Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev

Principles and Practice of Accounting

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CA Foundation : Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev

The document Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev is a part of the CA Foundation Course Principles and Practice of Accounting.
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LEARNING OUTCOMES:-
After studying this chapter, you will be able to:-

  • Understand the meaning and nature of depreciation. 
  • Understand how to determine the amount of depreciation from the total value of Property, Plant and Equipment and its useful life. 
  • Understand various methods of depreciation and learn advantages and disadvantages of such methods. 
  • Understand how to calculate the amount of profit or loss resulting from the sale/disposal of Property, Plant and Equipment. 
  • Familiarize with the accounting treatment for change in the method of depreciation from Straight Line Method to Reducing Balance method. 
  • Familiarize with the accounting treatment for change in estimated useful life and residual value of property, plant and equipment.

Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev

1. INTRODUCTION:- Property, plant and equipment are tangible items that:
(a) are held for use in the production or supply of goods or services, for rental to others, or for  administrative purposes; and
(b) are expected to be used during more than a period of twelve months.
These are also called fixed assets in common parlance. When a fixed asset is purchased, it is recorded in books of account at it original or acquisition/purchase cost. However fixed assets are used to earn revenues for a number of accounting periods in future with the same acquisition cost until the concerned fixed asset is sold or discarded. It is therefore necessary that a part of the acquisition cost of the fixed assets is treated or allocated as an expense in each of the accounting period in which the asset is utilized. The amount or value of fixed assets allocated in such manner to respective accounting period is called depreciation. Value of such assets decreases with passage of time mainly due to following reasons.
1. Wear and tear due to its use in business
2. Efflux of time even when it is not being used
3. Obsolescence due to technological or other changes
4. Decrease in market value
5. Depletion mainly in case of mines and other natural reserves
It is important to account for value of portion of property, plant and equipment utilized for generating revenue during an accounting year to ascertain true income. This portion of cost of  Property, Plant & Equipment allocated to an accounting year is called depreciation.
As per Schedule II under the Companies Act, 2013, Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. The depreciable amount of an asset is the cost of an asset or other amount substituted for cost, less its residual value. The useful life of an asset is the period over which an asset is expected to be available for use by an entity, or the number of production or similar units expected to be obtained from the asset by the entity.
Thus there are 3 important factors for computing depreciation:
Estimated useful life of the asset
Cost of the asset
Residual value of the asset at the end of the of its estimated useful life
Depreciation of an asset begins when it is available for use, i.e., when it is in the location and condition necessary for it to be capable of operating in the manner intended by management. Thus it is not necessary that an asset must be used to be depreciated. There is decrease in value of assets due to normal wear and tear even when these are not physically used. Accordingly, value of such wear and tear should be estimated and accounted for.
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.
The loss in the value of assets employed for carrying on a business being an essential element of business expenditure, it is necessary to calculate the amount of such loss and to make a provision, and therefore, arrive at the amount of profit or loss made by the business.
Basically, the cost of an asset used for purpose of business has to be written off over its economic (not physical) life which necessarily must be estimated. A point to remember is that usually, at the end of the economic life, an asset has some value as scrap or otherwise. The amount to be written off in each year should be as such which will reduce the book value of the asset, at the end of its economic life, to its estimated scrap value.
A pertinent question, of course, is the price likely to prevail at the time of replacement. That is why some people advocate the calculation of depreciation on the basis of replacement price rather than cost.
1.2 Depreciation on components of an assets:-
It may be noted that Accounting Standards as well as the Companies Act, 2013 requires depreciation to be charged on a component basis.  Each part of an item of Property, Plant and Equipment with a cost that is significant in relation to the total cost of the item should be depreciated separately. An enterprise should allocate the amount initially recognised in respect of an item of property, plant and equipment to its significant parts/components and should depreciate each such part separately based on the useful life and residual value of each  particular component. For Example- Aircraft is a classic example of such an asset. The airframe (i.e. the body of the aircraft), the engines and the interiors have different individual useful lives. If the life of the airframe (being the longest of the individual lives of the three major types of components) is taken as the life of the aircraft, it is important that other two major components i.e. engine and interiors are depreciated over their respective useful life and not over the life of airframe. Other components (usually small and low value) which will require replacement very frequently may be depreciated over the useful life of airframe and their frequent replacement cost may be charged to expense as and when it is incurred.
Here it is important to note that a part of  Property, Plant & Equipment to be identified as a separate component should have both
(a) significant cost when compared to overall cost of item of property, plant and equipment and
 (b) and estimated useful life or depreciation method different from rest of the parts of the property   plant and equipment.
A significant part of an item of property, plant and equipment may have a useful life and a depreciation method that are the same as the useful life and the depreciation method of another significant part of that same item. Such parts may be grouped in determining the depreciation charge.
1.3 Objectives for Providing Depreciation:-
Prime objectives for providing depreciation are:
(1) Correct income measurement: Depreciation should be charged for proper estimation of periodic profit or loss. In case an enterprise does not account for depreciation on Property, Plant & Equipment, it will not be considering loss in value of property, plant & equipment due to their use in production or operations of the enterprise and will not result in true profit or loss for the period.
(2) True position statement: Value of the Property, Plant & Equipment should be adjusted for depreciation charged in order to depict the actual financial position. In case depreciation is not accounted for appropriately, the property, plant and equipment would be disclosed in financial statements at a value higher than their true value.
(3) Funds for replacement: Generation of adequate funds in the hands of the business for replacement of the asset at the end of its useful life. Depreciation is a good indication of the amount an enterprise should set aside to replace a fixed asset after its economic useful life is over. However, the replacement cost of a fixed asset may be impacted by in inflation or other technological changes.
(4) Ascertainment of true cost of production: For ascertaining the cost of the production, it is necessary to charge depreciation as an item of cost of production.
Further depreciation is a non-cash expense and unlike other normal expenditure (e.g. wages, rent, etc.) does not result in any cash outflow. Further depreciation by itself does not create funds it merely draws attention to the fact that out of gross revenue receipts, a certain amount should be retained for replacement of assets used for carrying on operation.

