Lesson 6

Depreciation Accounting

LESSON OUTLINE
LEARNING OBJECTIVES

– Introduction Capital expenditures results in the acquisition of

– Meaning of Depreciation fixed assets for utilisation in the process of
– Definition of Depreciation providing goods and services to the customers.
– Characteristics of Depreciation Fixed assets are utilised for a number of
– Causes of Depreciation accounting periods. Value of fixed asset
– Objectives of Providing Depreciation decreases with the passage of time. Moreover,
– Factors in Measurement of Depreciation the portion of asset utilised for generating
– Accounting Concept of Depreciation revenue, should be recovered during the
– Review Questions accounting year to match the expenses of a
– Methods of Providing Depreciation period with the revenue of the same period. This
– Uniform Charge Methods allocation of portion of fixed assets is the concept
– Declining Charge Methods of depreciation, which will be dealt in detail in
– Other Methods this lesson.
– Review Questions
The objective of this lesson is to make students
– Change in Method of Depreciation
understand the meaning, causes and nature of
– Calculation of Profit or Loss on Assets Sold
depreciation and accounting treatment of
– Depreciation and Replacement of Assets
depreciation. It will provide an understanding of
– Lesson Round Up
the principles and methods of calculating and
– Glossary
accounting of depreciation.
– Self-Test Questions

After all, sustainability means running a corporation with depreciation, amortization & maintenance accounts.
In other words, keeping the asset whole, rather than under mining your natural capital.
Maurice Strong
 114 FP-FA&A

INTRODUCTION

Meaning of Depreciation
A business enterprise acquires different types of fixed assets depending upon its requirements and financial
conditions. Fixed assets have a long life and are held for use in the business for production of goods and
services. Whenever an asset is used in business its value gets reduced and sooner or later the asset
becomes useless. Thus, depreciation is a permanent, continuous and gradual shrinkage in the book value of
a fixed asset. It is the fall in the quality or value of a fixed asset through physical wear and tear due to use or
passage of time or from any other cause. Depreciation takes place irrespective of regular repairs and
maintenance. As the asset is used for business purpose, the annual loss in the value of the asset is like any
other expenditure. Hence, the cost of fixed assets has to be written off over its useful economic life as a loss.
Thus, depreciation is a process of allocating the cost of a fixed asset over its estimated useful life in a rational
and systematic manner.

Definition of Depreciation
The Institute of Charted Accountants of India has defined depreciation 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
depreciable amount in each accounting period during the expected useful life of the asset. Depreciation
includes amortisation of assets whose useful life is predetermined.”
Depreciation Accounting has been defined by the American Institute of Certified Public Accountants as “ a
system of accounting which aims to distribute the cost or other basic value of tangible capital assets less
salvage (if any) over the estimated useful life of the unit (which may be a group of assets) in a systematic and
rational manner. It is a process of allocation and not of valuation.”

Characteristics of Depreciation
The following are the important characteristics of depreciation:
(i) Depreciation refers to a permanent, continuous and gradual decrease in the utility value of a fixed
asset and it continues till the end of the useful life of the asset.
(ii) Depreciation is a charge against profit (i.e. revenue earned) for a particular accounting period.
(iii) Depreciation is always computed in a systematic and rational manner since it is not a sudden loss.
(iv) Depreciation is a process of allocation of expired cost and not of valuation of fixed assets.
(v) Whatever method for calculating depreciation is followed, the exact amount of depreciation can never
be calculated, and it can only be estimated.
(vi) Depreciation is caused due to physical factors and functional factors.
(vii) The fundamental objectives of depreciation are - (a) to maintain the nominal capital invested in fixed
assets, and (b) to allocate the expired portion of the cost of fixed assets over a number of accounting
periods.
(viii) Depreciation is must, i.e. it always takes place whether the asset is carefully handled or neglected.
(ix) If the market value of a fixed asset is fluctuating, the same does not affect the amount of depreciation
so made on the respective assets.
(x) Depreciation is calculated in respect of fixed assets only, i.e. plant, machinery, furniture etc.
(xi) Total depreciation cannot exceed its depreciable value or original cost where the scrap value is nil.

Causes of Depreciation
(i) Physical Wear and Tear Resulting from Use: Tangible fixed assets like, machinery, buildings, furniture
 Lesson 6  Depreciation Accounting 115
etc. get worn out or torn out on account of friction, strain, weathering, intensity of use, chemical
reaction, handling etc. This is the most important cause of charging depreciation in respect of such
assets which are in constant use.
(ii) Physical Deterioration Resulting from Atmospheric Exposure: Number of assets deteriorates with
passage of time and being continually exposed nature.
(iii) Passage of Time: A machine kept continuously idle also becomes potentially useless by the passage
of time.
(iv) Depletion: Wasting assets such as mines and quarries lose their value because they get exhausted on
account of continuous extractions.
(v) Obsolescence: Sometimes an asset becomes useless because of technical changes within the
industry, technical progress in other industries, changes in tastes and habits of consumers, changes in
supply and locations of natural resources etc.

Objectives of Providing Depreciation

The objectives of providing depreciation are as follows:
 (i) To ascertain the correct profit: When a particular asset is used for earning the income of the business,
the depreciation in the value of assets should be deducted from the income in order to calculate the
correct and real profit of the business.
(ii) To present true financial position: In order to show the true financial position of the business in the
balance sheet, it is necessary that assets must be shown at their true values after deducting
reasonable depreciation. If depreciation is not provided, the assets will be overstated in the financial
statements and it will be against sound business principles.
(iii) To make provision for replacement of assets: Since depreciation is a non-cash expense, the amount
charged can be kept separately and utilised for the replacement of the fixed asset after the expiry of
the useful life of the asset.
(iv) To ascertain the proper cost of the product: In order to ascertain the cost of production, it is necessary
to charge depreciation as an item of cost of production.
(v) To maintain the capital invested in the cost of the asset intact in the business so that it can be
reinvested in profit earning process.
(vi) To derive maximum tax benefit.
(vii) To meet the legal requirements: In the case of joint stock companies, it is necessary to charge
depreciation on fixed assets before declaring dividends.
Factors in Measurement of Depreciation
The factors which affect measurement of depreciation are given below:
(i) The original cost of asset: The cost includes all cost incurred in acquiring the asset, i.e. purchase price
including transportation and installation costs, if any.
(ii) The additions, if any, made to the assets during the year taking into consideration the date on which
these additions were made.
(iii) The estimated useful life of the asset.
(iv) The scrap or the residual value of the asset.
(v) Obsolescence, i.e., the chance of the asset going out of fashion.
(vi) The working hours of the asset concerned.
(vii) The repairs and renewals.
(viii) The skill of the operators who handle the asset.
(ix) The legal provisions or other restrictions relating to depreciation.
116 FP-FA&A

ACCOUNTING CONCEPT OF DEPRECIATION

Depreciable assets are assets which

– are expected to be used for more than one accounting period;

– have a limited useful life and

– are held by the organization for use in the production or supply of goods and services.

