What is Depreciation for Accounting?
What is a Depreciation for Accounting? Methods of depreciation accounting
Concepts
Every business organization uses some fixed assets for the smooth of its trading activities. These assets are purchase to increase the earning capacity of the business and not for resale.
Every year. These fixed assets except land many get depreciated due to various reasons. The value of these assets decrease with the passage of time. Such gradual reduction in the value
of assets due to various causes is called depreciation. The word depreciation is derived from the Latin word "depretium" which "de" means decrease and "premium' means price, so the "depretium" means decrease in the price of fixed assets. Depreciation is expenses for the business, so it is charged to profit & loss a/c and it must be deducted from respective assets to ascertain its net value.
Cause of depreciation
The following are the main causes of depreciation:
• We & tear: the value of assets decrease due to its constant use in the business. Such reduction in the value is said to be the cause of wear & tear.
• Expiry of time: the value of some assets like patent right, copy right, leasehold property etc. decrease due to the passage of time. After the expiration of time, the rights of such assets become useless.
• Obsolescence: the demand of assets of assets may decrease due to the changes in technology, changes in taste and habits of customer. The value of old assets decrease due to the invention of new assets.
• Exhaustion: the value of assets like mines and quires go on declining due to their constant consumption. The value of assets of assets decrease as the level of minerals Decease.
• Accident: the value of assets may also decease if the accident occurs.
Advantages for providing depreciation
• It helps to ascertain the true and correct amount of profit and loss by charging depreciation as revenue expenses to profit & loss account.
• It helps to present the true and fair of financial position. If depreciation is not changed, the true value of assets can't be shown in balance sheet.
• It helps to calculate the actual cost of production by considering it as an item of cost.
• It helps to replace the old machine by the fund created each year with the amount of depreciation.
Factors affecting the amount of depreciation
The amount of depreciation is affected by the following three factors:
• Cost of assets: cost of assets includes the purchase price plus all the expenses necessary to bring the assets to a usable condition. Depreciation is charge on cost of assets.
• Estimated working life: all the fixed assets have a certain working or useful life which can be estimated. It will be worthless or obsolete after the expiration of its use working life.
• Estimated scarp value: scrap value means the estimated amount realized by selling fixed assets after the expiry of the estimated working life. This is also known as resident value or salvage value or disposal value or break –up value. It is deducted from the cost of assets to determine the amount of depreciation.
Accounting treatment for depreciation
The following journal entries are passed for the accounting records of depreciation.
1. For the purchase of assets:
Assets a/c dr.
To, ban or cash a/c (on cash at through bank)
To, suppliers a/c (on credit)
2. For the payment of carriage or installation:
Assets a/c dr.
To: cash or bank a/c
3. For charging depreciation:
Depreciation a/c dr.
To, assets a/c
4. For transferring the depreciation to profit & loss a/c:
Profit & loss a/c dr.
To, assets
5. For the sale of assets:
Cash or bank a/c dr.
To, assets a/c
6. If profit on sale
Assets a/c dr.
To profit and loss a/c
7. If loss on sale:
Profit & loss a/c dr.
To, assets a/c
Methods of providing depreciation
The following are the various methods of calculation depreciation:
• Fixed installment methods
• Reducing balance method
• Annuity method
• Depreciation fund method
• Depreciation found method
• Insurance policy method
• Revaluation method
• Machine hour rate method
• Sum of the year's digit method
Out of these, only fixed installment method and reducing balance method are prescribed as per the syllabus of Ram shah.
Fixed installment method
The method which charges same amount of depreciation in each year is known as fixed installment method. It is also known as straight line original cost method. Under this method, a fixed amount of depreciation is charged every year. A fixed percentage of original cost of assets is charged as depreciation each year.
The following formula is used to determine the amount of depreciation.
When the rate of depreciation is given:
Annual depreciation =rate/100 x (cost of assets – scrap value)
Advance of fixed installment method
• It is simple to understand.
