1

Accounting for Fixed Assets

Fixed Asset
Every business acquires various types of fixed assets such as land & building, plant &
machinery, furniture, vehicles etc. These assets are used to derive production capacity.
Therefore, they are also known as earning assets. Fixed assets are purchased for continued and
long-term use in earning profit in a business. They are written off against profits over their
anticipated life by charging an annual amount calculated so as to eliminate the original cost, less
scrap, over that period.

The life of fixed assets spans over several years. Therefore, the business needs to make long term
investment in fixed assets.


Depreciation
Except land, all fixed assets have a limited life. During such period, due to continuous use and/or
lapse of time, the value of some assets starts decreasing. Such a gradual decrement of value of
assets is called Depreciation. Hence, depreciation can be defined as a decline in the value of an
asset due to constant use.

Since these assets have limited life, sooner or later they have to be replaced. At the time of
replacement, the business incurs heavy cash outflow which can create liquidity problem in that
year. In order to avoid such problem, a fixed amount out of profit is set aside as depreciation
account. By the time the fixed asset expires, sufficient amount of fund will be accumulated in
depreciation account which, then can be used to buy new asset. Hence, the process of setting
aside a fixed amount as expense in depreciation account is called Depreciation.

Characteristics of Depreciation
The following are some of the features of depreciation:
1. Depreciation may be physical and functional.
2. Depreciation is a gradual/permanent and continuous decrease in the utility value of a
fixed asset and it continues till the end of useful life of an asset.
3. Depreciation arises due to the use of assets in productive activities.
4. The primary object of depreciation is to allocate expired cost of fixed assets against a
number of accounting periods.
5. Depreciation is charged in respect of fixed assets only i.e., building, machinery,
equipment and furniture etc.
6. Depreciation is a charge against profit.
7. Total depreciation of an asset can not exceed its depreciable value (cost less scrap value).

Causes of Depreciation
Depreciation is a measure of reduction in the use-value of an asset. It can be physical
deterioration or decrease in the market value. The primary causes of depreciation are as follows:
1. Wear and Tear: Due to constant use, assets get worn or torn out.
2. Exhaustion: Exhaustion is the depletion of some assets due to continuous use and lapse
of time. In case of mines and oil wells, the continuous extraction of minerals or oil, a
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stage comes when the mine or well gets completely exhausted an nothing is left.
3. Obsolescence: Some assets are discarded before they are completely worn out because of
changed conditions. This is the case when an asset becomes usefulness because of
technological advancement, new invention, change in style etc. in that asset.
4. Efflux of time: Certain assets get decreased in their value with the passage of time. This
is true in case of assets like leasehold properties, patents and copyrights etc.
5. Accidents: Accidents can cause depreciation in the value of the asset.


Objectives of making provision for depreciation
Depreciation accounting is a must for every business for attaining the following objectives:
1. To ascertain net profit
Depreciation is the expense for the business. Hence to ascertain the net profit, it must be
included in the total cost of sales.

2. To depict the true financial position of the business
The balance sheet depicts true financial position of a business at a point of time. To
depict the true financial position of the business the assets should be shown in balance
sheet not in its original cost but at the depreciated cost. That is all fixed assets should be
shown at cost less the amount of depreciation suffered by them till the date of the balance
sheet.

3. To ascertain cost of production
Depreciation is an expense. Hence it is necessary to charge depreciation in the total cost
of production to fix true sales price of the goods and service.

4. Replacement of assets
One of the primary objectives of depreciation is the provision for the replacement cost on
the retirement of original assets.

5. To follow the company act
According to company act, it is compulsory to charge depreciation on fixed assets.

6. To ascertain income tax
If depreciation is not charged, the operation will show more profit. As a result, the
taxable income will be higher. Hence, depreciation is charged for the correct
ascertainment of total taxable income.

Accounting Treatment for Depreciation
Since depreciation is an expense it must be charged to Profit & Loss a/c. The entire process
begins with the purchase of fixed asset. In the next step, the following journal entries have to be
passed for recording depreciation on assets.