When a fixed asset is purchased, it is recorded in the books of account at its original cost. But, the fixed asset
is 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 asset is treated or allocated as an expense in each of the accounting period in which the asset is used.
This allocation of cost in the form of an expense is known as depreciation in accounting.

Suppose, a business purchases a machinery for ` 10,00,000 and after using it for five years, it is sold for `
2,00,000. The cost of the machinery used in the business is ` 8,00,000 (`10,00,000 – `2,00,000). This cost
must be allocated as an expense of the business at the rate of `1,60,000 (8,00,000 ÷ 5 ) for each of five
accounting periods in which the machinery has been used to earn revenues. This ` 1,60,000 charge as
expense is called accounting concept of depreciation.

It is the cost for the services obtained from the use of the asset in the same manner as the cost of wages,
rent, etc. Depreciation is the expense charged to profit and loss account before arriving at the net profit for the
year. In other words, the cost of fixed asset in the form of depreciation has to be matched against the
revenues of the years over which the asset is used.

Thus, in accounting, depreciation means apportionment or allocation of the cost of the fixed asset over its
useful life. Its aim is to spread over and allocate or distribute the cost of the fixed asset to the years of its use
and charge the depreciable cost to profit and loss account before arriving at the profits of each the accounting
periods in which the fixed asset has been utilized.

Purpose of Depreciation Accounting: The primary purpose of depreciation accounting is cost allocation.
Provision for depreciation in the profit and loss account does not involve the outflow of cash and hence funds
to the extent of depreciation charged over the years will remain in the business and these funds can be easily
used for replacement of asset.

SUMMARY

– Depreciation accounting is the process of allocating the cost of the tangible fixed asset less its salvage
value over its serviceable life.

– Depreciation is an expense that is to be charged against the revenue whether the business makes
profit or incurs loss;

– Depreciation provides funds for replacing the asset when its useful life ends. Depreciation is not a
process of valuation but it is an allocation. Even if the market value of an asset increases, depreciation
has to be recorded because of allocation process.

JOURNAL ENTRIES

(1) WHEN THE DEPRECIATION IS DIRECTLY CHARGED TO ASSET ACCOUNT:

Depreciation Account Dr.

To Asset Account
The asset account in this case appears at its reduced value in the balance sheet i.e.
 Lesson 6  Depreciation Accounting 117
Cost or book value XXX
Less: Depreciation for the accounting period. XXX
Depreciation expense is transferred to the debit of profit and loss account.
Profit and Loss Account Dr.
To Depreciation Account
(2) WHEN PROVISION FOR DEPRECIATION ACCOUNT IS OPENED:
For charging depreciation:
Depreciation Account Dr.
To Provision for Depreciation Account
For transferring depreciation expense:
Profit and Loss Account Dr.
To Depreciation Account
In this method, the asset account is not affected by the amount of depreciation and the value of asset appears
in the ledger and the balance sheet at its original cost until it is sold or discarded. The amount of depreciation
written off is accumulated in provision for depreciation account.
When the asset is sold or discarded or exchanged for a new asset, the total accumulated depreciation for that
asset in the provision for depreciation account is transferred to that asset account by the following journal entry.
Provision for Depreciation A/c Dr.
To Relevant Asset A/c
Thus, the balance in the provision for depreciation account always shows the accumulated depreciation on
the assets which are in use on not sold out.
In the balance sheet, the asset account is shown at its original cost less accumulated balance in the provision
for depreciation account.
On the assets side of the balance sheet
Relevant Asset A/c XXX
Less: Provision for Depreciation XXX
Alternatively, the asset account can be shown at its original cost on the assets side and provision for
depreciation account can be shown on the liabilities side.

REVIEW QUESTIONS

1. Depreciation is the process of allocating cost of ____________ over its

estimated life.
2. ____,____,____ are some of the causes of depreciation.
3. The asset account is not affected by the amount of depreciation when
___ account is opened.
4. Fixed costs are recorded in the books of accounts at _____ value less
_________.
118 FP-FA&A
METHODS OF PROVIDING DEPRECIATION

FIXED INSTALMENT METHOD

ANNUITY METHOD

UNIFORM CHARGE DEPRECIATION FUND METHOD

METHODS

INSURANCE POLICY METHOD

DIMINISHING BALANCE METHOD

SUM OF YEARS DIGITS METHOD

DECLINING CHARGE
METHODS
DOUBLE DECLINING METHOD

GROUP DEPRECIATION METHOD

INVENTORY SYSTEM (VALUATION)

OTHER METHODS
DEPLETION METHOD

MACHINE HOUR RATE METHOD

A. UNIFORM CHARGE METHODS

Depreciation is charged uniformly every year for those assets which are uniformly productive. Four methods
fall in this category:

1. Fixed Instalment Method or Straight Line Method

Under this method, a fixed proportion of the original cost of the asset is written off each year so that asset
account may be reduced to its residual value at the end of its estimated economic useful life. It is assumed
that depreciation is a function of time. Depreciation is charged on a uniform basis every year till the asset is
written off.
Depreciation = Original Cost of the Fixed Assets – Estimated Scrap Value
Life of the Assets in Number of Year
Percentage of Depreciation = Depreciation x 100
Original Cost of the Fixed Assets
Note:
– Additional asset purchased during the year must be depreciated only from the date of purchase to the
close of the accounting period.
– When no date of addition is mentioned, depreciation may be charged for half of the year on the
assumption that addition was made in the middle of the year.
– Assets sold during the year should be depreciated from the beginning of the year till the date of sale.
 Lesson 6  Depreciation Accounting 119
ADVANTAGES DISADVANTAGES
– It is a simple and easy method. – The assumption that the asset shall be
– The value of the asset can be completely equally useful throughout its life seems to be
written off, i.e. the value can be reduced to illogical.
zero. – It does not take into account the effective
– This method can be applied where asset gets utilization of the asset.
depreciated because of effluxion of time like – Even though the asset is used uniformly from
furniture, equipments, patents, leasehold etc. period to period, the total charge for the use
– There is no change either in the rate or of the asset keeps on increasing every year.
amount of depreciation over the useful life of This is because cost of repairs in each
the asset. subsequent year rises though equal amount
of depreciation is written off every year.
– The value of the asset each year in the
balance sheet is reasonably fair.

