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Concept and Accounting of Depreciation
Concept and Accounting of Depreciation
Concept and Accounting of Depreciation
Meaning of Depreciation
Depreciation is the process of allocating the cost of a fixed asset (less any residual value)
over its estimated useful life in a rational and systematic manner.
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful
life.
Most fixed assets (Property, Plant, & Equipment), such as building, plant, machinery, office
equipments, and the like have a limited useful life.
These assets are usually used in the business for generating revenue over a number of future
accounting periods.
When a fixed asset is acquired, it is recorded in the accounts at its acquisition cost, i.e. the
price paid to acquire it. The acquisition cost should be written off as an expense during its
useful life, i.e. a portion of the cost should be charged against profit as an expense in each of
the accounting periods in which the asset is gainfully used.
This accounting process of gradually converting the unexpired costs of fixed assets into
expenses over a series of accounting periods is called depreciation.
Value of fixed assets decreases with the passage of time mainly due to the following
reasons:
(2) Ascertaining Correct Profit or Losses: To find out the net profit or loss for an
accounting period, we add all the revenues of that period and deduct all the expenses incurred
in that period in earning those revenues. One such expense is the periodic depreciation of
fixed assets. If depreciation is not provided for, periodic expenses will be understated. In
effect, profits for that period will be overstated.
(3) Ascertaining True and Fair View of Financial Position: To present a true and fair view
of the state of affairs of the business, the assets must be valued correctly on the Balance
Sheet. Unless depreciation is charged, the value of the assets will be overstated in the
Balance Sheet. As a result, the fixed assets would stand in the books at an amount which is in
excess of their true value to the business. In effect, net worth will be overstated.
(4) Ascertaining Profit or Loss on Sale: A fixed asset is to be sold at the end of its useful
life or may be even before. If no depreciation is provided, the written down value of the
asset on the date of sale cannot be ascertained. In effect, the profit or loss on the sale of
that asset cannot be determined.
(5) Maintenance of capital: Capital is invested for purchasing fixed assets. If depreciation is
not charged, expired cost of capital invested in fixed assets will not be recovered. In
effect, the business will not be able to maintain its capital.
(6) Providing Funds for Replacement: A fixed asset is to be replaced by a new one after the
end of its useful life. If depreciation is not charged, the profit available for distribution will be
overstated. It may be possible that the whole of the profit may be withdrawn during the life of
that asset. In effect, the business may not have sufficient funds to replace the asset.
(7) Making Distinction between capital and revenue expenditure: The buying of a fixed
asset is a capital expenditure but charging depreciation on that against profit is a revenue
expenditure. If no depreciation is provided, the distinction between the above two cannot be
made.
(8) Meeting Legal Obligation: Certain types of business organisations, For example, joint
stock companies are under obligation to charge depreciation on fixed assets according to
the provisions of the law.
Residual Value: The residual value of an asset is the estimated amount that an enterprise
would currently obtain from disposal of the asset, after deducting the estimated cost of the
disposal, if the assets were already of the age and in the condition expected at the end of its
useful life.
Cost is the amount of cash or cash equivalents paid or the fair value of the other consideration
given to acquire an asset at the time of its acquisition or construction or, where applicable, the
amount attributed to that asset when initially recognised in accordance with specific
requirements of the other Accounting Standards.
Element of Cost
(a) its purchase price, including import duties and non-refundable purchase taxes, after
deducting trade discounts and rebates;
(b) any cost directly attributable to bring the asset to the location and condition necessary for
it to be capable of operating in the manner intended by management;
(c) the initial estimate of the costs of dismantling, removing the item and restoring the site on
which it is located, referred to as ‘de-commissioning, restoration and similar liabilities’, the
obligation for which an enterprise incurs either when the item is acquired or as a consequence
of having used the item during a particular period for purposes other than to produce
inventories during that period.
