Accounting Standards 6

Depreciation Accounting

Accounting standards
The accounting standard(AS) 6, Depreciation Accounting, issued by the ICAI. This standard was first issued in November 1985 and made mandatory from 1st April, 1995.

Learning Objectives:
1) Definition of Depreciation 2) Causes of Depreciation 3) Factors that affect the calculation of Depreciation 4) Methods of Depreciation a) Straight-line method b) Reducing balance method 5) Conclusion

AS-6: DEPRECIATION ACCOUNTING

According to Accounting Standard (AS 6) Depreciation is 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

Definition of Depreciation
It represents the diminution in value of a fixed asset over a period of time. Since depreciation is a provision, it is important to calculate this figure as accurately as possible. As a fixed asset has a life of over 1 year and is expected to produce revenue over a number of years, it is important to spread the cost of the fixed asset over these years.

Why do we have to include depreciation in the balance sheet and P & L A/c ?

The depreciation charge in the profit and loss account represents a cost of expense and can be viewed as the cost of using the fixed asset over the period that the profit and loss account covers.

Causes of Depreciation
1) Physical deterioration i) Wear and tear When a motor vehicle or machinery or fixtures and fittings are used, they eventually wear out. ii) Erosion, rust, rot and decay Land may be eroded or wasted away by the action of wind, rain, sun and other elements of nature.

Causes of Depreciation

(cont.)

2) Economic factors i) Obsolescence: Process of becoming out of date. For example, replacing a computer with old operating system with a new computer with XP system. ii) Inadequacy: Arises when an asset is no longer used because of the growth and changes in the size of the firm. For example, a small ferryboat that is operated by a firm at a coastal resort will become entirely inadequate cause of popularity, so the firm may replace it with a large ferryboat.

Causes of Depreciation

(cont.)

3) The time factor (the effluxion of time) Some assets might have a legal life fixed in terms of years. For example, the patents, and leasehold. Rent some buildings for 10 years. 4) Depletion Other assets are of wasting character, perhaps due to the extraction of raw materials from them. For example, Natural resources such as mines, quarries and oil wells come under this heading.

Factors that affect the calculation of Depreciation

1) Cost of asset
(include expenses and capital expenditure incurred eg. The installation fees, the legal fees)

2) Estimated useful life of asset

This is the number of years that the asset is expected to be used

3) Residual or scrap value of the asset

This is the value of the asset at the end of its life.

4) Method of calculating depreciation

Methods of Depreciation
1) STRAIGHT LINE METHOD Amount of depreciation is fixed. Useful to assets whose service remain uniform throughout the year. For eg: Furniture & fixtures 2) WRITTEN DOWN VALUE METHOD Rate of depreciation is fixed. 3)

ANNUITY METHOD Depreciation is calculated from annuity table. SINKING FUND METHOD The amount of depreciation created is invested outside. INSURANCE POLICY METHOD Amount of depreciation of each year is paid as an insurance premium.

4)

5)

Methods of Depreciation (cont.)

6) ANNUAL EVALUATION METHOD 7) KILOMETRE METHOD Depreciation calculated on the distance run by the transportation means. 8) LABOUR HOUR RATE METHOD Depreciation is calculated on the basis of labour hour worked. 9) GLOBAL METHOD Depreciation is calculated on the sum of all the assets. 10) PRODUCTION UNIT METHOD Mostly used in mines to calculate the depreciation on production. 11) STATUATORY METHOD Depreciation value/rate is fixed by this method.

Straight Line Method

It is a very popular method because its simplicity & consistency.

Straight Line Method

a) Straight-line method (using equation)
Straight-line method of depreciation is based on the cost of an asset that is then depreciated, by the same amount, over the estimated useful life of the asset. Cost Estimated Disposal Value Depreciation per annum = Expected useful life

Example 1: ABC Ltd. Bought a machine at a cost of Rs. 80,000. The machine has an expected useful life of 5 years and at the end of the 5th year, it can be sold for Rs. 10,000. Depreciation per annum = Rs. 14,000

Straight Line Method

Depreciation for 5 years would be:
Cost Annual Depreciation Provisionfor Depreciation NBV

Dateofpurchase

80,000

80,000

Endof1styear Endof2cdyear Endof3rdyear Endof4thyear Endof5thyear

80,000 80,000 80,000 80,000 80,000

14,000 14,000 14,000 14,000 14,000

14,000 28,000 42,000 56,000 70,000

66,000 52,000 38,000 24,000 10,000

Straight Line Method

ADVANTAGES

1. It is simple to calculate & easy to understand. 2. It can reduce the book value of the asset to zero. 3. The valuation of the asset each year in the balance sheet is reasonably fair.

DISADVANTAGES

1. It ignores the fact that the service yielding ability of the asset fall while the repairs & maintenance cost increase with the passage of time. 2. If an additional asset is acquired, the amount to be charged as depreciation needs to be calculated.

Reducing Balance Method

Amount of depreciation goes on declining every year.

LIFE OF ASSETS

b) Reducing balance method Depreciation is calculated on a fixed percentage on the Diminishing Balance of the Asset (the NBV). This results in a higher depreciation charge in the earlier years of the assets estimated useful life. Example 2: A machine costs Rs. 50,000 is to be depreciated at 15% on Reducing Balance Method.
Cost AnnualDepreciation Provisionfor Depreciation NBV

Dateofpurchase

50,000

50,000

Endof1styear Endof2cdyear Endof3rdyear Endof4thyear Endof5thyear

50,000 50,000 50,000 50,000 50,000

50,000x15%=7,500 42,500x15%=6,375 36,125x15%=5,419 30,706x15%=4,606 26,100x15%=3,915

7,500 13,875 19,294 23,900 27,815

42,500 36,125 30,706 26,100 22,185

Reducing Balance Method

ADVANTAGES:
1. 2. 3. 4. Appropriate for assets which lose value quickly in the early year Appropriate for assets which become outdated/obsolete Easy calculation. Balanced effect on profit or loss account of different years.

DISADVANTAGES:
1. 2. 3. 4. Asset is never completed written off Loss of Interest Unequal burden of Profit & Loss A/c. For assets which have a short life, the percentage used to calculate depreciation is very large

Double entry records for Depreciation

For Purchase of Fixed Asset
Asset A/c. To Cash/Bank A/c. Dr. xx xx

For Depreciation of Fixes Asset

Depreciation A/c. To Machinery / Asset A/c. Dr. xx Xx

For Transfer of Depreciation to P & L A/c.

P & L A/c. To Depreciation A/c. Dr. xx xx

Double entry records for Depreciation

For Selling Asset Depreciation till date
Depreciation A/c. To Machinery / Asset A/c. Dr. xx xx

For Selling Asset Cash Received

Cash/bank A/c. To Machinery / Asset A/c. Dr. xx xx

For Profit or loss on sale of Asset

Machinery/ Asset A/c. To Profit on sale of asset A/c. Loss on Sale of asset A/c. To Machinery A/c. Dr. xx xx Dr. xx

xx

Double entry records for Depreciation

For Providing Depreciation on Asset
Depreciation A/c. xx To Provision for Depn. A/c. Dr. xx

For Transferring Prov. For Depn. On Asset Sold

Prov. For Depn. A/c. To Asset Sale A/c. Dr. xx Xx

CONCLUSION
For determination of net profit or net loss. For showing asset at fair and true value in the balance sheet. Provision of funds for replacement of assets. Ascertaining accurate cost of production. Distribution of dividend out of profit only.

Thank you