1. For purchase of fixed assets
Fixed assets a/c Dr.
To, Cash/Bank a/c
3
(For purchase of fixed assets)
2. For charging depreciation at the end of the year
Depreciation a/c Dr.
To, Fixed asset a/c
(For depreciation on asset)

3. For transferring depreciation to PL a/c
Profit & Loss a/c Dr.
To, Depreciation a/c
(For transfer of depreciation to P/L a/c)


Additional Entries
4. For sale of fixed assets
Cash/Bank a/c Dr.
To, Fixed asset a/c
(For sale of fixed asset)

5. For gain on sale of fixed assets
Fixed asset a/c Dr.
To, Profit & Loss a/c
(For gain on sale of fixed asset)

6. For loss on sale of fixed asset
Profit & Loss a/c Dr.
To, Fixed asset
(For loss on sale of fixed asset)

Methods of Depreciation
There are a number of different methods of providing depreciation for the assets. The method of
depreciation depends on a number of factors such as type of asset, life, policy organization etc.
The following are the list of methods of depreciation:
1. Fixed installment method
2. Diminishing Balance method
3. Sum of the year digits method
4. Annuity method
5. Depreciation Fund method
6. Insurance policy method
7. Revaluation method
8. Depletion method
9. Machine hour rate method
10. Double declining methods
11. MACRS (Modified Accelerated Cost Recovery System) method

As per the syllabus of BIM 4
th
Semester, we will discuss following 3 methods only:
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1. Straight Line Method
2. Written Down Method
3. Depreciation Fund Method

Straight Line Method
This method is also known as Fixed Installment Method, Equal Installment Method, Original
Cost Method, Simple or Historical Cost Method. Under this method, a fixed proportion of
original cost of the asset is written-off annually so that by the time asset is worn out, its value in
the books is reduced to zero or residual value.

The amount of depreciation to be charged each year can be found out as follows:

asset of Life
value scrap estimated asset fixed of Cost Original
on Depreciati Annual



Advantages
1. It is simplest to understand and easy to apply.
2. The value of asset can be reduced to zero or its scrap value.

Disadvantages
1. This method does not take in account the effective utilization of the asset. The same
amount of depreciation is charged from year to year, irrespective of use of the asset.
2. With the passage of time, efficiency of asset decreases but the amount of depreciation
remains the same, which does not seem to be justified.

Accounting Treatment
1. Pass the necessary journal entries
2. Fixed asset account
3. Depreciation account


Illustration 1

A machine was bought on January 1, 2010 for Rs.8,000. It cost Rs.1,000 for transportation and
Rs.1000 for installation. The scrap value of the machine is estimated to be Rs.1,000 at the end of
its three years of working life. Prepare plant account with the help of journal entries for 3 years
after charging depreciation according to Straight Line Method.
Solution:
Total cost of machine =Rs.8,000 +1,000 +1,000
=Rs.10,000

Estimated scrap value =Rs.1,000

asset of Life
value scrap estimated machine of cost Total
on Depreciati Annual


5
3
000 , 1 000 , 0 1

=Rs.3,000

Journal Entries

Date Particular LF Debit Credit
Jan 1, 2010 Machine a/c Dr.
To, Bank a/c
(For purchase of machine)
10,000
10,000
Dec. 31,
2010
Depreciation a/c Dr.
To, Machine a/c
(For charging depreciation on
machine)
3,000
3,000
Dec. 31,
2010
Profit & Loss a/c Dr.
To, Depreciation a/c
(For transfer of depreciation to P/L
a/c)
3,000
3,000
Dec. 31,
2011
Depreciation a/c Dr.
To, Machine a/c
(For charging depreciation on
machine)
3,000
3,000
Dec. 31,
2011
Profit & Loss a/c Dr.
To, Depreciation a/c
(For transfer of depreciation to P/L
a/c)
3,000
3,000
Dec. 31,
2012
Depreciation a/c Dr.
To, Machine a/c
(For charging depreciation on
machine)
3,000
3,000
Dec. 31,
2012
Profit & Loss a/c Dr.
To, Depreciation a/c
(For transfer of depreciation to P/L
a/c)
3,000
3,000
Dec. 31,
2012
Cash/Bank a/c Dr.
To, Machine a/c
(For realization of scrap value)
1,000
1,000