2. FACTORS IN THE MEASUREMENT OF DEPRECIATION:-
Estimation of exact amount of depreciation is not easy. Generally following factors are taken into consideration for calculation of depreciation.
1. Cost of asset including expenses for installation, commissioning, trial run etc.
2. Estimated useful life of the asset.
3. Estimated scrap value (if any) at the end of useful life of the asset.
The above mentioned factors can be explained, in detail, as follows:
Cost of a depreciable asset represents its money outlay or its equivalent in connection with its acquisition, installation and commissioning as well as for additions to or improvement thereof for the purpose of increase in efficiency. We have discussed this in more detail in coming paragraphs. ‘Useful Life’ is either
(i) the period over which a depreciable asset is expected to be used by the enterprise or
(ii) the number of production or similar units expected to be obtained from the use of the asset by the enterprise. Determination of the useful life is a matter of estimation and is normally based on various factors including experience with similar type of assets. Several other factors like estimated working hours, production capacity, repairs and renewals, etc. are also taken into consideration on demanding situation. Determination of the residual value is normally a difficult matter. If such value is considered as insignificant, it is normally regarded as nil. On the other hand, if the residual value is likely to be significant, it is estimated at the time of acquisition/ installation, or at the time of subsequent revaluation of asset.
Depreciable amount of a depreciable asset is its historical cost, or other amount substituted for historical cost in the financial statements, less the estimated residual value. For example, a machinery is purchased for ₹1,10,000. The residual value is estimated at ₹10,000. It is estimated that the machinery will work for 5 years. The cost to be allocated as depreciation in the accounting periods will be calculated as:

Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
Cost of Property, Plant and Equipment comprises:
(a) its purchase price, including non-refundable import duties and purchase taxes, after deducting   trade discounts and rebates.
(b) any cost directly attributable to bring the asset to the location and condition necessary for it to be  capable of operating in a manner intended by the enterprise.
(c) the initial estimate of the costs of dismantling, removing, the item and restoring the site on which   an asset is located.
Examples of costs directly attributable costs are:
(a) cost of employee benefits arising directly from acquisition or construction of an item of property, plant and equipment.
(b) cost of site preparation
(c) initial delivery and handling costs
(d) installation and assembly costs
(e) cost of testing whether the asset is functioning properly, after deducting the net proceeds from   selling the items produced while testing (such as samples produced while testing)
(f) professional fees e.g. engineers hired for helping in installation of a machine.
Thus all the expenses which are necessary for asset to bring it in condition and location of desired used will become part of cost of the asset. However, following expenses should not become part of cost of asset:
(a) costs of opening new facility or business, such as inauguration costs;
(b) cost of introducing new product or service (for example cost of advertisement or promotional   activities).
(c) cost of conducting business in a new location or with a new class of customer (including cost of   staff training); and
(d) administration and other general overhead costs.
Once an asset has been brought to its intended condition and location of use, no cost should recognized as part of cost of the asset unless there is major repair or addition which increases the useful life of the asset or improves the production capacity of the asset. Accordingly, cost incurred while and item is capable of operating in intended manner but it is not yet put to use or is used at less than full capacity should not be capitalized as part of cost of the asset. Similarly, cost of relocation of an asset should not be capitalized.
Any additions made to a particular item of property, plant and equipment after it is initially put to use are depreciated over the remaining useful life of the asset. Therefore, it is important to maintain an asset register capturing asset wise details of cost, rate of depreciation, date of capitalization etc. All these details need to be captured for any additions to existing assets as well. In the absence of the adequate information, it will be very difficult to compute depreciation expense year on year. Also, at the time of disposal or discard of a particular asset, it will not be possible to compute gain or loss on such disposal/discard.

3. METHODS FOR PROVIDING DEPRECIATION :-
Generally, methods for providing depreciation are based on formula, developed on a study of the behavior of the assets over a period of years for readily computing the amount of depreciation suffered by different forms of assets. Each of the methods, however, should be applied only after carefully considering nature of the asset and the conditions under which it is being used.
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
The Income Tax Rules, however, prescribe the Diminishing Balance Method except in the case of assets of an undertaking engaged in generation and distribution of power.

3.1 Straight Line Method:- According to this method, an equal amount is written off every year during the working life of an asset so as to reduce the cost of the asset to nil or its residual value at the end of its useful life. The advantage of this method is that it is simple to apply and gives accurate results especially in case of leases, and also in case of plant and machinery. This method is also known as Fixed Instalment Method.
According to this method, an equal amount is written off every year during the working life of an asset so as to reduce the cost of the asset to nil or its residual value at the end of its useful life. The advantage of this method is that it is simple to apply and gives accurate results especially in case of leases, and also in case of plant and machinery. This method is also known as Fixed Instalment Method.
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
The underlying assumption of this method is that the particular tangible asset generates equal utility during its lifetime. But this cannot be true under all circumstances. The expenditure incurred on repairs and maintenance will be low in earlier years, whereas the same will be high as the asset becomes old. Apart from this the asset may also have varying capacities over the years, indicating logic for unequal depreciation provision. However, many assets have insignificant repairs and maintenance expenditures for which straight line method can be applied.
While using this method the period of use of an asset in a particular year should also be considered. In the year of purchase of an asset it may have been available for use for part of the year only, accordingly depreciation should be proportioned to reflect the period for which it was available for use. For example, if an asset was purchased on March 1, 2017 and the enterprise prepares financial statements for the year ending on March 31, 2017 depreciation will be provided for a period of 1 month only. Similar situation will arise in the year in which an asset is retired from its intended used or is sold. However, under income tax rules depreciation is provided for full year if the asset was used for more than 180 days in a particular financial year.

