method:

8. Mr. A bought a machine for Rs 25,000 on which he spent Rs 5,000 for carriage and freight; Rs 1,000 for brokerage of the middleman; Rs 3,500 for installation and Rs 500 for an iron pad. The machine is depreciated @ 10% every year on written down basis. After three years the machine was sold to Mr. B for Rs 30,500 and Rs 500 was paid as commission to the broker. Find out the profit or loss on the sale of machine.

Answer: Profit on sale Rs 4,485

9. On Jan 1, 2007, Renu Ltd purchased a second hand machine for Rs 96,000 and spent Rs 24,000 on its carriage, repairs and installation. On Sep 30, 2008, this machine was sold for Rs 60,000. Depreciation is to be provided @ 20% p.a. according to Written Down Value Method.

Answer: Loss on sale Rs 22,080

10. On Jan 1, 2006, X Ltd purchased machinery for Rs 72,000 and on June 30, 2007 acquired additional machinery at a cost of Rs 12,000. On Mar 31, 2008 one of the original machines which had cost Rs 3,000 on Jan 1, 2006 was found to have become obsolete and was sold as scrap for Rs 300. It was replaced on that date by a new machine costing Rs 4,800. Depreciation is provided @ 15% p.a. on the written Down Value. The books are closed on Dec 31st every year.
   You are required to show ledger accounts for the first three years.

Answer: Loss Rs 1,785; Balance Rs 56,070

11. Model: Provision for Depreciation:

On Jan 1, 2006, ABC Ltd purchased a machinery for Rs 12,00,000. On July 1, 2008, a part of the machinery purchased on Jan 1, 2006 for Rs 80,000 was sold for Rs 45,000 and a new machinery at a cost of Rs 1,58,000 was purchased and installed on the same date. Depreciation has to be provided at 10% p.a. on the original cost. You are required to show the necessary ledger accounts if: (i) Provision for Depreciation Account is maintained and (ii) Provision for Depreciation Account is not maintained.

Answer:

  1. Loss on sale Rs 15,000; Balance of Machinery A/c Rs 12,78,000; Balance of Provision for Depreciation A/c Rs 3,43,900.
  2. Loss on sale Rs 15,000; Balance of Machinery A/c Rs 9,34,100

12. On Jan 1, 2006, LM Ltd purchased a machinery for Rs 48,00,000. On July 1, 2008, a part of the machinery was purchased on Jan 1, 2006 for Rs 3,20,000 was sold for Rs 1,80,000 and a new machinery at a cost of Rs 6,32,000 was purchased and installed on the same day. Depreciation has to be provided at 10% p.a. on the diminishing balance of the machinery.
   You are required to show the necessary ledger account if (i) Provision for Depreciation Account is not maintained (ii) Provision for Depreciation Account is maintained.

Answer:

  1. Loss on sale Rs 66,240; Balance of Machinery A/c Rs 38,66,920
  2. Loss on sale Rs 66,240; Balance of Machinery A/c Rs 51,12,000 and Balance of Provision for Depreciation A/c Rs 12,45,680

Model: Change in Depreciation Methods.

13. On Jan 1, 2008 Fortune Ltd purchased a machine for Rs 50,000 and provided depreciation @ 10 % p.a. At the end of 2009, the company decided to change the method of depreciation from Straight Line Method to Written Down Value Method retrospectively, the rate of depreciation remaining same. Prepare the Machinery Account for the year 2009.

Answer: Excess Depreciation Rs 1,450

14. On Jan 1, 2006, Renu Ltd purchased a machine for Rs 60,000 and provided depreciation @ 10% p.a. At the end of 2009, the company decided to change the method of depreciation from Written Down Value to Straight Line Method retrospectively, the rate of depreciation remaining the same. Prepare the Machinery Account for the year 2009.

Answer: (Deficit) Short Depreciation Rs 1,740

15. Machinery Account of LBM Ltd showed debit balance of Rs 97,200 on Jan 1, 2009. Depreciation was provided @ 10% p.a. On July 1, 2009, a part of the machinery purchased for Rs 30,000 on Jan 1, 2007 was sold for Rs 21,000 and on the same date a new machinery which costs Rs 60,000 was purchased. On Dec 31, 2009, the company decided to change the method of depreciation from Diminishing Balance Method to Fixed Installment Method effective from Jan 1, 2007 depreciation rate remaining unaltered.
   Show the Machinery Account for 2009

Answer: Additional Depreciation Rs 1,200; Closing Balance Rs 1,20,000

16. Model: Sinking Fund Method
   The Directors of MAC Ltd decided to replace their entire plant. They accepted the quotation of M/s APT @ Co amounting to Rs 22,50,000
   The old Machinery and Plant Account stood at Rs 11,40,000. The accumulated balance of Depreciation Fund in the books of the company was Rs 9,73,500. The fund was represented by securities which were sold for Rs 9,74,900. Some of the materials comprising the old machinery were found to be in good condition. M/s APT @ Co agreed to take over this at an agreed value of Rs 70,500. The remainder of the old machinery was auctioned for Rs 25,600
   Show the various accounts in the books of the company.

Answer: Profit on sale of investments Rs 1,400; Loss on sale Rs 69,000

17. XYZ Ltd purchased a machinery on Apr 1, 2004 for Rs 6,00,000. The machinery has to be replaced at he end of 5 years for which purpose a Sinking Fund is established. It is expected that securities will earn @ 10% p.a. interest. Sinking Fund Table shows that Re. 0.163797 invested in each year will produce Re. 1 at the end of 5 years at 10% p.a. interest. XYZ Ltd closes their accounts on Mar 31, each year.
   At the end of the period, the securities are sold at their book value. New machinery was installed on Apr 1, 2009, at a cost of Rs 7,20,000.
   You are required to show all the necessary ledger account for all the years.

 

18. Y Ltd traded a piece of equipment with an original cost of Rs 12,000 and accumulated depreciation to date of Rs 9,600 for another piece of equipment which had a list price of Rs 18,000. The payment for the new equipment consisted for a trade-in-allowance of Rs 4,200 on the old equipment plus Rs 13,800 cash. The old equipment could have been sold for Rs 3,300 cash.
   You are required to give entries to record the exchange.

 

   Answer:

Profit on exchange Rs 600 is the difference between Rs 3,000 and Rs 2,400. Record new equipment at Rs 16,800 – an extra allowance of Rs 1,200 is treated as a reduction in the price of new equipment.

 

19. A machine costing Rs 1,00,000 with no salvage value and estimated life 10 years had the following balances at the end of 2 years:
   Machinery: Rs 1,00,000
   Accumulated Depreciation: Rs 20,000
   It was estimated that the future life would be 4 years instead of 8 years. You are requested to show the revision of rate to be recorded.

Answer: Revised depreciation per year: Rs 20,000