Dr. Depreciation Account Cr.
Date Particular LF Amount Date Particular LF Amount
Dec.31,
2010
To, Machine a/c 3,000 Dec.31,
2010
By, P/L a/c 3,000
3,000 3,000
Dec.31,
2011
To, Machine a/c 3,000 Dec.31,
2011
By, P/L a/c 3,000
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3,000 3,000
Dec.31,
2012
To, Machine a/c 3,000 Dec.31,
2012
By, P/L a/c 3,000
3,000 3,000

Dr. Machine Account Cr.
Date Particular LF Amount Date Particular LF Amount
Dec.31,
2010
To, Bank a/c 10,000 Dec.31,
2010
By, Dep. a/c
By, Bal c/d
3,000
7,000
10,000 10,000
Dec.31,
2011
To, Bal b/d 7,000 Dec.31,
2011
By, Dep. a/c
By, Bal c/d
3,000
4,000
7,000 7,000
Dec.31,
2012
To, Bal b/d 4,000 Dec.31,
2012
By, Dep. a/c
By, Bank a/c
3,000
1,000
4,000 4,000

Problem
A trader bought machinery on 1
st
January, 2013 for Rs.1,25,000 whose useful life has been
estimated 5 years. After the expiry of useful life the scrap will realize Rs.25,000. Prepare
machinery account and depreciation account, charging depreciation by fixed installment method
for 5 years. Also pass necessary journal entries.


Addition and sale of assets during the year
During the accounting period, a firm can buy and/or sale its fixed assets. The additional purchase
of assets increase the amount of depreciation whereas sales of existing assets decrease the
amount of depreciation at the end of the period.

Addition of asset
The depreciation for the additional assets purchased during the accounting period may be
provided on either of the following two basis:
1. Depreciation may be provided for a year for the additional assets irrespective of use
period. That is, depreciation may be provided for a year even if assets are added in
middle or near to end of accounting period.
2. Depreciation may be provided on assets added for the use period only. That is,
depreciation should be provided for the period of the date of purchase to end of
accounting period, i.e., for use period only.

Note: If date of addition and method of charging deprecation is given in the problem, then
depreciation on additional assets should be provided for use period only.


Illustration 2
The financial year of a firm is closed on December 31, each year. It purchased the following
machinery:
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On January 1, 1996 Machine costing Rs.30,000
On July 1, 1996 Machine costing Rs.20,000
On April 1, 1997 Machine costing Rs.10,000
The machinery is to be depreciated by fixed installment method at 10% p.a. Show the machinery
account for 1996 and 1997.
Solution:
Year Particular Machine Total
Depreciation 1 2 3
1996 Cost
Depreciation
30,000
3,000
20,000
1,000
-
-

4,000
1997 Bal b/d
Depreciation
27,000
3,000
19,000
2,000
10,000
750

5,750
Balance 24,000 17,000 9,250

Note: - Depreciation for 1
st
machine is provided for a year in 1996 and 1997.
- Depreciation on 2
nd
machine is provided only for 6 months in 1996 and for a year in
1997.
- Depreciation on 3
rd
machine is provided for 9 months in 1997.


Dr. Machinery Account Cr.
Date Particular LF Amount Date Particular LF Amount
Jan 1,
1996
July 1,
1996
To, Bank a/c

To, Bank a/c
30,000

20,000
Dec.31,
1996
By, Dep. a/c
By, Bal c/d
4,000
46,000
50,000 50,000
Jan 1,
1997
April 1,
1997
To, Bal b/d

To, Bank a/c
46,000

10,000
Dec.31,
2011
By, Dep. a/c
By, Bal c/d
5,750
50,250
56,000 56,000

Problem
On 1
st
January 1999 a company purchased a plant and machinery costing Rs.1,00,000. It is
estimated that the working life of the plant is 10 years after which its break up value will be zero.

Additions are made on 1
st
April, 2000 to the value of Rs.50,000. Its probable life was estimated
at 5 years and scrap value at the end of life is Rs.10,000.

More additions are made on 1
st
July, 2001 to the value of Rs.44,000 (Break up value Rs.4,000).
The working life was estimated at 4 years.