3.2 Reducing or Diminishing Balance Method:-  Under this system, a fixed percentage of the diminishing value of the asset is written off each year so as to reduce the asset to its residual value at the end of its life. Repairs and small renewals are charged to revenue. This method is commonly used for plant, fixtures, etc. Under this method, the annual charge for depreciation decreases from year to year, so that the earlier years suffer to the benefit of the later years. Also, under this method, the value of asset can never be completely extinguished, which happens in the earlier explained Straight Line Method. However, it is very simple to operate.
This method is based on the assumption that cost of repairs will increase as the asset get old, therefore, depreciation in earlier years should be high when the repair cost is expected to be low and depreciation in later years should be low when the repair cost is expected to be high. Therefore, this method will result in almost equal burden in all the years of use of the asset as depreciation will reduce with increase in repair costs will increase with every passing year. On the other hand, under the Straight Line Method, the charge for depreciation is constant, while repairs tend to increase with the life of the asset.
Among the disadvantages of this method is the danger that too low a percentage may be adopted as depreciation with the result that over the life of the asset full depreciation may not be provided; also if assets are grouped in such a way that individual assets are difficult to identify, the residue of an asset may lie in the asset account even after the asset has been scrapped. The last mentioned dificulty could be, however, over come if a Plant register is maintained.
The rate of depreciation under this method may be determined by the following formula:
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
where, n = useful life
Similar to straight line method, in this method also period of use in a particular year e.g. year of purchase or sale an item of property plant and equipment needs to be considered while computing the depreciation amount.
Accounting Entries under Straight Line and Reducing Balance Methods:-
There are two alternative approaches for recording accounting entries for depreciation.
First Alternative:- A provision for depreciation account is opened to accumulate the balance of depreciation and the assets are carried at historical cost.
Accounting entry
Depreciation Account  Dr.
To Provision for Depreciation Account
Profit and Loss Account  Dr.
To Depreciation Account
Second Alternative:- Amount of Depreciation is credited to the Asset Account every year and the Asset Account is carried at historical cost less depreciation.
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev

ILLUSTRATION 1:- Jain Bros. acquired a machine on 1st July, 2015 at a cost of ₹14,00,000 and spent ₹1,00,000 on its installation. The firm writes off depreciation at 10% p.a. of the original cost every year. The books are closed on 31st December every year.
Required 
Show the Machinery Account and Depreciation Account for the year 2015 and 2016.
Machinery Account:-
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
Depreciation Account:-
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev

ILLUSTRATION  2:- Jain Bros. acquired a machine on 1st July, 2015 at a cost of ₹14,00,000 and spent ₹1,00,000 on its installation. The firm writes off depreciation at 10% p.a. every year. The books are closed on 31st December every year.
Required:- Show the Machinery Account on diminishing balance method for the year 2015 and 2016.
SOLUTION:- As per Reducing Balance Method
Machinery Account:-
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev

3.3 Sum of Years of Digits Method:- It is variation of the “Reducing Balance Method”. In this case, the ansnual depreciation is calculated by multiplying the original cost of the asset less its estimated scrap value by the fraction represented by:
The number of years (including the present year) of remaining life of the asset/Total of all digits of the life of the asset (in years)
Suppose the estimated life of an asset is 10 years; the total of all the digits from 1 to 10 is 55 i.e.,10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1, or by the formula:
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
The depreciation to be written off in the first year will be 10/55 of the cost of the asset less estimated scrap value; and the depreciation for the second year will be 9/55 of the cost of asset less estimated scrap value and so on.
The method is not yet in vogue; and its advantages are the same as those of the Reducing Balance Method.

ILLUSTRATION  3:- M/s Akash purchased a machine for ₹10,00,000. Estimated useful life and scrap value were 10 years and ₹1,20,000 respectively.  The machine was put to use on 1.1.2010.
Required:- Show Machinery Account and Depreciation Account in their books for 2015 by using sum of years digits method.
 SOLUTION:-
In the books of M/s Akash Machinery Account:-
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
Depreciation Account:-
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
Working Notes:-
(1) Total of sum of digit of depreciation for 2010-2014:-
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
(2) Written down value as on 1-1-2015:-
₹10,00,000 – ₹6,40,000 = ₹3,60,000
(3) Depreciation for 2015:-
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev

3.4 Annuity Method:- This is a method of depreciation which also takes into account the element of interest on capital outlay and seeks to write off the value of the asset as well as the interest lost over the life of the asset. It assumes that the amount laid out in acquiring asset, if invested elsewhere, would have earned interest which must be reckoned as part of the cost of asset. On that basis, the amount of depreciation to be annually provided in the accounts is ascertained from the Annuity Tables, to write off each year interest on the capital outlay as well as part of the capital sum at a rate that the whole of the capital sum and interest accruing thereon would be written off over the life of the asset.
Though the amount written off annually is constant, the interest in the earlier years being greater, only small amount of the capital outlay is written off. This proportion is reversed with the passage of time. This method is eminently suitable for writing off the amounts paid for long leases which involve a considerable capital outlay. It is not practicable to adopt this method for writing off depreciation of plant and machinery on account of frequent changes in the value of such assets which would necessitate the recalculation of the amount of depreciation to be written off annually.