• It is easy to calculator the amount of depreciation.
• It provides the equal amount of depreciation through out the life of assets.
• It helps to fore case the amount of depreciation in advance.
Disadvantages of fixed installment method
• It is not suitable as it assumes to have zero book value after the expiry of useful life of assets.
• It is not acceptable for tax purpose.
• This method assumes the uniform use of assets over different years. This may not be true in reality.
Reducing balance method
The method in which the amount of depreciation is reducing is each year is known as reducing balance Method. It is also knows as diminishing balance method or written down value method. Under this method, a fixed percentage of current book value of assets as shown in the beginning of each year. Is charged as depreciation every year. The amount of depreciation is decreasing each year as it charges from the beginning value of assets of each year.
If the rate of depreciation is given:
Annual depreciation = rate/100 x beginning value of assets of each year./ balance value of assets of each year
Advance of reducing balance method
• It is easy to calculate and simple to understand.
• It is acceptable for income tax purpose.
• It is more realistic because the amount of deprecation is decreasing as the value of assets goes on decreasing year after year.
Difference between straight line method and reducing balance method
Straight line method
1. The amount of depreciation is uniform in each year.
2. Depreciation is charged on the original cost of assets.
3. The value of assets will be reduced to zero at the end of its life.
4. This method in not accepts by tax authorities.
Reducing balance method
1. The amount of depreciation is decreasing in each year.
2. Depreciation is charged on the balance value of assets of each year.
3. The value of assets won't be reduced to zero at the end of its life.
4. This method is accepted by tax authorities' model.
Accounting treatment for addition and sale of assets
Addition of assets
Additional assets may be purchase during the accounting year. For such assets, additional depreciation is to be charged by considering the following points.
• It the purchase date of additional assets is not given, the depreciation for the whole year is credited to assets a/c or
• If the purchase date is given, the depreciation for the used period is only credited to assets a/c.
Sale of assets
The existing assets may be sold during the accounting period either at profit or loss. The amount realized by selling assets is credited to assets account. Deprecation of that sold assets must be charged up to the period till the assets is sold.
Profit on sale of assets is transferred to profit & loss a/c and shown in the debit side of assets a/c, but the loss on sale of assets is credited assets with the word.
Every year. These fixed assets except land many get depreciated due to various reasons. The value of these assets decrease with the passage of time. Such gradual reduction in the value
Cause of depreciation
The following are the main causes of depreciation:
• We & tear: the value of assets decrease due to its constant use in the business. Such reduction in the value is said to be the cause of wear & tear.
• Expiry of time: the value of some assets like patent right, copy right, leasehold property etc. decrease due to the passage of time. After the expiration of time, the rights of such assets become useless.
• Obsolescence: the demand of assets of assets may decrease due to the changes in technology, changes in taste and habits of customer. The value of old assets decrease due to the invention of new assets.
• Exhaustion: the value of assets like mines and quires go on declining due to their constant consumption. The value of assets of assets decrease as the level of minerals Decease.
• Accident: the value of assets may also decease if the accident occurs.
Advantages for providing depreciation
• It helps to ascertain the true and correct amount of profit and loss by charging depreciation as revenue expenses to profit & loss account.
• It helps to present the true and fair of financial position. If depreciation is not changed, the true value of assets can't be shown in balance sheet.
• It helps to calculate the actual cost of production by considering it as an item of cost.
• It helps to replace the old machine by the fund created each year with the amount of depreciation.
Factors affecting the amount of depreciation
The amount of depreciation is affected by the following three factors:
• Cost of assets: cost of assets includes the purchase price plus all the expenses necessary to bring the assets to a usable condition. Depreciation is charge on cost of assets.
• Estimated working life: all the fixed assets have a certain working or useful life which can be estimated. It will be worthless or obsolete after the expiration of its use working life.
