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MGT101 - Financial Accounting - I - Lecture Handout 18

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METHODS OF CHARGING DEPRECIATION (Continued)

It is a systematic allocation of the cost of a depreciable asset to expense over its useful life”.

Grouping of Fixed Assets

Major groups of Fixed Assets:

  • Land
  • Building
  • Plant and Machinery
  • Furniture and Fixtures
  • Office Equipment
  • Vehicles

No depreciation is charged for ‘Land’. In case of ‘Leased Asset/Lease Hold Land’ the amount paid for it is charged over the life of the lease and is called Amortization.

Recording of Journal Entries

Purchase of fixed asset:

Debit: Relevant asset account
Credit: Cash, Bank or Payable Account

For recording of depreciation, following two heads of accounts are used:
• Depreciation Expense Account
• Accumulated Depreciation Account

Depreciation expense account contains the depreciation of the current year. Accumulated depreciation contains the depreciation of the asset from the financial year in which it was bought. Depreciation of the following years in which asset was used is added up in this account. In other words, this head of account shows the cost of usage of the asset up to the current year. Depreciation account is charged to profit & loss account under the heading of Administrative Expenses. In the balance sheet, fixed assets are presented at written down value i.e.

WDV = Actual cost of fixed asset – Accumulated Depreciation.

Journal entry for the depreciation is given below:

Debit: Depreciation Account
Credit: Accumulated Depreciation Account

Methods of Calculating Depreciation

There are several methods of calculating depreciation. At this stage, we will discuss only two of them namely:
• Straight line method
• Reducing balance method

Straight Line Method

In this method, a fixed amount is calculated by a formula. That fixed amount is charged every year irrespective of the written down value of the asset. The formula for calculating the depreciation is given below:

Depreciation = (cost – Residual value) / Expected useful life of the asset

Residual value is the cost of the asset after the expiry of its useful life.

Reducing Balance Method

In this method, depreciation is calculated on written down value. In the first year, depreciation is calculated on cost. Afterwards written down value is calculated by deducting accumulated depreciation from the cost of that asset (cost – accumulated depreciation) and depreciation is charged on that value.

Cost of Asset – Price at which the asset was initially recorded

Written Down Value / Book Value – Cost minus Accumulated Depreciation.

In reducing balance method, a formula is used for calculation the depreciation rate i.e.

reducing balance

Year 1
Cost

100,000

Depreciation 100,000 x 42%
(42,000)

WDV (Closing Balance)

58,000

Year 2
WDV (Opening Balance)
58,000


Depreciation 58,000 x 42%
(24,360)

WDV (Closing Balance)

33,640

Year 3
WDV (Opening Balance)

33,640
Depreciation 33,640 x 42%
(14,128)
WDV (Closing Balance)
19,511

Disposal of Asset

Cost of Asset

= 100,000
Life of the Asset
= 5 Years
Depreciation Method
= Straight Line
Residual Value
= Rs.10000
Sale Price after Five Years
= Rs.15000

Depreciation per year = (100000-10000) / 5

= Rs.5000 per year

Total Depreciation in Five Years
= 18,000 x 5 = 90,000

Book Value after Five Years
= 100,000- 90,000 = 10,000

Profit on Disposal
= 15,000 – 10,000 = Rs.5000

Recording of Disposal

Debit Fixed Asset Disposal A/c

100,000
Credit Fixed Asset Cost A/c
100,000
(With the cost of asset)

Debit Accumulated Dep. A/c

90,000
Credit Fixed Asset Disposal A/c
90,000
(With the depreciation accumulated to date)

Debit Cash / Bank / Receivable A/c

15,000
CCredit Fixed Asset Disposal A/c
15,000

(With the price at which asset is sold)

[Note: one group to appear at a time]

Disposal of Asset Account

Fixed Asset Disposal Account
Debit Credit
Cost Account 100,000 Acc. Dep. Account 90,000
    Cash / Bank 15,000
P & L Account
( Balancing Figure)
5000    
Total 105000 Total 105000

Policy for Depreciation

The management of the business selects the policy for charging depreciation. There is no law binding on the management. The management is free to choose method of depreciation and policy of charging depreciation. Normally two policies are commonly used:
• Depreciation on the basis of use
• In the year of purchase, full year’s depreciation is charged; where as, in the year of sale no depreciation is charged.
Now it is up to the management to decide, what method and what policy is better and effective for their business.