Relevant Journal entries are:- 
(1) For charging interest on asset account
Asset Account  Dr.
To Interest Account
(2) For charging depreciation on asset
Depreciation Account  Dr.  
To Asset Account or Provision for Depreciation Account
(3) For transferring depreciation to Profit and Loss Account
Profit and Loss Account  Dr.  
To Depreciation Account
(4) For transferring interest to Profit and Loss Account
Interest Account  Dr.  
To Profit and Loss Account

ILLUSTRATION 4:- A lease is purchased on 1st April, 2012 for 4 years at a cost of ₹2,00,000. It is proposed to depreciate the lease by the annuity method charging 5 percent interest. A reference to the annuity table shows that to depreciate ₹1 by annuity method over 4 years charging 5% interest, one must write off a sum of  ₹0.282012 [To write off ₹2,00,000 one has to write off every year ₹56,402.40 i.e. 0.282012 × 2,00,000].
Required:- Show the Lease Account for four years and also the relevant entries in the profit and loss account.

SOLUTION:- Lease Account
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev
Profit and Loss Account:-
Concept and Accounting of Depreciation (Part - 1) CA Foundation Notes | EduRev

3.5 Sinking Fund Method:- If a large sum of money is required for replacement of property, plant and equipment at the end of its effective life, it may not be advisable to leave in the amount of depreciation set apart annually, for it may or may not be available in the form of the readily realisable assets to the enterprise at the time it is required. To safeguard this position, the amount annually provided for depreciation may be placed to the credit of the Sinking Fund Account, and at the same time an equivalent amount may be invested in Government securities. The interest on these securities, when received, would be re-invested and the amount thereof would be credited to the Sinking Fund Account. The amount of annual provision for depreciation in such a case is calculated after taking into account interest, that the amounts annually invested shall be earning over the period these will remain invested. When the asset is due for replacement, the securities are sold and the new asset is purchased with the proceeds of their sale. The book value of the old asset, at the time, is transferred to the Sinking Fund Account. Any amount realised on sale of the old asset, as well as the profit or loss on sale of securities, is transferred to the Sinking Fund Account and it is closed off by transfer of the balance of the Profit and Loss Account or General Reserve.
The amount to be set apart annually by way of depreciation is ascertained from Sinking Fund tables. They readily show the amount which must be invested each year to accumulate to ₹1 at a given rate of interest within the stated period.
Relevant Journal entries are:-

(1) For transfer of depreciation to Sinking Fund  
Depreciation Account  Dr.
To Sinking Fund (S.F. )Account
(2)  For charging depreciation to profit and loss account
Profit and Loss Account  Dr.  
To Depreciation Account
(3)  For investment of amount of depreciation
Sinking Fund Investment Account  Dr.  
To Bank Account
(4) In subsequent years, for interest earned on sinking fund investment and on investment of the interest and depreciation
Bank Account  Dr.
To Interest on Sinking Fund Investment Account
Interest on Sinking Fund Investment Account  Dr.
To Sinking Fund Account
(In addition to these entries, entries (1) and (2) will also be passed in subsequent years for transfer of depreciation to sinking fund and for charging it to profit and loss account)
Sinking Fund Investment Account  Dr.
To Bank Account
(yearly depreciation + interest earned)
(5) For sale of sinking fund investment at the end of useful life of the asset
Bank Account  Dr.  
To Sinking Fund Investment Account
If sales is at a profit
Sinking Fund Investment Account  Dr.  
To Sinking Fund Account
If sales is at loss
Sinking Fund Account  Dr.  
To Sinking Fund Investment Account
(6)  For transfer of the amount to the extent of book value of the asset from asset account to sinking fund account
Sinking Fund Account  Dr.  
To Asset Account
(7)  Any surplus in Sinking Fund Account may be transferred to General Reserve Account and if any deficit, that may be transferred to Profit and Loss Account

Sinking Fund Account  Dr.  
To General Reserve Account                  
OR

Profit and Loss Account   Dr.  
To Sinking Fund Account
The aforementioned method may also be operated a little differently. The amount set apart on account of depreciation, instead of being invested annually in the purchase of government securities may be paid out as premium on a policy maturing at the end of the life of the asset, for an amount equal to the sum that will be required for its replacement. In that case the amount of the premium when paid will be debited to the Policy Account instead of the Investment Account.

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