It was decided to write off depreciation by Straight Line Method. The accounts are closed on 31
st

December each year.
Required: Show the plant and machinery account for the first 4 years.
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Sale of assets
During the accounting period, the firm may sell its partial or whole assets due to various reasons
before the expiry of their useful life. In such a case, the depreciation should be provided on those
assets up to their date of sales. The assets can be sold at book value (original cost accumulated
depreciation) or at a profit or at loss. The gain or loss should be accounted accordingly.

Illustration 3
Clinton maintains his books of accounts on calendar year basis. He purchased on 1.1.94 a
machine for Rs.40,000. He purchased another machine on 1
st
October 1994 for Rs.20,000 and on
1
st
July 1995 for Rs.10,000. On 1
st
July, 1996 one fourth of the machine installed on 1
st
January,
1994 became obsolete and was sold for Rs.6,800.

Show hoe the machinery account will appear in the books of Clinton for all the 3 years under
fixed installment method. Depreciation is to be charged at 10% per annum.
Solution:

Year Particular Machine Total
Depreciation 1 2 3
1994 Cost
Depreciation
40,000
4,000
20,000
500
-
-

4,500
1995 Balance & cost
Depreciation
36,000
4,000
19,500
2,000
10,000
500

6,500
1996 Balance
Depreciation
32,000
3000+500
17,500
2,000
9,500
1,000

6,500


Dr. Machinery Account Cr.
Date Particular LF Amount Date Particular LF Amount
1.1.94
1.10.94
To, Bank a/c
To, Bank a/c
40,000
20,000
31.12.94 By, Dep. a/c
By, Bal c/d
4,500
55,500
60,000 60,000
1.1.95
1.7.96
To, Bal b/d
To, Bank a/c
55,500
10,000
31.12.95 By, Dep. a/c
By, Bal c/d
6,500
59,000
65,500 65,500
1.1.96 To, Bal b/d

59,000 31.12.96 By, Bank a/c
By, Dep. sold
machine
By, P/L a/c
(loss)
By, Dep. a/c
By, Bal c/d
6,800
500

700

6,000
45,000
59,000 59,000

Problem
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A machine was purchased for Rs.10,000 on 1
st
January, 1988. It was decided to depreciate it at
the rate of 10% on original cost method. On 1
st
July, 1989 another machinery was purchased for
Rs.20,000. On 1
st
January, 2010 the machinery bought on 1
st
January, 1998 was sold for
Rs.8,500.

Prepare machinery account for 3 years, assuming that the books are closed on 31
st
December
each year.

(Ans: Profit on sale of machinery Rs.500; Balance on machinery account on 31
st
Dec, 2010,
Rs.17,000).


Written Down Method
This method is also known as Diminishing Balance method, Reducing Balance method. Under
this method, a fixed percentage of depreciation is charged on the reducing balance of asset (cost -
depreciation) till the amount is reduced to scrap value. Since a constant percentage rate is being
applied to the written down value, the amount of depreciation charged every year decreases over
the life of the asset. This method assumes that an asset should be depreciated more in 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 cost as depreciation, can be
obtained by following formula
n
asset of cost e Depreciabl
Value Scrap
- 1 on Depreciati of Rate
Where, n =Estimated useful life of the asset

Example
The cost of asset is Rs.2,16,000 and salvage value at the end of useful life is Rs.27,000. The
estimated useful life of asset is three years. It is decided to depreciate the asset under written
down value method.
Required: Rate of Depreciation

Solution:
n
asset of cost e Depreciabl
Value Scrap
- 1 on Depreciati of Rate

3
2,16,000
27,000
- 1 on Depreciati of Rate
=50%

Advantages
1. The amount of depreciation decreases continuously with the gradual decrease in the
service potential of asset.
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2. When additions are made to the asset, fresh calculation of depreciation is not required.
3. Under this method larger amount of depreciation is provided in earlier years and thus
method minimizes the impact of obsolescence.

Disadvantages
1. Amount of depreciation expenses decreases even if the efficiency of asset is maintained
by way of repairs and maintenance.
2. Heavy depreciation expenses will be charged to profit and loss account in earlier years.
3. Even after becoming obsolete, the book value of asset can never be zero.