Illustration 1:
A firm acquired a machinery on 1st July 2008 at a cost of ` 45,000 and spent ` 5,000 for its installation. The
firm writes off depreciation at 10% per annum on the original cost every year. The books are closed on 31st
March every year. Show Machinery Account and Depreciation Account for three years.
Solution:
Dr. Machinery Account Cr.
Date Particulars ` Date Particulars `
2008 2009
Jul 1 To Bank 45,000 Mar.31 By Depreciation
Jul 1 To Bank (Installation (10% on `50,000 for 9
Expenses) 5,000 months) 3,750
_______ Mar.31 By Balance c/d 46,250
50,000 50,000
2009 2010
April 1 To Balance b/d 46,250 Mar. 31 By Depreciation
(10% on `50,000) 5,000
_______ Mar. 31 By Balance c/d 41,250
46,250 46,250
2010 2011
April 1 To Balance b/d 41,250 Mar. 31 By Depreciation
(10% on `50,000) 5,000
_______ Mar. 31 By Balance c/d 36,250
41,250 41,250
2011
April 1 To Balance b/d 36,250

Dr. Depreciation Account Cr.

Date Particulars ` Date Particulars `

2009 2009
Mar.31 To Machinery A/c 3,750 Mar.31 By Profit & Loss A/c 3,750
2010 2010
Mar.31 To Machinery A/c 5,000 Mar.31 By Profit & Loss A/c 5,000
2011 2011
Mar.31 To Machinery A/c 5,000 Mar.31 By Profit & Loss A/c 5,000
120 FP-FA&A
2. Depreciation Fund (Sinking Fund) Method
Under depreciation fund method, funds are made available for the replacement of asset at the end of its
useful life. The depreciation amount is fixed and remains the same year after year and is charged to profit and
loss account every year through the creation of “depreciation fund” or “sinking fund”. The amount of annual
depreciation is invested outside the business every year in good securities bearing interest at a specified rate.
The aggregate amount of interest and annual provision is invested every year. When the asset is completely
written off or is to be replaced, the securities are sold and money realised by selling securities is used to
replace old asset. Depreciation fund account is closed by transfer of its balance to old asset account.
JOURNAL ENTRIES
(a) At the end of first year:
(i) For setting aside the amount of depreciation:
Depreciation A/c Dr. (with the installment calculated with the
To Depreciation Fund A/c help of Sinking Fund Tables)
(ii) For investing the amount of depreciation:
Depreciation Fund Investment A/c Dr. (with the amount in depreciation fund)
To Bank
Note: The depreciation account, of course, goes to the debit of Profit and Loss Account. The Depreciation
Fund Account and Depreciation Fund Investments Account are balanced and are shown in the Balance
Sheet, the former on the liabilities side and the latter on the assets side.
(b) In the second and subsequent years:
(i) For interest received on investments
Bank Dr.
To Interest on Depreciation Fund Investment A/c
(ii) For transferring interest to Depreciation Fund Account
Interest on Depreciation Fund Investment A/c Dr.
To Depreciation Fund A/c
(iii) For annual installment of depreciation:
Depreciation A/c Dr.
To Depreciation Fund A/c
(iv) For investing the amount of depreciation and interest received on investment:
Depreciation Fund Investment A/c Dr. (with the total amount in depreciation fund)
To Bank
(c) At the end of the last year:
In the last year, interest is received on investments and annual installment of depreciation is transferred to
Depreciation Fund Account as usual. But the amount is not invested because at the end of the last year, old
asset is replaced by new one which will necessitate the selling of all investments. Therefore in the last year
entries Nos. (i), (ii) and (iii) are repeated. Thereafter, the following additional entries are passed.
(i) For sale of investments:
Bank Dr.
To Depreciation Fund Investment A/c
(ii) For transfer of profit or loss on sale of investments:
In case of profit :
 Lesson 6  Depreciation Accounting 121
Depreciation Fund Investment A/c Dr. (with the net profit on sale of investment
To Depreciation Fund A/c
In case of loss :
Depreciation Fund A/c Dr. (with the net loss on sale of investment)
To Depreciation Fund Investment A/c
(iii) For sale of the old asset:
Bank Dr. (with the net amount realised on sale)
To Old Asset A/c
(iv) For transferring Depreciation Fund Account to Old Asset Account:
Depreciation Fund A/c Dr. (with the balance of depreciation
To Old Asset A/c fund account)
(The balance in the Old Asset Account represents profit or loss. It will be transferred to the Profit and
Loss Account.)
(v) For purchase of new asset:
New Asset A/c Dr. (with the cash realised on sale of old
To Bank assets & investments)

ADVANTAGES DISADVANTAGES
A separate sum is provided for replacing the There is a fixed charge for depreciation.
asset. Moreover, the charge for repairs increases every
year. Hence, the profit and loss account is unduly
burdened in later years.

Illustration 2:
A company purchased 3 years, lease on 1st April, 2008 for ` 50,000. It is decided to provide for the
replacement of the lease at the end of 3 years by setting-up a depreciation fund. It is expected that
investment will fetch at 12% p.a. Sinking fund tables shows that ` 0.296349 invested each year will produce
`1 at the end of 3 years at 12% per annum. The investments are sold for ` 28,500.
Give Lease Account, Depreciation Fund Account and Depreciation Fund Investments Account.
Solution:
Annual Depreciation = ` 50,000 x 0.296349 = ` 14,817.45
Dr. Lease Account Cr.

Date Particulars ` Date Particulars `

2008 2009
Apr. 1 To Bank 50,000 Mar.31 By Balance c/d 50,000
2009 2010
Apr. 1 To Balance b/d 50,000 Mar.31 By Balance c/d 50,000
2010 2011
Apr. 1 To Balance b/d 50,000 Mar.31 By Depreciation Fund A/c 47,088
______ By Profit & Loss A/c __2,912
50,000 50,000
122 FP-FA&A
Dr. Depreciation Fund Account Cr.

Date Particulars ` Date Particulars `

2009 2009
Mar.31 To Balance c/d 14,817.45 Mar.31 By Depreciation A/c 14,817.45
2010 2009
Mar.31 To Balance c/d 31,412.94 Apr. 1 By Balance b/d 14,817.45
2010
Mar.31 By Depreciation A/c 14,817.45
By Interest on
Depreciation Fund
________ Investment A/c 1,778.04
31,412.94 31,412.94
2011 2010
Mar.31 To Depreciation 2,912.00 April. 1 By Balance b/d 31,412.94
Fund Investment
A/c
To Lease A/c 47,088.00 2011
Mar.31 By Depreciation A/c 14,817.45
By Interest on
Depreciation Fund
________ Investment A/c 3,769.44
50,000.00 50,000.00
Dr. Depreciation Fund Investment Account Cr.