• Estimated scarp value: scrap value means the estimated amount realized by selling fixed assets after the expiry of the estimated working life. This is also known as resident value or salvage value or disposal value or break –up value. It is deducted from the cost of assets to determine the amount of depreciation.
Accounting treatment for depreciation
The following journal entries are passed for the accounting records of depreciation.
1. For the purchase of assets:
Assets a/c dr.
To, ban or cash a/c (on cash at through bank)
To, suppliers a/c (on credit)
2. For the payment of carriage or installation:
Assets a/c dr.
To: cash or bank a/c
3. For charging depreciation:
Depreciation a/c dr.
To, assets a/c
4. For transferring the depreciation to profit & loss a/c:
Profit & loss a/c dr.
To, assets
5. For the sale of assets:
Cash or bank a/c dr.
To, assets a/c
6. If profit on sale
Assets a/c dr.
To profit and loss a/c
7. If loss on sale:
Profit & loss a/c dr.
To, assets a/c
Methods of providing depreciation
The following are the various methods of calculation depreciation:
• Fixed installment methods
• Reducing balance method
• Annuity method
• Depreciation fund method
• Depreciation found method
• Insurance policy method
• Revaluation method
• Machine hour rate method
• Sum of the year's digit method
Out of these, only fixed installment method and reducing balance method are prescribed as per the syllabus of Ram shah.
Fixed installment method
The method which charges same amount of depreciation in each year is known as fixed installment method. It is also known as straight line original cost method. Under this method, a fixed amount of depreciation is charged every year. A fixed percentage of original cost of assets is charged as depreciation each year.
The following formula is used to determine the amount of depreciation.
When the rate of depreciation is given:
Annual depreciation =rate/100 x (cost of assets – scrap value)
Advance of fixed installment method
• It is simple to understand.
• It is easy to calculator the amount of depreciation.
• It provides the equal amount of depreciation through out the life of assets.
• It helps to fore case the amount of depreciation in advance.
Disadvantages of fixed installment method
• It is not suitable as it assumes to have zero book value after the expiry of useful life of assets.
• It is not acceptable for tax purpose.
• This method assumes the uniform use of assets over different years. This may not be true in reality.
Reducing balance method
The method in which the amount of depreciation is reducing is each year is known as reducing balance Method. It is also knows as diminishing balance method or written down value method. Under this method, a fixed percentage of current book value of assets as shown in the beginning of each year. Is charged as depreciation every year. The amount of depreciation is decreasing each year as it charges from the beginning value of assets of each year.
If the rate of depreciation is given:
Annual depreciation = rate/100 x beginning value of assets of each year./ balance value of assets of each year
Advance of reducing balance method
• It is easy to calculate and simple to understand.
• It is acceptable for income tax purpose.
• It is more realistic because the amount of deprecation is decreasing as the value of assets goes on decreasing year after year.
Difference between straight line method and reducing balance method
Straight line method
1. The amount of depreciation is uniform in each year.
2. Depreciation is charged on the original cost of assets.
3. The value of assets will be reduced to zero at the end of its life.
4. This method in not accepts by tax authorities.
Reducing balance method
1. The amount of depreciation is decreasing in each year.
2. Depreciation is charged on the balance value of assets of each year.
3. The value of assets won't be reduced to zero at the end of its life.
4. This method is accepted by tax authorities' model.
Accounting treatment for addition and sale of assets
Addition of assets
Additional assets may be purchase during the accounting year. For such assets, additional depreciation is to be charged by considering the following points.
• It the purchase date of additional assets is not given, the depreciation for the whole year is credited to assets a/c or
• If the purchase date is given, the depreciation for the used period is only credited to assets a/c.
Sale of assets
The existing assets may be sold during the accounting period either at profit or loss. The amount realized by selling assets is credited to assets account. Deprecation of that sold assets must be charged up to the period till the assets is sold.
Profit on sale of assets is transferred to profit & loss a/c and shown in the debit side of assets a/c, but the loss on sale of assets is credited assets with the word.
0 comments:
Post a Comment