www.gradeup.

co

1
www.gradeup.co

Depreciation

Generally, the term ‘depreciation’ is used to denote decrease in value, but in accounting, this term
is used to denote decrease in the book value of a fixed asset.

Need for Providing Depreciation

1. To ascertain correct profit / loss

For proper matching of cost with revenues, it is necessary to charge depreciation against revenue
in each accounting year, to calculate the correct net profit or net loss.

2. To present a true and fair view of the financial position

If the amount of depreciation is not provided on fixed assets in the books of account, the value of
fixed assets will be shown at a higher value than its real value in the balance sheet.

3. To ascertain the real cost of production

For ascertaining the real cost of production, it is necessary to provide depreciation.

4. To comply with legal requirements

Causes of Depreciation:

1. Wear and tear: Use of the tangible fixed asset.

2. When a machine is kept continuously idle, it becomes potentially less useful.

3. The value of machine deteriorates rapidly because of lack of proper maintenance.

4. Depletion: It refers to the physical deterioration by the exhaustion of natural resources eg.,
mines, quarries, oil wells etc.

5. Obsolescence: The old asset will become obsolete (useless) due to new inventions, improved
techniques and technological advancement.

6. Time Factor: Lease, copy-right, patents are acquired for a fixed period of time. On the expiry of
the fixed period of time, the assets cease to exist.

Terms used for Depreciation

1. Amortization: This refers to loss in the value of intangible assets such as goodwill, patents and
preliminary expenses.

2. Depletion: Decrease in the value of mineral wealth such as coal, oil, iron ore, etc. is termed as
depletion.

2
www.gradeup.co

3. Obsolescence: When an asset becomes useless due to new inventions, improved techniques and
technological advances, it is termed as obsolescence.

Methods of Calculating Depreciation

1. Straight line method or fixed instalment method.

2. Written down value method or diminishing balance method

3. Annuity method.

4. Depreciation Fund method.

5. Insurance Policy method.

6. Revaluation method

Straight Line Method or Fixed Instalment Method or Original Cost Method

The same amount of depreciation is charged every year throughout the life of the asset.

Merits:

1. Simplicity: It is very simple and easy to understand.

2. Easy to calculate: It is easy to calculate the amount and rate of depreciation.

3. Assets can be completely written off: Under this method, the book value of the asset becomes
zero or equal to its scrap value at the expiry of its useful life.

Demerits:

The amount of depreciation is same in all the years, although the usefulness of the machine to the
business is more in the initial years than in the later years.

Illustration :

Raheem & Co. purchased a fixed asset on 1.4.2000 for Rs.2,50,000. Depreciation is to be provided
@10% annually according to the Straight line method. The books are closed on 31st March every
year.

3
www.gradeup.co

Pass the necessary journal entries, prepare Fixed asset Account and Depreciation Account for the
first three years.

Written Down Value Method or Diminishing Balance Method or Reducing Balance

Method

Under this method, depreciation is charged at a fixed percentage each year. The amount of
depreciation goes on decreasing every year.

Merits:

1. Uniform effect on the Profit and Loss account of different years: The total charge (i.e.,
depreciation plus repairs and renewals) remains almost uniform year after year, since in earlier
years the amount of depreciation is more and the amount of repairs and renewals is less, whereas
in later years the amount of depreciation is less and the amount of repairs and renewals is more.

2. Recognised by the Income Tax authorities: This method is recognised by the Income Tax
authorities

3. Logical Method: It is a logical method as the depreciation is calculated on the diminished

balance every year.

Demerits:

It is very difficult to determine the rate by which the value of asset could be written down to zero.

Illustration :

A Company purchased Machinery for Rs.50,000 on 1st April 2002. It is depreciated at 10% per
annum on Written Down Value method. The accounting year ends on 31st March of every year.
Pass necessary Journal entries, prepare Machinery account and Depreciation account for three
years.

Annuity Method:

❑ The annuity method considers that the business besides loosing the original cost of the
asset in terms of depreciation, also looses interest on the amount used for buying the
asset.

❑ This is based on the assumption that the amount invested in the asset would have earned
in case the same amount would have been invested in some other form of investment.

❑ This method is used to calculate depreciation amount on lease.

Depreciation Fund Method or Sinking Fund Method :

4
www.gradeup.co

➢ Under this method, funds are made available for the replacement of asset at the end of its
useful life.

➢ The depreciation remains the same year after year and is charged to Profit and Loss
account every year through the creation of depreciation fund.

➢ The amount of annual depreciation is invested in good securities bearing interest at a

specified rate.

➢ ·When the asset is to be replaced, the securities are sold and the amount so realised by
selling securities is used to replace the old asset

Insurance Policy Method:

❑ According to this method, an Insurance policy is taken for the amount of the asset to be
replaced.

❑ The amount of the policy is such that it is sufficient to replace the asset when it is worn
out.

❑ A sum equal to the amount of depreciation is paid as premium every year. The amount is
received on maturity.

❑ The amount so received is used for the purchase of new asset, replacing the old one.

Revaluation Method:

Under this method, the assets like loose tools are revalued at the end of the accounting period
and the same is compared with the value of the asset at the beginning of the year. The difference
is considered as depreciation.

Recording Depreciation

1. Entry for the amount of depreciation to be provided at the end of the year:

2) For transferring the amount of depreciation at the end of the year.

Calculation of Profit or Loss on sale of asset

❑ This is done by comparing the selling price with the book value of the asset.

❑ Book value = Cost Price less Total Depreciation provided till the date of sale

❑ If the book value is less than the selling price, then it is Profit on Sale.

❑ If the book value is more than the selling price, it is Loss on Sale.

5
www.gradeup.co

Illustration :

Robert & Co. purchased a Machinery on 1st April 2002 for Rs.75,000. After having used it for three
years it was sold for Rs.35,000. Depreciation is to be provided every year at the rate of 10% per
annum on Diminishing balance method.

Accounts are closed on 31st March every year. Find out the profit or loss on sale of machinery.

Illustration :

Deepak Manufacturing Company purchased on 1st April 2002, Machinery for Rs.2,90,000 and
spent Rs.10,000 on its installation. After having used it for three years it was sold for Rs.2,00,000.
Depreciation is to be provided every year at the rate of 15% per annum on the Fixed Instalment
method.

Pass the necessary journal entries, prepare machinery account and depreciation account for three
years ends on 31st March every year.

Illustration :

Machinery account showed a balance of Rs.80,000 on 1st April 2001. On 1st October 2003, another
machinery was purchased for Rs.48,000. On 30th September 2003, a machinery which has book
value Rs.80,000 on 1.4.2001 was sold for the Rs.48,000. Depreciation is to be provided at 10% per
annum on Written Down Value Method. The accounting year ends on 31st March.

Prepare Machinery account and Depreciation account for three years.

Illustration :

Vimal & Brothers purchased a Machinery for Rs.3,75,000 on 1st July 2002. It is depreciated at 20%
per annum on Straight Line Method for three years. Having became obsolete it was sold for
Rs.75,000 on 31.3.2005.

Pass the journal entries, prepare Machinery account and Depreciation account. Accounts are
closed 31st March every year.

Illustration :

On April 1, 2001 Machinery was purchased for Rs.4,00,000. On 1st October 2002, a new machine
costing Rs.2,40,000 was purchased. On 30th September 2003, the machinery purchased on 1st
April 2001 having became obsolete was sold for Rs.2,40,000. The accounting year ends on 31st
March and depreciation is to be provided at 10% p.a. on straight line method.

***