Unit- III

BBA 3rd Semester

Financial Accounting

Depreciation

Definition of 'Depreciation'

Depreciation is a method of allocating the cost of a tangible asset over its useful life.
Businesses depreciate long-term assets for both tax and accounting purposes. Depreciation can
also be stated as decrease in an asset’s value caused by unfavorable market conditions.

For accounting purposes, depreciation indicates how much of an asset’s value has been used up.
For tax purposes, businesses can deduct the cost of the tangible assets they purchase as business
expenses; however, businesses must depreciate these assets in accordance with IRS rules about
how and when the deduction may be taken based on what the asset is and how long it will last.

Depreciation is used in accounting to try to match the expense of an asset to the income that the
asset helps the company earn. For example, if a company buys a piece of equipment for $1
million and expects it to have a useful life of 10 years, it will be depreciated over 10 years. Every
accounting year, the company will expense $100,000 (assuming straight-line
depreciation), which will be matched with the money that the equipment helps to make each
year.

The major causes of depreciation are as follows:

1. Wear And Tear: wear and tear refers to a decline in the efficiency of asset due to its constant
use. When an asset losses its efficiency, its value goes down and depreciation arises. This is true
in case of tangible assets like plant and machinery, building, furniture, tools and equipment used
in the factory.

2.Passage of Time: The value of asset may decrease due to the passage of time even if it is not
in use. There are some intangible fixed assets like copyright, patent right, and lease hold
premises which decrease its value as time elapse.
3. Exhaustion: An asset may loss its value because of exhaustion too. This is the case with
wasting assets such as mines, quarries, oil-wells and forest-stand. On account of continuous
extraction, a stage will come where mines and oil-wells get completely exhausted.

4. Obsolescence: Changes in fashion are external factors which are responsible for throwing out
of assets even if those are in good condition. For example black and white televisions have
become obsolete with the introduction of color TVs, the users have discarded black and white
TVs although they are in good condition. Such as loss on account of new invention or changed
fashions is termed as obsolescence.

5. Other Causes: Market value and accident of an asset are other causes of depreciation which
decrease in the value of assets.

Methods of Depreciation:

Straight line of method

In this method of depreciation can be defined as method under which depreciation amount
remains fixed and is calculated using a predetermined formula and at the end of useful life of
machine the value of machine becomes zero. Here is the list of advantages and disadvantages of
straight line method which is used for calculating depreciation –

Advantages:

1. It is simple to understand and easy to apply

2. It makes possible to distribute the deprecation cost over useful life of the asset uniformly.
3. Since under this method same amount is charged as depreciation, it makes the
comparison of profits for several years easy.

Disadvantages:

1. Since it charges same depreciation for each year, it does not take into account factor that
as years passes the efficiency of machine declines.
2. It cannot be used for those machines where it is difficult to estimate the useful life of the
machines.

Diminishing balance method

In this method the method of providing depreciation is very important from accounting point of
view. In this method, accountant calculates depreciation on the asset from which he deducts all
previous depreciation from asset. So, every year amount of depreciation will go down.

For example
Suppose we purchase a machinery at $ 50000 and if we fix 10 % depreciation on machinery
with diminishing balance method , then first year depreciation will $ 5000 , next year will
calculate depreciation $ 50000 - $ 5000 = $ 45000 X 10 % = $ 4500

Third year depreciation will apply on $ 45000 - $ 4500 = $ 40500

So, we calculate depreciation on written down value of asset so , its other name is written down
method or reducing value method .
Now we are seeing the value of depreciation is decreasing

Ist year = $ 5000

2nd year = $4500
3rd year = $ 4050

Advantages of this method

1. This is also very easy method.

2. This is very scientific method and provides logic that which asset is abolish due to
spending of time at that portion of depreciation is not included in asset.
3. Income tax officer prefers this method for assessment of business and professional
income.
If we buy any asset after first year, we need not to calculate depreciation from beginning.

Disadvantages of this method

1. In this method we also ignore interest on capital which is used for purchasing such asset.
2. All new and old assets are mixed with each other, for an auditor, it is so difficult to differ
among them.
3. It is difficult to calculate optimum rate of depreciation

Machine hour rate method:

Under this method , the depreciation expense is allocated in proportion to the degree the asset is
used for the production. The estimated life of the machine is fixed in terms of hours and not a
calendar time period. It may be clarified that units of production capacity might be miles driven
by a vehicle, flying hours of an air craft engine, number of stamping machine, and so on.

Provision and Reserve

Provision
The Provision means to keep aside a particular sum of money to cover up an anticipated liability
which arises from the past events. It is a recognition of an expected obligation, which will result
in the outflow of cash from the business. The amount of the liability should be easily estimated
by the entity to provide for it.

The recognition is to be made to provide for a known liability or decrease in the value of assets
over time or a disputed claim whose probability of occurrence is maximum.

If a provision is made in excess of the amount what is required, then after paying off the liability,
it needs to be written back to the profit and loss account.

Examples:

 Provision for Bad Debts

 Provision for Depreciation
 Provision for Tax

Reserve

The Reserve is a fraction of retained earnings, which is kept aside for any use in future. It is
regarded as a part of shareholder’s fund. The sum appropriated in the name of reserves can be
used for any of the given purposes:

 For purchasing an asset in future.

 To pay the dividends to shareholder consistently year by year.
 For meeting out unexpected contingencies.