If the useful life of an asset is 10 years, the depreciation rate will be 1/10 or 10%. This may
be put in the shape of a formula as under:
Example
If a machine costs Tk 1,20,000 on 1.1.2017, has a salvage value at Tk 20,000 and a life of 10
years, assuming the accounting year ends on 31st December, the depreciation per annum will
be:
1, 20,000−20,000
Depreciation = = Tk 10,000
10
This method is appropriate for those assets where the use of time is an important factor, e.g.
benefits to be derived from the use of the asset within a fixed time period. Examples are:
lease, patents, copyrights, etc.
This method is often used for other assets, when the following two conditions are satisfied:
(1) the asset renders uniform service throughout its service life; and,
(2) it does not involve repair or maintenance cost (or it is equal throughout its service life).
1. This method ignores the fact that the service yielding ability of the assets fall
while the repairs and maintenance costs increase with the passage of time. Though
each year’s charge for depreciation is the same, the charge for repairs and renewals
goes on increasing as the asset becomes older. Therefore, the charge to the Profit and
Loss Account increases over the years.
2. If an additional asset is acquired, the amount to be charged as depreciation needs to be
recalculated.
The Ledger Account entries for depreciation are quite straightforward. There are two ways or
methods of recording depreciation in the books:
1. The First Method ---- When no provision for Depreciation Account is maintained
2. The Second Method ---- When Provision for Depreciation Account is maintained
Under this method, the depreciation for the period is debited to Depreciation Account and
credited to ‘Accumulated Depreciation Account’ or Provision for Depreciation Account.
As in the previous method, Depreciation Account is closed by transferring it to the Profit and
Loss Account. In the Balance Sheet, asset appears at its original cost and the accumulated
depreciation is shown as a deduction from the Asset Account. Here, from the Balance Sheet,
the original cost of the asset and the total depreciation to-date that has been charged on that
asset can be easily ascertained. As the year passes, the balance of the accumulated
depreciation goes on increasing since constant credit is given to this account in each
accounting year. After the expiry of the useful life, these two accounts are closed by debiting
Accumulated Depreciation Account and crediting Asset Account----any balance in Asset
Account is transferred to the Profit and Loss Account.
Illustration 1
B. Brown purchased a machine by cheque for Tk 90,000 on 1st January, 2015. Its probable
working life was estimated at 10 years and its probable scrap value at the end of that time at
Tk 10,000. It was decided to write off depreciation by equal annual instalments. You are
required to pass necessary Journal entries for first two years and show necessary accounts and
the Balance Sheet:
(a) When Provision for Depreciation Account is maintained. [It was decided to close books
each year on December 31.]
Solution:
90,000−10,000
Annual Depreciation = = Tk 8,000
10
Journal
Though the percentage at which depreciation is charged remains fixed, the amount of
depreciation goes on diminishing year after year.
This method assumes that an asset should be depreciated more in the earlier years of use
than later years because the maximum loss of an asset occurs in the early years of use. The
fixed percentage rate, to be applied to the allocation of net costs as depreciation, can be
obtained by the following formula:
r =1– √
n S
C
(The formula cannot be applied if the asset has no or insignificant scrap value.)
Where,
Example:
If the cost of a machine is Tk 10,000 and scrap value after 4 years is Tk 2,000, the rate of
depreciation is calculated as under:
r =1– √
4 2,000
10,000 = 33.33%
1. The rate of depreciation to be charged (r) is calculated by applying the above formula.
2. The first year's depreciation is calculated by multiplying the rate by the acquisition cost
of the asset.
3. For the second and subsequent years, the depreciation is computed by multiplying its rate
by the written down value (cost less accumulated depreciation) of the asset at the beginning
of the year.
4. No further depreciation is charged when the written down value declines to its
estimated salvage value. There may be some small difference between the estimated and
resulting residual values. This arises because the depreciation rate is generally calculated to
the nearest to two decimal places.
Taking the above example, the calculation of depreciation for each of the four years would be
as follows:
** In the last year, the depreciation is adjusted to the amount of (988-963=25) to bring the
carrying value of the assets to its estimated scrap value.