Date Particulars ` Date Particulars `

2009 2009
Mar.31 To Bank 14,817 Mar.31 By Balance c/d 14,817
2009
Apr. 1 To Balance b/d 14,817
2010 2010
Mar.31 To Bank 16,595 Mar.31 By Balance c/d 31,412
31,412 31,412
2010 2011
Apr. 1 To Balance b/d 31,412 Mar.31 By Bank 28,500
______ By Depreciation Fund A/c _2,912
31,412 31,412

Illustration 3:
On 1st April 2007, Glory Ltd., purchased a machine for ` 1,10,000 and spent ` 6,000 on its installation. The
expected life of the machine is 4 years at the end of which the estimated scrap value will be ` 16,000.
Desiring to replace the machine on the expiry of its life, the company establishes a sinking fund. Investments
are expected to realize 12% interest.
On 31st March, 2011, the machine was sold off as scrap for ` 18,000 and the investments were realised at
5% less than the book value. On 1st April, 2011, a new machine was installed at a cost of ` 1,25,000, Sinking
fund tables show that Re. 0.2092 invested each year will produce Re. 1 at the end of 4 years at 12%. Show
the necessary ledger accounts in the books of Glory Ltd. for all the years.
 Lesson 6  Depreciation Accounting 123
Solution:

Dr. Machine Account Cr.

Date Particulars ` Date Particulars `
2007 To Bank (`1,10,000 2008
Apr. 1 + 16,000) 1,16,000 Mar.31 By Balance c/d 1,16,000
2008 2009
Apr. 1 To Balance b/d 1,16,000 Mar.31 By Balance c/d 1,16,000
2009 2010
Apr. 1 To Balance b/d 1,16,000 Mar.31 By Balance c/d 1,16,000
2010 2011
Apr. 1 To Balance b/d 1,16,000 Mar.31 By Bank (sale of scrap) 18,000
By Sinking Fund A/c 96,470
_______ By Profit & Loss A/c __1,530
1,16,000 1,16,000
2011
Apr. 1 To Bank (installation
of new machine) 1,25,000

Dr. Sinking Fund Account Cr.

Date Particulars ` Date Particulars `
2008 2008
Mar.31 To Balance c/d 20,920 Mar.31 By Depreciation A/c 20,920
2009 2008
Mar.31 To Balance c/d 44,350 Apr. 1 By Balance b/d 20,920
2009
Mar.31 By Depreciation A/c 20,920
______ By Interest on Investment __2,510
44,350 44,350
2010 2008
Mar.31 To Balance c/d 70,592 Apr. 1 By Balance b/d 44,350
2009
Mar.31 By Depreciation A/c 20,920
______ By Interest on Investment __5,322
70,592 70,592
2011 2010
Mar.31 To Sinking Fund April. 1 By Balance b/d 70,592
Investment A/c 3,530
(loss on sale) 2011
To Machinery A/c 96,470 Mar.31 By Depreciation A/c 20,937
_______ By Interest on Investment __8,471
100,000 100,000
124 FP-FA&A
Dr. Sinking Fund Investment Account Cr.

Date Particulars ` Date Particulars `

2008 2008
Mar.31 To Bank 20,920 Mar.31 By Balance c/d 20,920
2008
Apr. 1 To Balance b/d 20,920
2009 2009
Mar.31 To Bank (`20,920 + Mar.31 By Balance c/d 44,350
`2,510) 23,430 ______
44,350 44,350
2009 2010
Apr. 1 To Balance b/d 44,350 Mar.31 By Balance c/d 70,592
2010
Mar. 31 To Bank (`20,920 +
` 5,322) 26,242
70,592 70,592
2010 2011 By Bank (Sale - 70,952 less
Apr. 1 To Balance b/d 70,592 Mar.31 5%) 67,062
By Sinking Fund A/c (loss
______ on sale) _3,530
70,592 70,592

Working Notes:

(i) Amount required = ` 1,10,000 + ` 6,000 - ` 16,000 = ` 1,00,000

(ii) Annual contribution is therefore ` 1,00,000 X ` 0.2092 = ` 20,920
(iii) Accounting period must be assumed to end on 31st March.
(iv) In order to make sinking fund at ` 1,00,000, the depreciation amount in last year is suitably adjusted.

3. Insurance Policy Method

Under this method, the business takes an insurance policy for required amount to replace the asset when it is
worn out. A fixed amount of premium is paid every year. However, this amount will have to be paid in the
beginning of each year. At the end of the specified period, the insurance company pays the agreed amount
with which the new asset can be purchased.
(a) First year and subsequent years:
(i) At the beginning of the year, for insurance premium paid:
Depreciation Insurance Policy A/c Dr.
To Bank
(ii) At the end of the year:
Profit and Loss A/c Dr.
To Depreciation Reserve A/c
(b) At the end of the last year :
(i) On realisation of money from the insurance company:
Bank Dr.
To Depreciation Insurance Policy A/c
 Lesson 6  Depreciation Accounting 125
(ii) For transfer of profit on insurance policy:
Depreciation Insurance Policy A/c Dr.
To Depreciation Reserve A/c
(iii) For transfer of accumulated depreciation to the Asset Account:
Depreciation Reserve A/c Dr.
To Asset A/c
(iv) On purchase of new asset :
New Asset A/c Dr.
To Bank

DIFFERENCE BETWEEN SINKING FUND METHOD AND INSURANCE POLICY METHOD

Sinking Fund Method Insurance Policy Method

(i) Interest is an integral part of sinking fund (i) Interest is not considered under insurance
method policy method

(ii) Investment in securities is the basic feature (ii) The money is not invested in any outside
of sinking fund method securities under insurance policy method.
Only an insurance policy is taken for the
required amount to replace the asset at the
end of the useful life of the asset.

(iii) Under sinking fund method, investments are (iii) Premium is paid in advance at the beginning
made at the end of the accounting period. of the year under insurance policy method.

(iv) Under sinking fund method, the amount (iv) But, under insurance policy method, the
realised is affected by fluctuations in interest amount realised at the end of the life of the
rate and value of securities. asset is fixed.

REVIEW QUESTIONS

1. The amount of depreciation charged remains same in __________

methods of depreciation.

2. Premium is paid at the _____ of the year under insurance policy

method.

Illustration 4:
A firm purchases a lease for 3 for years for ` 60,000 on 1.4.2008. It decides to provide for its replacement by
means of an insurance policy for ` 60,000. The annual premium is ` 19,000. On 1.4.2010, the lease is
renewed for a further period of 3 years for ` 60,000. You are required to show necessary ledger accounts.
Books are closed on 31st March every year.
126 FP-FA&A
Solution:
Dr. Lease Account Cr.
Date Particulars ` Date Particulars `
2008 2009
Apr. 1 To Bank 60,000 Mar.31 By Balance c/d 60,000
2009 2010
Apr. 1 To Balance b/d 60,000 Mar.31 By Balance c/d 60,000
2010 2011
Apr. 1 To Balance b/d 60,000 Mar.31 By Depreciation Reserve A/c 60,000
Dr. Depreciation Insurance Policy Account Cr.
Date Particulars ` Date Particulars `
2008 2009
Apr. 1 To Bank (premium) 19,000 Mar.31 By Balance c/d 19,000
2009
Apr. 1 To Balance b/d 19,000
2010
To Bank 19,000 Mar.31 By Balance c/d 38,000
38,000 38,000
2010 2011
Apr. 1 To Balance b/d 38,000 Mar.31 By Bank 60,000
To Bank 19,000
To Depreciation 3,000
Reserve A/c (profit
transferred) ______ ______
60,000 60,000
Dr. Depreciation Reserve Account Cr.
Date Particulars ` Date Particulars `
2009 2009
Mar.31 To Balance c/d 19,000 Mar.31 By Profit & Loss A/c 19,000
2010 2009
Mar.31 To Balance c/d 38,000 Apr. 1 By Balance b/d 19,000
2010
______ Mar.31 By Profit & Loss A/c 19,000
38,000 38,000
2011 2010
Mar.31 To Lease A/c 60,000 Apr. 1 By Balance b/d 38,000
2011
Mar.31 By Profit & Loss A/c 19,000
By Depreciation Insurance
______ Policy A/c` 3,000
60,000 60,000

