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METHODS OF DEPRECIATION

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METHODS OF DEPRECIATION

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  1. Depreciation is the diminution in the value of the fixed assets because of their use, wear and tear, efflux of time; depletion etc. It is a common experience that whenever an asset is used, it reduces in value, which is known as depreciation. Thus, depreciation is a permanent, continuing and gradual shrinkage in the book value of a fixed asset. Pickles defines depreciation as “The permanent and continuing diminution in the quality, quantity or value of an asset”

  2. METHODS OF DEPRECIATION There are various methods, which are used for charging depreciation. But, the following are important: (i) Straight Line Method: In this method, depreciation is calculated by dividing the cost of the asset minus scrap value by the effective life of the asset. The amount of depreciation, remains fixed over the whole life of the asset. This method is simple and works well when an asset has a fixed life as in the case of lease etc.

  3. Diminishing Balance Method: Under this method, depreciation is charged at a fixed rate on the opening balance of the asset, every year. As the opening balance of the asset decreases year after year, the depreciation amount also reduces in value, year after year. However, repairs would increase, with the age of the asset.

  4. BASIC FACTORS FOR CALCULATION OF DEPRECIATION Amount of depreciation is dependant on the following basic factors: (A) Cost: Depreciation is to be calculated on the cost of the asset. After purchase, certain expenses may be incurred to bring the asset into working condition or improved capacity. This, normally, happens with a second hand asset. The nature of the expenses is not repair, but of reconditioning nature, so they are a part of the cost of the asset. Similarly, erection expenses are to be capitalized. It means these expenses are to be treated as the part of the cost of the asset. So, depreciation is to be calculated on the total cost of the asset, which includes expenses on reconditioning as well as erection.

  5. (B) Estimated Life of the Asset: Life of the asset is to be estimated. Depreciation is to be written off, totally, over the estimated life of the asset, except for its scrap value. (C) Scrap Value: The estimated residual or scrap value at the end of the life of the asset also influences the amount of depreciation.

  6. Period of Holding: Depreciation is to be calculated on the actual period of holding of the asset. If the fixed asset is purchased in the middle of the year, depreciation is to be calculated from the date of purchase. In other words, depreciation is to be calculated pro rata to the period of holding. If the asset is sold in the middle of the year, depreciation is to be calculated till the date of sale.

  7. DEPRECIATION ACCOUNTING • On purchasing of the fixed asset Fixed Asset A/c Dr. To Cash/Bank A/c II. On charging Depreciation Depreciation Account …………………….Dr. To Fixed asset Account (name the asset, say, Machinery Account) (Being depreciation provided on the asset)

  8. iii. On sale of fixed asset Cash/Bank Account……….Dr. To Fixed Asset Account iv. On closing Depreciation Account Profit & Loss Account………Dr. To Depreciation Accounting v. Profit on sale of fixed assets Machinery Account……….Dr. To P & L Account vi. If there is loss on sale of fixed assets P & L Account……………Dr. To Machinery Account

  9. Illustration No. 1 On 1st January, 2000 Shakti & Co. purchases machinery worth Rs. 50,000. On 1st July, 2002, it buys additional machinery worth Rs. 10,000 and spends Rs. 1,000 on its erection. The accounts are closed each year on 31st December. Assuming the annual depreciation to be 10% show the machinery account for 5 years under (1) Straight Line Method (2) Diminishing Balance Method.

  10. X ltd. Purchased on 1st January 2011 a second hand plant for Rs, 60,000 and immediately spent Rs. 40,000in putting the same in working condition. On July 2011 additional machinery costing Rs. 40,000 was purchased. On January 2013 , the plant purchased on 1st January 2011 become obsolete and was sold for Rs. 50,000. on 1st July 2013 new machinery was purchased at a cost of Rs. 1,20,000. the firm provided depreciation on straight line method at 10% per annum on the original cost of asset. Show machinery account for the calendar years 2011 to 2014.

  11. Illustration No. 2 Neha & company whose accounting year is the calendar year, purchased on 1st April, 2006 machinery costing Rs. 30,000. It purchased further machinery on 1st October, 2006 costing Rs. 20,000 and on 1st July, 2007 costing Rs. 10,000. On 1st January, 2008, one third of the machinery which was installed on 1st April, 2006 became obsolete and was sold for Rs. 3,000. Show how the machinery account would appear in the books of Neha & company, assuming that machinery was depreciated by fixed instalment at 10% p.a.

  12. 5. A Second hand machinery was purchased on 1st January, 2007 for Rs. 40,000 and Rs. 16,000 and Rs. 14,000 were spent on its repairs and erection immediately. On 1st July, 2008 machinery was purchased for Rs. 36,000 and on 1st july, 2009 the first machinery having become obsolete was auctioned for Rs. 40,000. On the same date machinery was purchased for Rs. 35,000. On 1st July, 2010 the second machinery was also sold off and it fetched Rs. 33,000. Depreciation was provided on machinery at the rate of 10% on the original cost annually on 31st December. In 2009 the method of providing depreciation was changed to the written down (diminishing) value method at the rate of depreciation being 15% p.a.

  13. On 1st April 2008, a firm purchased a machinery for Rs. 2,00,000. On 1st October in the same accounting year, additional machinery costing Rs. 1,00,000 was purchased. On 1st October, 2009 the machinery purchased on 1st April, 2008, having become obsolete, was sold off for Rs. 90,000. On 1st October, 2010, new machinery was purchased for Rs. 2,50,000 while the machinery purchased on 1st October, 2008 was sold for Rs. 85,000 on the same day. The firm provides depreciation on its machinery @ 10% per annum on original cost (fixed instalment method) on 31st March every year. Show Machinery Account and Depreciation Account for the period of four accounting years ending 31st March, 2012.

  14. Gangadhar & co has been running a crusher from the year 2005. Written down value of Machinery is Rs. 1,20,000 as on 1st Jan, 2006. The firm has purchased a second machine for Rs. 40,000 on 1st April, 2007 and has sold the same for Rs. 65,000 on 1st Jan, 2008. The firm has been following diminishing balance method from the beginning. Depreciation rate for the machine has been 10%. Accounts are closed at the end of calendar year. Show the Machinery account for the years 2006 to 2008.

  15. A manufacturing firm purchased on 1st January, 1996 certain machinery for Rs. 1,00,000 and spent Rs. 20,000 on erection. On 1st July in the same year, additional machinery costing Rs. 50,000 was acquired. On 1st January, 1998, the machinery purchased on 1st January 1996 (having become obsolete) was auctioned for Rs. 40,000 and on the same date, fresh machinery was purchased at a cost of Rs. 25,000. Depreciation was provided, annually, on 31st December at 10% per annum on the original cost of the asset. In 1998, this method was changed and that of writing of 15% on the written down value was adopted, with retrospective effect.

  16. What do you mean by Accounting? Explain the users of accounting information? • “A doctor feels the pulse of a person and knows whether he is enjoying good health or not. In the same manner, by looking at the balance sheet, one can know whether the firm is solvent or not” – In the light of this statement, detail the objectives of Accounting?

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