DEPRECIATION CAUSES

AND TREATMENT

SUBMITTED BY
K.POTHANNA SETTI

16331E0046
SECTION A
FIRST SEMESTER

ACCOUNTING FOR MANAGERS

D E PA RT M E N T O F M A N A G E M E N T S T U D I E S
MVGR COLLEGE OF ENGINEERING

CONTENT

INTRODUCTION
DEFINITIONS
CHARACTERSTICS OF DEPRECIATION
CAUSES OF DEPRECIATION
NEED OR OBJECTIVES OF DEPRECIATION
METHODS OF CALCULATING DEPRECIATION
SINKING FUND METHOD
STEPS INVOLVED IN WORKING OF SINKING FUND METHOD
CASE STUDY
REFERENCE

INTRODUCTION
Normally, in all types of business the fixed assets are used e.g. land, building, machinery,
computer, furniture, office equipment, vehicle etc. These assets are purchased for generating
income for a long time. Value of these assets decreases due to their continuous use and

obsolescence. Decrease in value of fined assets is called depreciation. It is necessary to

calculate the depreciation for correct computation of profit & loss.

DEFINITIONS
WILLIAM PICKLES:

The permanent and continuing diminution in the quality, quantity or value of an asset.
SPICER AND PEGLER:

Depreciation is a measure of wearing out, consumption or other loss of value a

depreciable asset arising from use, effusion of time or obsolescence through technology and
market changes.
R. N. Carter:
Depreciation is the gradual wad permanent decrease in the value of an asset from any cause.

CHARACTERSTICS OF DEPRECIATION
Depreciation is the decrease in the value of assets.

Depreciation word is used for decrease in the value of tangible fixed assets.
There is permanent decrease in the value of assets due to depreciation. Once the depreciation
is charged, it reduces the value of assets permanently.

The value of assets (excluding land) decreases gradually due to charge of depreciation.
Depreciation is a process of allocation not of valuation.
Depreciation word is not always used for decrease in the value of assets hut many times.

Depreciation is a gradual and continuous process.

CAUSES OF DEPRECIATION
By Constant Use: Earning capacity of assets decrease due to their continuous use e.g. decrease in the

value of machines, plant, computer, furniture etc. This is one reason of depreciation.
Effect of Time: The value of assets decreases gradually with the passage of time. whether the asset is
used in business or not.
By expiry of Legal Rights: Life time of some of the assets is fixed whether they are used in business
or not. For example, a trader purchased an asset for 20 years on lease for Rs. 10.00,000. the decrease

in the value of assets be Rs. 50,000 annually.

Accident: The value of assets also decreases due to accident e.g. fire, flood, earthquake, etc.

CAUSES OF DEPREIATION
Human Mistake: The value of assets also decreases due to human mistake or decrease in efficiency

of employees.
Obsolescence: Due to new experiment, old assets do not remain useful and their value decreases.

Fall in Price: The value of assets also decreases due to fluctuation in market price and if this fall is
permanent, then this is assumed depreciation.
Depletion: Some assets get depleted through working due to their limited quantity, and the value of
such assets decreases e.g. mines, oil wells. etc.

NEED OR OBJECTIVES OF DEPRECIATION

Need or Objectives or Significance of Providing Depreciation:

Ascertain True Profit or Loss: As the other expenses arc recorded, similarly decrease in the
value of assets is recorded. Hence, the depreciation is charged on assets.
Ascertainment of Correct Cost of Production: Without charging depreciation on assets.
neither the cost of production can be calculated nor the price of goods can be decided.
Presentation of Correct Economic Position by Balance Sheet: It is expected from every
business that its balance sheet will depict true economic position. Hence, the depreciation is
charged on assets.

To Save Income Tax: If the depreciation, is not accounted then profits of business will
increase and more income tax is to be paid.

NEED OR OBJECTIVES OR SIGNIFICANCE OF

PROVIDING DEPRECIATION
Arrangement of Funds for the Re-establishment of Assets: If amount of depreciation is not

deducted annually from profits of business, then trader will use more profits. When new asset will be
purchased, then there will be more economic burden on business and the economic position of
business will be badly effected.