4. Annuity Method
The annuity method considers that the business besides losing the original cost of the asset also loses
interest on the amount used for buying the asset, which would have been earned in case the same amount
would have been invested in some other form of investment. Thus, this method takes into account the interest
factor. The amount of interest is calculated on the book value of the asset in the beginning of each year. The
amount of depreciation is uniform and is determined on the basis of annuity table.
 Lesson 6  Depreciation Accounting 127
Journal Entries
(i) On purchase of the asset:
Asset Account Dr.
To Bank
(ii) For charging interest on asset:
Asset Account Dr.
To Interest Account
(iii) For charging depreciation:
Depreciation Account Dr.
To Asset Account
(iv) For transfer of Interest Account to Profit and Loss Account:
Interest Account Dr.
To Profit and Loss Account
(v) For transfer of Depreciation Account to Profit and Loss Account:
Profit and Loss Account Dr.
To Depreciation Account
Illustration 5:
A firm purchased a lease-hold property on 1st April 2006 for 5 years at a cost of ` 5,00,000. It decided to write
off the lease by annuity method presuming the rate of interest at 14%. The annuity table shows that annual
amount necessary to write off Re. 1 in 5 years at 14% is ` 0.291284. Show the lease account for 5 years.
Calculations to be made to the nearest rupee.
Solution:
Dr. Lease Account Cr.
Date Particulars ` Date Particulars `
2006 2007
April 1 To Bank 5,00,000 Mar.31 By Depreciation
2007 (`5,00,000 x 0.291284) 1,45,642
Mar.31 To Interest
(14% of 5,00,000) __70,000 Mar.31 By Balance c/d 4,24,358
5,70,000 5,70,000
2007 2008
April 1 To Balance b/d 4,24,358 Mar. 31 By Depreciation
2008 (`5,00,000 x 0.291284) 1,45,642
Mar.31 To Interest Mar. 31 By Balance c/d 3,38,126
(14% of 4,24,358) __59,410 ________
4,83,768 4,83,768
2008 2009
April 1 To Balance b/d 3,38,126 Mar. 31 By Depreciation
2009 (`5,00,000 x 0.291284) 1,45,642
Mar.31 To Interest Mar. 31 By Balance c/d 2,39,822
(14% of 3,38,126) 47,338 ________
3,85,464 3,85,464
128 FP-FA&A
Date Particulars ` Date Particulars `

2009 2010
April 1 To Balance b/d 2,39,822 Mar. 31 By Depreciation
2010 (`5,00,000 x 0.291284) 1,45,642
Mar.31 To Interest Mar. 31 By Balance c/d 1,27,755
(14% of 2,39,822) _33,575 ________
2,73,397 2,73,397
2010 2011
April 1 To Balance b/d 1,27,755 Mar. 31 By Depreciation
2011 (`5,00,000 x 0.291284) 1,45,642
Mar.31 To Interest _17,887 _______
1,45,642 1,45,642
Working Notes:
– Amount of depreciation ` 5,00,000 x ` 0.291284 = ` 1,45,642
– The amount of depreciation is fixed for all the years.
– The amount of interest is reduced every year because it is calculated on the written down balance.
DISTINCTION BETWEEN SINKING FUND AND ANNUITY METHODS OF DEPRECIATION
(i) Under sinking fund method, the annual amount is set aside to a separate fund account. However, the
annual amount is not set aside to a separate fund account in annuity method.
(ii) Since annual amount set aside are invested in outside securities, sufficient funds will be available for
replacement of asset under sinking fund method. However, there is no provision of funds at the time of
replacement of assets in annuity method.
(iii) In sinking fund method, as the investment is made at the end of the first year, the first interest is
earned only during the second year. In annuity method, interest is assumed to accrue in the first year
of purchase of asset, therefore, it is charged from the end of the first year.
(iv) Under sinking fund method, the total depreciation is less than the asset’s depreciable cost due to
deduction of interest. However, in annuity method, as the interest is added to the cost of the assets,
the total depreciation is more than the depreciable cost of the asset.
(v) Under sinking fund method, interest is actually realised since it is to be received from investments
outside the business. In annuity method, interest is only assumed as against actual receipt.
(vi) Under sinking fund method, annual net effect on profit and loss account is same because of uniform
fixed amount of depreciation. However, in annuity method, annual net effect on profit and loss account
increases due to fixed depreciation charge and declining interest.
(vii) Under sinking fund method, interest realised is credited to sinking fund account, while interest is
credited to profit and loss account and debited to asset account in annuity method.
B. DECLINING CHARGE METHODS
The amount of depreciation charged decreases for each subsequent year of the assets’ life. This method can
be applied:
(a) When the asset becomes old and receipts decline or
(b) When it is necessary to charge depreciation according to the asset’s expected earnings.
The following three methods fall in this category.
1. Diminishing Balance Method (Reducing Balance Method)
Under this method, depreciation is calculated at a certain percentage each year on the balance of the asset
which is brought forward from the previous year. The amount of depreciation charged on each period is not
fixed but it goes on decreasing gradually as the beginning balance of the asset in each year will reduce. Thus,
amount of depreciation becomes higher at the earlier periods and becomes gradually lower in subsequent
periods, when repairs and maintenance charges increase gradually.
 Lesson 6  Depreciation Accounting 129

Depreciation = 1 – Net Residual Value

n
Cost of Acquisitio n
Rate of Depreciation = 1 – n
Where, n = life of the asset in years.

ADVANTAGES DISADVANTAGES
– It is a simple and easy method. – It is difficult to determine an appropriate rate of
depreciation.

– Every year, there is an equal burden for using the – The value of the asset cannot be brought down to
asset. This is because depreciation goes on zero.
decreasing every year whereas cost of repairs
increases.
– The obsolescence problem is given due care – Depreciation is neither based on the use of the
since major part of the depreciation is charged in asset nor distributed evenly throughout the useful
earlier years and the management may find it life of the asset.
easy to replace the asset.
– Income tax authorities recognize this method.