Disposal of Fixed Asset

When depreciable asset is disposed off at any time during the financial year, an entry should be made to give effect of the disposal. Since, the residual value of asset is only estimated; it is common for asset to be sold at price that differs from its book value at the date of disposal. When asset is sold, any profit or loss is computed by comparing book value with the amount received from sale. As you know, book value is obtained by deducting accumulated depreciation from original cost of the asset. A sale price in excess of the book value produces profit; a sale price below the book value produces loss. This profit or loss should be shown in the profit & loss account.

Entries for Recording Disposal

Debit Fixed Asset Disposal A/c
Credit Fixed Asset Cost A/c
(With the cost of asset)

Debit Accumulated Dep. A/c
Credit Fixed Asset Disposal A/c
(With the depreciation accumulated to date)

Debit Cash / Bank / Receivable A/c
Credit Fixed Asset Disposal A/c
(With the price at which asset is sold)

Example

  • An asset is purchased for Rs. 500,000 on Nov. 01, 2001.
  • Depreciation rate is 10% p.a.
  • The Asset is sold on Apr. 30, 2004.
  • Financial Year is July 1 to June 30

Required:

Calculate the WDV For both policies

Depreciation is charged on the Basis of Use

Year On the Basis of Use Rs.
1-11-2001 Cost 500,000
2001-2002 Dep. 500,000 x 10% x 8 / 12 (33,333)
30-6-2002 WDV 466,667
2002-2003 Dep. 466,666 x 10% (46,667)
30-6-2003 WDV 420,000
2003-2004 Dep. 420,000 x 10% x 10 / 12 (35,000)
30-4-2004 WDV 385,000

Full Depreciation in the Year of Purchase

Year On the Basis of Use Rs.
1-11-2001 Cost 500,000
2001-2002 Dep. 500,000 x 10% (50,000)
30-6-2002 WDV 450,000
2002-2003 Dep. 450,000 x 10% (45,000)
30-6-2003 WDV 405,000
2003-2004 Dep. 00 in the year of sale 00
30-6-2004 WDV 405,000

Contents of Fixed Assets Register
• Different record for each class of assets
• Date of purchase
• Detailed particulars of asset
• Location of asset
• Record of depreciation

Illustration
Cost of asset

Rs. 200,000
Life of the asset
5 years
Depreciation method
Straight line
Residual value
Rs. 20,000
Sale price after 5 years
Rs.30,000

Calculate profit/Loss on the sale of the asset?

Solution

Written down value = 200,000 – 20,000 = 180,000
Depreciation/year = 180,000/5 = 36,000 (Straight line method)

Particulars Depreciation
(Rs)
Written
Down
Value (Rs.)
Depreciable cost
Dep. Of the 1st year
Dep. Of the 2nd year
Dep. Of the 3rd year
Dep. Of the 4th year
Dep. Of the 5th year
(36,000)
(36,000)
(36,000)
(36,000)
(36,000)
200,000
164,000
128,000
92,000
56,000
20,000

Book value after five years

Rs. 20,000
Sale price
Rs. 30,000
Profit on sale
Rs. 10,000 (30,000 – 20,000)

Same illustration is solved by reducing balance method

Cost of asset

Rs. 200,000
Residual value
Rs. 20,000
Estimated useful life
5 years

Calculation of depreciation rate

Depreciation Rate = 1 – n√Rv/c
_____________
= 1 - 5√20,000/200,000
= 37%
Allocation of depreciation is given below:

Particulars Depreciation
(Rs)
Accumulated
Depreciation
(Rs.)
Written Down Value
(Rs.)
Depreciable cost     200,000
Dep. Of the 1st year
200,000 x 37%
74,000 74,000 126,000
Dep. Of the 2nd year
126,000 x 37%
46,620 120,620 79,380
Dep. Of the 3rd year
79,380 x 37%
29,371 149,991 50,009
Dep. Of the 4th year
50,009 x 37%
18,503 168,494 31,506
Dep. Of the 5th year
31,506 x 37%
11,657 180,151 19,849

Book value after five years

Rs. 19,849
Sale price
Rs. 30,000
Profit on sale
Rs. 10,151 (30,000 – 19,849)

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