Illustration
An asset was purchased for Rs.50,000 on 1
st
January, 1998. Assuming annual depreciation to be
10%, show the asset account for 3 years under written down value method.
Solution:

Calculating depreciation for 3 years
Year Balance of asset Depreciation
1 50,000 5,000
2 45,000 4,500
3 40,500 4,050

Asset Account
Date Particular LF Amount Date Particular LF Amount
1.1.1998 To, Bank a/c 50,000 31.12.98 By, Dep. a/c
By, Bal c/d
5,000
45,00
50,000 50,000
1.1.98 To, Bal b/d 45,000 31.12.98 By, Dep. a/c
By, Bal c/d
4,500
40,500
45,000 45,000
1.1.98 To, Bal b/d 40,500 31.12.98 By, Dep. a/c
By, Bal c/d
4,050
36,450
40,500 40,500

Dr. Depreciation Account Cr.
Date Particular LF Amount Date Particular LF Amount
31.12.98 To, Asset 5,000 31.12.98 By, P/L a/c 5,000
5,000 5,000
31.12.98 To, Asset 5,000 31.12.98 By, P/L a/c 5,000
5,000 5,000
31.12.98 To, Asset 5,000 31.12.98 By, P/L a/c 5,000
5,000 5,000

Problem
A firm purchased plant and machinery on 1
st
April 2013 for Rs.50,000. Depreciation is written-
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off at the rate of 10% per annum. Show 5 years plant and machinery account and depreciation
account under reducing balance method. The firm closes its books on 31
st
December each year.
[Ans: Balance 30,344]


Purchases of asset
Illustration
A machine was bought for Rs.40,000 with an estimated life of 10 years. Write off 10%
depreciation each on diminishing balance system and show the ledger account for the first five
years. At the commencement of third year a new machine worth Rs.5,000 was added.
Solution:

Journal Entries

Date Particular LF Debit Credit
1
st
year Machine a/c Dr.
To, bank a/c
(Being purchase of machine)
40,000
40,000
At the end
of 1
st
year
Depreciation a/c Dr.
To, Machine a/c
(Being depreciation charged at 10%)
4,000
4,000
Profit & Loss a/c Dr.
To, Dep. a/c
(Being transfer of depreciation to
P/L a/c)
4,000
4,000
At the end
of 2
nd
year
Depreciation a/c Dr.
To, Machine a/c
(Being depreciation charged at 10%)
3,600
3,600
Profit & Loss a/c Dr.
To, Dep. a/c
(Being transfer of depreciation to
P/L a/c)
3,600
3,600
In the beg.
of 3
rd
year
Machine a/c Dr.
To, Bank a/c
(Being purchase of new machinery)
5,000
5,000
At the end
of 3
rd
year
Depreciation a/c Dr.
To, Machine a/c
(Being depreciation charged at 10%)
3,740
3,740
Profit & Loss a/c Dr.
To, Dep. a/c
(Being transfer of depreciation to
P/L a/c)
3,740
3,740
At the end
of 4
th
year
Depreciation a/c Dr.
To, Machine a/c
(Being depreciation charged at 10%)
3,366
3,366
Profit & Loss a/c Dr. 3,366
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To, Dep. a/c
(Being transfer of depreciation to
P/L a/c)
3,366
At the end
of 5
th
year
Depreciation a/c Dr.
To, Machine a/c
(Being depreciation charged at 10%)
3,029
3,029
Profit & Loss a/c Dr.
To, Dep. a/c
(Being transfer of depreciation to
P/L a/c)
3,029
3,029


Dr. Machinery Account Cr.
Date Particular LF Amount Date Particular LF Amount
1
st
year To, Bank 40,000 1
st
year By, Dep. a/c
By, Bal c/d
4,000
36,000
40,000 40,000
2
nd
year To, Bal b/d 36,000 2
nd
year By, Dep. a/c
By, Bal c/d
3,600
32,400
36,000 36,000
3
rd
year To, Bal b/d
To, Bank
32,400
5,000
3
rd
year By, Dep. a/c
By, Bal c/d
3,740
33,660
37,400 37,400
4
th
year To, Bal b/d 33,660 4
th
year By, Dep. a/c
By, Bal c/d
3,366
30,294
33,660 33,660
5
th
year To, Bal b/d 30,294 5
th
year By, Dep. a/c
By, Bal c/d
3,029
27,265
30,294 30,294
6
th
year To, Bal b/d 27,265