 All items including additions are added together

and depreciated at the same rate.

DISTINCTION BETWEEN STRAIGHT LINE METHOD AND DIMINISHING BALANCE METHOD

OF DEPRECIATION

Straight Line Method Diminishing Balance Method

(i) Depreciation is charged at a fixed rate on the (i) Depreciation is charged at a fixed rate on
original cost of the asset. the original cost in the first year and on the
written down value (cost-minus total
depreciation) in the subsequent years.
(ii) The amount of depreciation remains the same (ii) The amount of depreciation goes on
in all the years of useful life of the asset. decreasing year after year.
(iii) The total burden on the profit and loss (iii) The total burden on the profit and loss
account is more in the later years because the account is almost same in the early years as
repair charges increase while the amount of well as is the later years because of more
depreciation remains the same. depreciation plus repairs cost in the
beginning and less depreciation plus more
repairs cost in the later years.
(iv) The book value of the asset becomes zero or (iv) The book value never becomes zero.
equal to scrap value.
(v) It is easy to calculate the rate of depreciation. (v) It requires the use of mathematical tables.

(vi) It is suitable where repair charges are less (vi) It is suited where repair charges are more in
and obsolescence is not frequent. later years and also where there is
obsolescence.
130 FP-FA&A

Illustration 6:
A firm acquired machinery on 1st July 2008 at a cost of ` 45,000 and spent ` 5,000 for its installation. The
firm writes off depreciation at 10% per annum on diminishing balance method. The books are closed on 31st
March every year. Show Machinery Account and Depreciation Account for three years.
Solution:
Dr. Machinery Account Cr.
Date Particulars ` Date Particulars `
2008 2009
Jul 1 To Bank 45,000 Mar.31 By Depreciation
Jul 1 To Bank (Installation (10% on `50,000 for 9
Expenses) 5,000 months) 3,750
______ Mar.31 By Balance c/d 46,250
50,000 50,000
2009 2010
April 1 To Balance b/d 46,250 Mar. 31 By Depreciation
(10% on ` 46,250) 4,625
______ Mar. 31 By Balance c/d 41,625
46,250 46,250
2010 2011
April 1 To Balance b/d 41,625 Mar. 31 By Depreciation
(10% on ` 41,625) 4,163
______ Mar. 31 By Balance c/d 37,462
41,625 41,625
2011
April 1 To Balance b/d 37,462
Dr. Depreciation Account Cr.
Date Particulars ` Date Particulars `
2009 2009
Mar.31 To Machinery A/c 3,750 Mar.31 By Profit & Loss A/c 3,750
2010 2010
Mar.31 To Machinery A/c 4,625 Mar.31 By Profit & Loss A/c 4,625
2011 2011
Mar.31 To Machinery A/c 4,163 Mar.31 By Profit & Loss A/c 4,163

2. Sum of Years’ Digits Method

In this method, the charge for depreciation for an accounting period is calculated in proportion of the
remaining life of the asset at the beginning of every accounting period. The rate of depreciation is determined
by the fraction where denominator is the sum of the digits representing the life of the asset and the
numerators are individual digits used in the life of asset taken in reverse order.
Depreciation goes on decreasing every year.
Depreciation = Remaining life of the asset including current year x Cost of the asset
Sum of the digits of the life of asset in years

3. Double Declining Balance Method

This method is similar to reducing balance method explained above except that the rate of depreciation is
double the straight line rate. Allowance for scrap value of the asset should not be allowed.
Advantages:
– The total cost of the asset is evenly spread over the economic life of the asset and such annual charge
includes cost of depreciation and repairs.
 Lesson 6  Depreciation Accounting 131
– Initially, the depreciation charged is more compared to subsequent years. This is advantageous since
there is considerable tax-saving, demand for funds in the initial year is more and money at present is
more beneficial than money in future.

C. OTHER METHODS

1. Depletion Method
This method is applicable in case of wasting assets, e.g. mines, quarries, oil well etc. from which a certain
quantity of output is expected to be obtained.
Under this, depreciation is charged on the basis of output extracted in comparison with the estimated total
contents of mine.
Rate of Depreciation = Total cost of mine
Total units
Depreciation = Quantity extracted during the year X Rate of Depreciation

ADVANTAGES DISADVANTAGES
– It relates depreciation with the use of the – It is difficult to estimate the output correctly.
asset.

2. Machine Hour Rate Method (Service Hours Method)

Under Machine hour rate method, depreciation is allocated in proportion to the degree of asset used for
production. The useful life of the asset is fixed in terms of hours. This method of depreciation can be charged
on plant, machinery, vehicles etc.
Rate of Depreciation = Original Cost of Asset - Scrap Value
Life of the Asset in Hours
Depreciation = Actual number of hours x Rate of Depreciation

ADVANTAGES DISADVANTAGES
Depreciation is related to actual working time of This method can be used only when the life of the
the asset. asset can be measured in terms of hours.

3. Group Depreciation Method

Assets having same average life expectancy are grouped together. Depreciation is not charged for each item
but is charged for the group as a whole.

4. Inventory System of Depreciation

In case of assets of small value, the life of the asset cannot be accurately determined, e.g., loose tools, cattle
etc. Depreciation in this case will be calculated as follows:
Value of asset at the beginning of the year XXX
Add : Additions during the year XXX
Total XXX
Less : Estimated value of asset at the end of the year XXX
Depreciation for the year XXX
132 FP-FA&A
CHANGE IN METHOD OF DEPRECIATION
Consistency principle of accounting requires that same accounting practices and methods should be
observed and followed from year to year as otherwise the reported profit or loss will not be comparable.
Hence, it is expected that the concern should consistently follow the method of depreciation which is once
chosen. However, sometimes, a change in the method becomes inevitable.
According to “Accounting Standard-6 (AS-6) Depreciation Accounting”, issued by the Institute of Chartered
Accountants of India, when a change in the method of depreciation is made, depreciation is re-calculated in
accordance with the new method from the date of asset coming into use. In brief, change in method is
permitted retrospectively, that is, from the date of purchase of existing assets.

Steps for change in method of depreciation

– Calculate the value of asset by the new method on the date of change.
– Calculate the depreciation of the past period of asset by both the existing and new method.
– Find the difference between the both.
– Then the difference has to be adjusted in the current year’s asset account by giving debit or credit to
profit and loss account.

Illustration 7:
M Ltd. which depreciates its machinery @ 10% per annum according to diminishing balance method, had on
1st April, 2010 ` 4,86,000 balance in its machinery account. During the year ended 31st March, 2011, the
machinery purchased on 1st April, 2008 for ` 60,000 was sold for ` 40,000 on 1st October, 2010 and a new
machinery costing ` 70,000 was purchased and installed on the same date; installation charges being `
5,000.
The company wants to change its method of depreciation from diminishing balance method to straight line
method w.e.f. 1st April, 2008 and adjust the difference before 31st March, 2011, the rate of depreciation
remaining the same as before.
Show the machinery account for the year ended 31st March, 2011.
Solution:
Dr. Machinery Account Cr.