To Prevent the Distribution of Profit out of Capital: According to section 205 of Companies Ac
profits are distributed after charging of depreciation. If profits are distributed before charging of
depreciation, then the shareholders will be paid more profits. In this situation amount distributed to
shareholders will be a part of capital.

METHODS OF CALCULATING DEPRECIATION

Different Methods of Providing Depreciation:
There are different methods of providing depreciation on assets. The use of method in business depends
on many factors. Methods of depreciation arc as follows:
Fixed Instalment Method
Diminishing Balance Method
Annuity Method
Depreciation Fund Method
Insurance Policy Method
Revaluation Method
Depletion Method
Machine Hour Rate Method
Sum of years Digit Method

SINKING FUND METHOD

A Sinking Fund is a fund which is created out of profit every year during the lifetime of debentures

issued and invested outside the business in marketable securities carrying fixed rate of interest. The
amount to be invested annually., annual instalment is calculated from the Sinking Fund Table. At the
time of redemption of debentures, securities are realised/sold and sale proceeds are used for redeeming
the debentures. Sinking Fund Method is also known as Debenture Redemption Fund Method.
It is to be noted that Sinking Fund serve the purpose of Debenture Redemption Reserve as required

bylaw. Therefore, there is no need to create Debenture Redemption Reserve separately in this method
of redemption of debentures.

SINKING FUND METHOD

OBSERVATIONS:
Nature:- It is just like a specific reserve It is to repay a loan or replace an asset.
Object:- It is repay loan or replace an asset.
Provision of law:- It is compulsory to create Sinking Fund
Mode of investment:- It is compulsory to Invest funds outside the business
Effect on working capital:- It Sinking Fund Is there, working capital is not at an affected.

SINKING FUND METHOD

FINANCING OF REDEMPTION OF DEBENTURES:
To ensure the availability of sufficient cash to redeem the debentures at the end of specified
period, a part of divisible profits is set aside and is invested outside the business. For investing

the funds outside the business, the company may adopt any one of the following methods:
(a) Sinking Fund Method or Debenture Redemption Fund Method

(b) Insurance Policy Method

STEPS INVOLVED IN WORKING OF

SINKING FUND METHOD
Practical Steps Involved In Working Of Sinking Fund Method:

Step 1:- Calculate the amount of profit to be set aside with the help of Sinking Fund Table.
Step 2:- Set aside the amount of profit at the end of each year.

Step 3:- Purchase the Investments at the end of each year (except last year).
Step 4:- Receive the interest on investments at the end of each year.
Step 5:- Repeat Step 2 for each year, Repeat Step 3 for each year except last year, Repeat Step 4 for
each year.
Step 6:- Realise the investments in the year of redemption.

PRACTICAL STEPS INVOLVED IN WORKING

OF SINKING FUND METHOD
Step 7:- Transfer profit/loss an sale of Investment to Debenture Redemption Fund Account.
Step 8:- Make due the amount payable to Debenture-holders.
Step 9:- Make payment to Debenture-holders.

Step 10:- Transfer unwritten off amount of Loss on Issue of Debentures equivalent to
Premium payable on redemption of Debentures, (if any), to the debit of Debenture
Redemption Reserve Account.
Step 11:- Transfer the balance left in Debenture Redemption Reserve Account to General
Reserve after all the debentures have been redeemed.

CASE STUDY
Goliath Infrastructures (GI) just issued 5 million $100-par bonds payable carrying 8% coupon
rate and maturing in 15 years. The bond indenture requires GI to set up a sinking up to pay off
the bond at the maturity date. Semi-annual payments are to be made to the fund which is
expected to earn 5% per annum. Find the amount of required periodic contributions.
SOLUTION:-

The future value required to be accumulated equals $500 million (= 5,000,000 $100)
Since the payments are semi-annual, the periodic interest rate = 5% 2 = 2.5%
Number of periods = 2 15 = 30

VC must deposit $11,388,820 at the end of each 6 months for 15 years in order to accumulate
enough money to pay off the bonds when they are due.

REFERENCE
Accountancy for class XI By V. K. Goyal.
CBSE Accountancy by P. C. Tulsian.
Xam idea Accountancy.
Financial Accounting Semester 1 By R. K. Mittal and M. R. Bansal.
CBSE Web material.