The reserves are mainly divided into following categories:

1. Capital Reserve
2. Revenue Reserve
o General Reserve
o Specific Reserve

Key Differences Between Provision and Reserve

The major differences between Provision and Reserve are as under:

1. The Provision means to keep some money for a known liability which is probable to arise
after a certain time. The Reserve is to retain some money from the profit to for any
particular future use.
2. The amount of provision cannot be used to pay off dividends, but the amount of the
reserves can be used for so.
3. The creation of a provision is compulsory against the anticipated liability. Conversely,
the creation of reserves is voluntary except in the case of Capital Redemption Reserve
(CRR), and Debenture Redemption Reserve (DRR).
4. The use of provision is specific, i.e. it must be used for which it is created. On the other
hand, reserves can be used otherwise.
5. Provisions are deducted from the concerned asset when it is created against an asset while
shown as a liability on the balance sheet when it is created against liability. As opposed
to Reserves, which are shown on the liabilities side.
6. It is immaterial for the creation of provision, whether the company earned the profit or
not whereas the company must earn the profit for the creation of reserves.
Contemporary Issues and Challenges in Accounting
Human Resource Accounting (HRA)

The American Association of Accountants (AAA) defines HRA as follows: ‘HRA is a process of
identifying and measuring data about human resources and communicating this information to
interested parties’.

Objectives of HRA:

1. Providing cost value information about acquiring, developing, allocating and maintaining
human resources.

2. Enabling management to monitor the use of human resources.

3. Assisting in developing effective management practices.

4. Increasing managerial awareness of the value of human resources.

5. For better human resource planning.

6. For better decisions about people, based on improved information system.

8. Assisting in effective utilization of manpower.

Need for HRA:

The need for human asset valuation arose as a result of growing concern for human relations
management in the industry.

1. Under conventional accounting, no information is made available about the human resources
employed in an organization, and without people the financial and physical resources cannot be
operationally effective.

2. The expenses related to the human organization are charged to current revenue instead of
being treated as investments, to be amortized over a period of time, with the result that
magnitude of net income is significantly distorted. This makes the assessment of firm and inter-
firm comparison difficult.

3. The productivity and profitability of a firm largely depends on the contribution of human
assets. Two firms having identical physical assets and operating in the same market may have
different returns due to differences in human assets. If the value of human assets is ignored, the
total valuation of the firm becomes difficult.

4. If the value of human resources is not duly reported in profit and loss account and balance
sheet, the important act of management on human assets cannot be perceived.
5. Expenses on recruitment, training, etc. are treated as expenses and written off against revenue
under conventional accounting. All expenses on human resources are to be treated as
investments, since the benefits are accrued over a period of time

Green Accounting

Green accounting is a type of accounting that attempts to factor environmental costs into the
financial results of operations. It has been argued that gross domestic product ignores the
environment and therefore policymakers need a revised model that incorporates green
accounting
Inflation Accounting /Price level Accounting

Inflation accounting or price level accounting is a term describing a range of accounting

systems designed to correct problems arising from historical cost accounting in the presence of
inflation.

Advantages of Inflation accounting

(1) It enables company to present more realistic view of its profitability because current revenues
are matched with current costs.

(2) Depreciation charged on current values of assets in inflation accounting further enables a firm
to show accounting profits more nearer to economic profits and replacement of these assets when
required.

(3) It enables a company to maintain its real capital by avoiding payment of dividends and taxes
out of its capital due to inflated profits in historical accounting.
(4) Balance Sheet reveals a more realistic and true and fair view of the financial position of a
concern because the assets are shown at current values and not on distorted values as in historical
accounting.

5) When financial statements are presented, adjusted to the price level changes, it makes possible
to compare the profitability of two concerns set up at different times.

6) Investors, employees and the public at large are not misled by inflated book profits because
inflation accounting shows more realistic profits. Higher paper profits without adjustment for
price level changes cause resentment among workers and they demand higher wages and also
excessive profits attract new entrepreneurs to enter the business.

Disadvantages of Inflation Accounting :

1. Adjusting accounts to price level changes is a never-ending process. It involves constant

changes and alterations in the financial statements.

2. The concept of price level accounting appears to have more theoretical importance than
practical because adjusting the accounts to the changes in the price levels may lead to
window dressing of accounts due to the element of subjectivity in it. People may adjust
the accounts according to the values most suited to them, thereby, making the financial
statements more inaccurate.

3. During deflation, when the prices are falling, adjustments of accounts to price level
changes will mean charging lesser depreciation and overstatement of profits.
4. Depreciation charged on current values of fixed assets is not acceptable under the Income
Tax Act, 1961 and hence adjusting it to price level changes does not serve any practical
purpose.

Social Responsibility Accounting

It discloses the social benefits created and costs incurred by the enterprise , Social benefits
include such facilities as medical. Housing , education and so on while the social costs may
include such matters as extra hours worked by the employees without payment , environment
pollution etc

Features of Social Accounting:

(i) Social accounting is an expression of a company’s social responsibilities.

(ii) Social accounting is related to the use of social resources.

(iii) Social accounting emphasize on relationship between firm and society.

(iv) Social accounting determines desirability of the firm in society.

(v) Social accounting is application of accounting on social sciences.

(vi) Social accounting emphasizes on social costs as well as social benefits.

Need/Benefits of Social Accounting:

The important benefits of social accounting are as follows:

 A firm fulfills its social obligations and informs its members, the government and
the general public to enables everybody to form correct opinion.
 It counters the adverse publicity or criticism leveled by hostile media and
voluntary social organisations.
 It assists management in formulating appropriate policies and programmes.
 Through social accounting the firm proves that it is not socially unethical in view
of moral cultures and environmental degradation.
 It acts as an evidence of social commitment.
 Social accounting is necessary from the view point of public interest groups,
social organisations investors and government.
 Through social accounting, the management gets feedback on its policies aimed
at the welfare of the society.