Date Particulars ` Date Particulars `

2010 2010
Apr. 1 To Balance b/d 4,86,000 Oct. 1 By Bank 40,000
Oct. 1 To Bank (cost and By Profit and Loss A/c
installation charges) __75,000 (loss on sale of 6,170
machinery)
2011
Mar. 31 By Depreciation A/c 60,180
By Profit and Loss A/c
(Additional
depreciation)
5,400
_______ By Balance c/d 4,49,250
_5,61,000 5,61,000
 Lesson 6  Depreciation Accounting 133
Working Notes:
`
(1) Calculation of loss on sale of machinery:
Cost of machinery on April 1, 2008 60,000
Less: Depreciation for 2008-09 6,000
54,000
Less: Depreciation for 2009-10 5,400
48,600
Less: Depreciation for half year 2,430
Book value as on 1st October, 2010 46,170
Less: Amount realised from sale 40,000
Loss on sale 6,170
(2) Additional depreciation:

 100 100 
Cost of machinery on 1st April, 2008  4,86, 000    6,00,000
 90 90 
Book value on 1st April, 2008 for machinery sold in 2010 60,000
Book value on 1st April, 2008 on original group 5,40,000
Depreciation for 2 years (2008-09 and 2009-10) @ 10% on ` 5,40,000 1,08,000
Less: Depreciation provided for 2 years under diminishing balance method 1,02,600
(` 54,000 + `48,600) ______
Additional depreciation due to change in the system charged to profit and loss account 5,400
______
(3) Depreciation for 2010-11
On machinery sold 2,430
On machinery purchased and installed 3,750
On machinery brought from previous year (i.e. on ` 5,40,000 on straight line method) 54,000
______
60,180
______

CALCULATION OF PROFIT OR LOSS ON ASSETS SOLD

Assets may be sold or discarded before or on the expiry of its useful life. Then it is necessary to calculate the
profit or loss, if any, on such sale. For this purpose the book value of the assets at the date of sale is to be
calculated by deducting the total depreciation from the date of purchase to the date of sale from the original
cost. If the sale price is more than the book value there is profit on sale of the assets and if the sale price is
less than the book value, the difference will be loss on sale.

Profit or loss on sale of assets = Sale price of asset - Book value of the asset on the date of
sale
Book value of the asset on the date of sale = Original cost of the asset – Total depreciation
on the asset till that date
134 FP-FA&A
The following journal entries are passed to record the above transactions when the depreciation is
directly credited to the asset account:
(i) On sale of assets:
Bank Dr.
To Assets Account (with the sale price)
(ii) For profit on sale of asset:
Asset Account Dr.
To Profit and Loss Account
(In case of loss the above entry is reversed.)
When Provision for Depreciation Account is maintained then the asset account appears at its cost
price and the following accounting procedure is followed:
(i) Transfer of accumulated depreciation including the depreciation created at the time of sale:
Provision for Depreciation Account Dr.
To Asset Account
(ii) On sale of the asset:
Bank Dr.
To Asset Account
(iii) If the amount of accumulated depreciation and sale price put together is less than the original cost of
the asset, the difference is loss on sale and transferred to profit and loss account:
Profit and Loss Account Dr.
To Asset Account
(iv) In case the accumulated depreciation and sale price put together is more than the original cost of the
asset, the difference is treated as profit on sale and is credited to profit and loss account:
Asset Account Dr.
To Profit and Loss Account
When Provision for Depreciation Account is maintained on sale of asset, alternatively, it is suggested
to open an `Asset Disposal Account’ in such case the following accounting entries may be passed:
(i) On transfer of original cost of asset to Asset Disposal Account:
Asset Disposal Account Dr.
To Asset Account
(ii) On sale of the asset:
Bank Dr.
To Asset Disposal Account
(iii) On transfer of Provision for Depreciation Account to Asset Disposal Account:
Provision for Depreciation Account Dr.
To Asset Disposal Account
(iv) For profit on disposal of asset:
Asset Disposal Account Dr.
To Profit and Loss Account
(In case of loss the above entry is reversed.)
 Lesson 6  Depreciation Accounting 135
Illustration 8:
On 1st April, 2008, a firm purchased a machinery for ` 2,00,000. On 1st October in the same accounting year,
additional machinery costing ` 1,00,000 was purchased. On 1st October, 2009, the machinery purchased on
1st April, 2008, having become obsolete, was sold off for ` 90,000. On 1st October, 2010, new machinery
was purchased for ` 2, 50,000 while the machinery purchased on 1st October, 2008 was sold for ` 85,000 on
the same day.
The firm provides depreciation on its machinery @ 10% per annum on original cost on 31st March every year.
Show machinery account, provision for depreciation account and depreciation account for the period of three
accounting years ending 31st March, 2011.
Solution:
Dr. Machinery Account Cr.

Date Particulars ` Date Particulars `

2008 2009
Apr. 1 To Bank 2,00,000 Mar.31 By Balance c/d 3,00,000
Oct. 1 To Bank 1,00,000
3,00,000 3,00,000
2009 2009
Apr. 1 To Balance b/d 3,00,000 Oct. 1 By Bank 90,000
By Provision for
depreciation A/c 30,000
By Profit & Loss A/c 80,000
2010
_______ Mar. 31 By Balance c/d 1,00,000
3,00,000 3,00,000
2010 2010
Apr. 1 To Balance b/d 1,00,000 Oct. 1 By Bank 85,000
Oct. 1 To Bank 2,50,000 By Provision for 20,000
depreciation A/c
To Profit & Loss A/c 5,000 2011
_______ Mar. 31 By Balance c/d 2,50,000
3,55,000 3,55,000
Dr. Depreciation Account Cr.

Date Particulars ` Date Particulars `

2009 To Provision for 2009
Mar.31 depreciation A/c 25,000 Mar.31 By Profit & Loss A/c 25,000
2009 To Provision for 2010
Oct. 1 depreciation A/c 10,000 Mar.31 By Profit & Loss A/c 10,000
2010 To Provision for
Mar.31 depreciation A/c 10,000 ______
20,000 20,000
2010 To Provision for 2011
Oct. 1 depreciation A/c 5,000 Mar.31 By Profit & Loss A/c 17,500
2011 To Provision for
Mar.31 depreciation A/c 12,500 ______
17,500 17,500
136 FP-FA&A
Dr. Provision for Depreciation Account Cr.