1. As the decreasing charge for depreciation cancels out the increasing charges for repairs
over the years, it gives a fair charge for depreciation.
4. The impact of obsolescence can be reduced if a significant part of the cost is written off
in early life.
2. This method cannot be applied for assets with a very short life.
4. The cost should be spread over evenly throughout the economic life of an asset or should
be spread according to use. This method follows neither principle.
The previous two methods made no attempt to generate fund for replacement of asset at the
end of its useful life. The sinking fund method not only takes depreciation into account but
also makes provision for replacement of the asset. Under this method, a fund is created by
debiting Depreciation Account and crediting Sinking Fund Account.
The asset is shown in the Balance Sheet, every year, at its original value. Sinking fund is
shown on the liabilities side and sinking fund investment is shown on the assets side of the
Balance Sheet.
At the end of the useful life of the asset, all investments are sold away. The proceeds are
utilised for purchasing the new asset. The Asset Account is closed by setting it off against the
Sinking Fund Account. It should be noted that profit or loss on sale of investment is also
transferred to the Sinking Fund Account.
The equal amount of cash to be invested each year is ascertained from the sinking fund table.
(1) To compute the sum of the digits from one through the number of years of the asset’s
economic life. If n is the estimated years of useful life, the numbers 1,2,3..... n are added. If
the estimated useful life of an asset is 5 years, the sum of the years’ digit is 1 + 2 + 3 + 4 + 5
= 15.
Taking n as the estimated useful life, the above sum can be computed by the following
formula:
n ( n+1 ) 5 ( 5+1 )
Sum of years’ digits = = =15
2 2
(2) For each year, the depreciation rate is expressed as a fraction in which the denominator is
the sum of the digits n (as calculated above) and the numerator of the fraction for each year is
determined by taking the digits in increasing order. Therefore, the numerator for the first year
is ‘n’, for the second year it is ‘n-1’, for the third year it is ‘n-2’ and so on. Taking the above
example, the denominator is 15 and the numerator of the fraction for the first year is 5, for the
second year is 4, for the third year is 3 and so on. The asset will be depreciated 5/15 in the
first year, 4/15 in the second year and so on.
Example: If the cost of a machine is Tk 5,000 and scrap value after 5 years is Tk 100, the
amount of depreciation to be charged in different years will be as under:
This method is well known as ‘Rule of 78’, because it is based on the sum of the digits 1 to
12. If the method is used on the monthly intervals and if the digit 1 is assigned to January,
and 2 to February, 3 to March and so on up to 12 to December, the sum of the digits for the
year becomes: (1+2+3 ... + 12) = 78.
To compute depreciation for a part of the year, the annual depreciation for different years is
computed first. When an asset is purchased during the year, the depreciation for one full year
will fall in two accounting periods. The depreciation for the first year will be the annual
depreciation multiplied by the appropriate fraction representing the portion of the year being
considered. For the second and subsequent years, the depreciation will be calculated as:
unallocated portion of the previous year’s depreciation will be added to the remaining portion
of the current year’s depreciation.
To illustrate, we consider the above example. If the asset is purchased on 1.7.2016 and the
accounting year ends on 31st December, each year, the first year of the asset’s life is 1.7.2016
to 30.6.2017. Therefore, depreciation for the first year will be 1/2 of Tk 1,633 = Tk 816.50.
The depreciation expense for the second year will be half of the first year’s depreciation and
half of the second year’s depreciation, i.e. 1/2 of Tk 1,633 plus 1/2 of Tk 1,307 = Tk 816.50
+ Tk 653.50 = Tk 1,470.
This method can best be applied to assets that provide more service benefits in the earlier
years as compared to the later years, e.g. Copying machines and Computers. It is also used in
allocating interest charges in hire-purchase, leasing and instalment sale accounting, and for
writing off discount on issue of debentures.