Date Particulars ` Date Particulars `

2009 2009 By Depreciation A/c
Mar.31 To Balance c/d 25,000 Mar.31 (` 20,000 + 5,000) 25,000
2009 To Machinery A/c 2009
Oct. 1 (` 20,000 + 10,000) 30,000 Apr. 1 By Balance b/d 25,000
Oct. 1 By Depreciation A/c 10,000
2010 2010
Mar.31 To Balance c/d 15,000 Mar.31 By Depreciation A/c 10,000
45,000 45,000
2010 To Machinery A/c 2010
Oct. 1 (` 5,000 + 10,000 + Apr. 1 By Balance b/d 15,000
5,000) 20,000
Oct. 1 By Depreciation A/c 5,000
2011 2011
Mar.31 To Balance c/d 12,500 Mar.31 By Depreciation A/c 12,500
32,500 32,500
2011
Apr.1 By Balance b/d 12,500

DEPRECIATION AND REPLACEMENT OF ASSETS

In the context of present inflationary conditions, it will be appropriate to provide for depreciation on the
replacement cost instead of on the historical cost. This is because of the fact that depreciation is provided for
replacing the asset. Sufficient funds will not be available for replacing an asset at the end of its serviceable life. If
depreciation is provided on the basis of historical cost, there is substantial increase in the cost of the new asset
to replace the old asset. But following difficulties may crop up when replacement cost system is used:
(a) Estimating replacement cost in advance is difficult.
(b) The method of charging depreciation on the basis of replacement cost is not recognized by income tax
authorities.
(c) The method of charging depreciation on replacement cost during inflationary conditions is preferred
but not during period of falling prices.
(d) According to the Companies Act, depreciation should be charged on the original cost of the asset and
any deficiency or surplus arising due to sale of such asset should be transferred to the profit and loss
account.
(e) Any new asset purchased, with few exceptions, is always of a better quality than the asset replaced.
Hence, it is difficult to calculate the cost of the asset replaced.
These difficulties can be obviated by taking the following steps:
(a) The additional amount required for replacing the asset over and above the original cost of the asset
may be estimated. Every year, an appropriate amount may be transferred from profit and loss account
besides usual depreciation on asset to provide for additional amount required for replacement of the
asset over and above the original cost of the asset. It may be debited to Profit and Loss Appropriation
Account and credited to Replacement Reserve account.
 Lesson 6  Depreciation Accounting 137
(b) The Replacement Reserve Account may be credited every year with interest at the current rate on the
accumulated balance standing on the credit of the account.

LESSON ROUND UP
– Depreciation is the process of allocation of cost of the asset to the period of its useful life. It is not the
process of valuation of asset.
 – Depreciation is used for recording the expired utility of a physical asset.
– Causes of depreciation are: physical wear and tear; deterioration in value of asset; disuse; depletion;
obsolescence; accidents, etc.
– Depreciation is provided to: ascertain the correct profit; present correct financial position; make
provision for replacement of asset; ascertain proper cost of the product; maintain uniform rate of
return; attain maximum tax benefit; to meet the legal requirements, etc.
– The main factors in measurement of depreciation are: total cost of the asset; estimated useful life;
estimated residual value, etc.
– The various methods of depreciation are: fixed installment method or straight line method; diminishing
balance method or written down value method and other methods.
– In order to adjust depreciation for past periods due to change of method, depreciation is to be
calculated for the past period of asset used both by existing as well as by the changed method and the
difference is adjusted in the current year’s asset account by giving debit or credit to profit and loss
account.

GLOSSARY

Depreciation Depreciation is a process of allocating the cost of a fixed asset over its
estimated useful life in a rational and systematic manner.
Useful Economic Life Useful economic life of an asset is either the period over which a depreciable
asset is expected to be used by the organization or the number of production
or similar units expected to be obtained from the use of the asset by the
organization.
Depreciable Value It is the cost price of the asset less scrap value or salvage value of the
asset.
Salvage Value The estimated value of an asset at the end of its useful life.

SELF-TEST QUESTIONS

Theory Questions
1. Why is correct calculation of depreciation necessary?
2. What are the methods of providing depreciation?
3. Discuss the various factors which are considered for calculating depreciation.
4. What are the various causes of depreciation on fixed assets?
5. Distinguish between straight line and diminishing balance methods of depreciation.
6. What do you mean by replacement cost? What are the difficulties faced while providing for
depreciation on the basis of replacement cost? What steps may be taken to obviate these difficulties?
138 FP-FA&A
7. Distinguish between sinking fund and annuity methods of depreciation.
8. “Depreciation is a process of allocation and not of valuation”. Comment.
Practical Questions
1. Deva Ltd. charges depreciation on its plant and machinery @10% per annum on the diminishing
balance method. On 31st March, 2011, the company decides to adopt straight line method of charging
depreciation with retrospective effect from 1st April, 2007, the rate of depreciation being 15%. On 1st
April, 2010, the plant and machinery account stood in the books at ` 2,91,600. On 1st July, 2010, a
sum of ` 65,000 was realised by selling a machine cost of which on 1st April, 2007 was ` 90,000. On
1st January, 2011, a new machine was acquired at a cost of ` 1,50,000. Show the plant and
machinery account in the books of the company for the year ended 31st March, 2011.
2. A firm acquired a machine for ` 5,00,000 on 1.4.2008. Depreciation was to be charged at 20% p.a. on
straight line method. During 2010-11, a modification was made to improve machine’s technical
reliability at a cost of ` 50,000 which it was considered would extend the useful to life of machine for 2
years. At the same time one important component of the machine was replaced at a cost of ` 10,000
because of excess wear and tear. Routine maintenance during the said accounting period cost `
7,500. Show the machine account, provision for depreciation on machine account and charge to profit
and loss account for the year ending 31st March, 2011.
3. Suman Enterprises purchased machinery on 1st April 2008 for `71,800 and paid `3,200 on its
installation. New machinery was acquired for `45,000 on October 1, 2008. On 1st April 2009, first
machinery was sold at `50,000 and on the same date fresh machinery was purchased for `45,000.
Depreciation is provided annually on 31st March at 10% p.a on written down value method. On April 1,
2010 the firm changed the method of providing depreciation and decided to provide depreciation at
10% p.a on the original cost with retrospective effect. Prepare machinery account to ascertain the
value of machinery as on 31st March 2011.
4. Simmon Ltd., charges deprecation on its plant and machinery @ 10% per annum on the diminishing
balance method. On 31st March, 2011, the company decided to adopt straight line method of charging
depreciation with retrospective effect from 1st April, 2008, the rate of depreciation being 15% p.a.
5. On 1st April, 2010, the plant and machinery account stood in the books of account at `5,00,000. On
1st August, 2010 a sum of `1,00,000 was realised by selling a machine the cost of which on 1st April,
2008 was `1,50,000. On 1st January, 2011 a new machine was acquired at a cost of `3,00,000. Show
the plant and machinery account in the books of the company for the year ended 31st March, 2011.
Lesson 6  Depreciation Accounting 139
140 FP-FA&A