6. Annuity Method
The basis of this method is to consider the time value of money and opportunity cost of
capital locked up in the asset. When an amount is invested in acquiring an asset, the business
has to forego some amount of interest, which could have been earned if the money was
instead employed in the purchase of an income producing asset, like securities. Under this
method, the total amount of depreciation written off during the life of the asset equals the net
cost of the asset plus interest calculated on the reducing balance. The rate of interest
(calculated at a fixed rate per cent) is applied to the cost value of the asset and the amount of
interest produced added to the asset. Therefore, interest is debited to the asset (on the
reducing balance) and credited to the Interest Account. Here, the asset is regarded as
providing an annuity (a series of equal periodic payments occuring at equal intervals of time)
and the equal amount of depreciation charged in each year is the value of the annuity.
Under this system, the annual amount of depreciation is calculated from the annuity table.
This method for deprecaition can only be applied to an asset the life of which will extend to a
known period, e.g. a lease. Since the depreciation charge is same and the interest charges
decrease each year (because interest is calculated on reducing balance), the net charge for
depreciation (depreciation less interest) gradually decreases.
7. Revaluation Method
This method is applied for the writing off of a fixed asset to its current market value. To
ascertain the real profit for an accounting period, it is necessary to value the assets each year
at the end of the period and any decrease in the value as compared with the book value should
be charged against profit as depreciation. Since there are many practical difficulties in
ascertaining the real value of an asset at any point of time, for obvious reasons, a depreciation
method never concerns itself with measuring the value of an asset. It remains as a process of
allocation only.
The revaluation method can only be used in the case of assets such as loose, tools, livestock,
and the like. Here, the assets are valued at their current market values and the depreciation is
calculated by finding out the difference between the written down value and the revaluation
figure. We consider the following example:
The point to note is that, under this method, there is no formal recording of individual asset
values. In effect, it is not possible to calculate profit or loss arising on sale of an individual
asset.
8. Depletion Method
This method is an accounting for natural resources rather than accounting for depreciation.
Wasting assets, such as mines, quarries, and the like are examples of such natural
resources. The distinguishing feature of these types of assets is that they cannot be
depreciated but can gradually be depleted. This is because these assets can be physically
consumed and converted into inventory. For example, a coal mine can be considered as an
underground inventory of coal. But such inventory cannot be considered as one of the current
assets. Therefore, this method is applied to wasting assets such as mines, quarries, and the
like where the output for each year depends on the quantity extracted. Here, depreciation is
calculated first by making an estimate in advance of the total quantity to be extracted
over its life and then the cost of the asset is apportioned over the periods of the asset in
proportion to the rate of extraction.
For example, suppose a mine is acquired for Tk 10,00,000 and it is estimated that 2,50,000
tonnes of coal can be extracted over its life. Therefore, the rate of depreciation per tonne of
coal is Tk 10,00,000/2,50,000 = Tk 4. If 50,000 tonnes are extracted in a year, then the
depreciation for that year will be 50,000 × Tk 4 = Tk 2,00,000.
50,000−10,000
Therefore, depreciation rate per machine hour is = =2
20,000
Under this method, each period is charged with depreciation to the extent of the use of
machine. But this method misses a vital point, i.e. depreciation also takes place even when a
machine is not in use.
Illustration:
Computer ‘Meteor-500’ is estimated to have effective life of 20,000 hours. The cost of the
computer is Tk 60,000. If the computer has worked for 2,000 hours in 2021 and 3,000 hours
in 2022, what will be the depreciation at the end of each year?
Solution:
60,000
Depreciation per hour = = Tk 3
20,000
Illustration:
Woodland Hospital Ltd. purchased an X-ray machine for Tk 50,00,000 on 1st April, 2017.
The expected useful life is 5 years and the residual value is Tk 5,00,000 (as per buy back
agreement with the manufacturer).
Solution:
50 ,00,000−5 , 00,000
Depreciation = × Yearly Output
9,000
50 ,00,000−5 , 00,000
Depreciation for 1st Year = × 1,500 = Tk 7,50,000
9,000
50 ,00,000−5 , 00,000
Depreciation for 2nd Year = × 2,000 = Tk 10,00,000
9,000