Depreciation Research Assignment

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INTERNAL RESEARCH ASSIGNMENT


Topic of assignment: DEPRECIATION ACCOUNTING

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Q. A firm purchased on 1st January, 1994 certain machinery for Rs 58,200 and spent Rs 1,800 on its erection. On 1st july, 1994 additional machinery costing Rs 20,000 was purchased. On 1st July, 1996 the machinery purchased on 1st January, 1994 having become obsolete was auctioned for Rs 28,600 and on the same date fresh machinery was purchased at a cost of Rs 40,000.

Depreciation was provided for annually on 31st December at the rate of 10% on written down value. In 1997, however, the firm changed this method of providing depreciation on the original cost of the machinery.

Give the Machinery Account as it would stand at the end of each year from 1994 to 1997.

MEANING OF FIXED ASSETS

NATURE

These are assets held with the intention of being used held on continuous basis for the purpose of producing or providing goods or services and are not held for resale in the normal course of business. Thus, the following are the characteristics of Fixed Assets-

  1. They are acquired for relatively long period for carrying on business of the enterprise.
  2. They are not intended for resale in the ordinary course of business.

Following are examples of the assets which fall in this category: Land, Building, Plant and Machinery, Furniture and Fittings, Motor Vans, etc.

Mode of Valuation

While valuing the fixed assets, the following accounting concepts are important:

  1. The fixed assets are meant for carrying on the operations of the business either by way of manufacturing the products or generating supporting services e.g., for transporting employees or goods or products purchased or sold by the company. They are not meant for resale and hence while valuing them the "going concern" concept of accounting is quite relevant. According to this concept it is assumed that the business will continue for a fairly long time to come. There is neither the intention nor the necessity to liquidate the particular business venture in the foreseeable future. Fixed asset are not meant for resale and hence it will be appropriate to value the assets at cost rather than their estimated realizable value in the event of the liquidation of the business.
  1. A closely related accounting concept to the "going concern" concert is the "cost concept" of accounting. According to is concept, an asset is ordinarily entered in the accounting records at the price paid to acquire it and this cost is the basis for all accounting for the same. On account of this concept the fixed asset should be valued at cost and subsequent increase or decrease in their market values should not be taken into account. The only exception to the statement is the diminution in the value of the fixed asset on account of depreciation. Thus, the fixed assets are to be shown at cost less appropriate depreciation. The ‘cost concept’ has the advantage of bringing objectivity in accounting. In the absence of this concept the valuation of the fixed asset would have been influenced by the personal bias or judgement of accounting causing distortions in the financial statements of the firm.

The cost of the fixed asset comprises its purchase price and any attributable cost of bringing the asset to its working condition for its intended use. Financing cost relating to deferred credits or to borrowed funds attributable to construction or acquisition of fixed assets for the period upto the completion of construction or acquisition of fixed assets should also be included in the cost of the asset to which they relate. However, the financing cost (including interest) of fixed assets purchased on a deferred credit basis or on money borrowed for construction or acquisition of fixed assets should not be capitalised to the extent that such costs relate to periods after such assets are ready to be put to use. The cost of a constructed fixed asset should comprise those costs that relate directly to the specific asset and those that are attributable to the construction

activity in general and can be allocated to the specific asset. When a fixed asset is acquired in exchange or in part exchange of other asset, the cost of the asset acquired should be recorded either at fair market value or the net book value of the asset given up, adjusted for any balancing payment or receipt of cash or other consideration. The valuation of fixed assets at cost and charging depreciation on cost basis creates problem for replacement of these assets under inflationary conditions. As a matter of fact, on account of continued inflationary tendencies, the preparation of the financial statements on the basis of historical cost has become largely irrelevant for judging the financial position of the business. As a result, there has been a growing demand by the accountants all over the world that the fixed assets should be valued at their current replacement price and depreciation be also charged in respect of them accordingly. Several studies have been made in this direction and the Institute of Cost and Management Accountants, London, the Institute of Chartered Accountants of India, etc., have made suitable suggestions. They have advocated for the adoption of current accounting methods as contained in the Statement of Standard Accounting Practice 16 (SSAP 16) issued by the Accounting Committee of U.K. However, this standard has also raised a lot of controversies. It is yet to be given recognition by the Government for presentation of accounts by the corporate bodies. As such the 'cost concept' of accounting still holds good for valuation of fixed assets.

DEPRECIATION

The concept of depreciation is closely linked to the concept of business income. In the revenue generating process the use of long-term assets tend to consume their economic potential. At some point of time these assets becomes useless and are disposed of and replaced. The economic potential so consumed represents the expired cost of these assets and must he recovered from the revenue of the business in order to determine the income earned by the business. Depreciation may, therefore, be defined as that portion of the cost of the rise that is deducted from revenue for assets' services used in the Operation of a business.

In order to have a clear understanding about the concept of depreciation, it will be useful to quote definitions given by some prominent writers. According to Pickles, ''Depreciation is the permanent and continuing diminution in the quality, quantity or value of an asset". The institute of Chartered Accountants of England and Wales defines depreciation as "that part of the cost of a fixed asset to its owners which is not recoverable when the asset is finally put out of use by him. Provision against this loss of capital is an integral cost of conducting the business during the effective commercial life of the asset and is not de amount of profit earned".

According to Spicer and Pegler, depreciation may be defined as, "the measure exhaustion of the effective life of an asset from any cause during a given period". From the above definitions, it can he concluded that depreciation is a gradual decrease in the value of an asset from cause.

CAUSES OF DEPRECIATION

The causes of depreciation are as follows:

  1. Wear and tear

Wear and tear of the assets due to constant usage or daily usage of the plant and machinery and furniture and fixture in the factory.

  1. Exhaustion

An asset may get exhausted through working. This is the case with mineral mines. oil wells etc. On account of continuous extraction of minerals or oil, a stage comes hen the mine or well gets completely exhausted and nothing is left.

  1. Obsolescence

Some assets are discarded before they are worn out because of changed conditions. For examples an old machine which is still workable may have to he replaced by a new machine because of the latter being more efficient and economical. Such a loss on account of new inventions or changed fashions is termed as loss on account of obsolescence.

  1. 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 or copy rights.

  1. Accidents

An asset may meet an accident and, therefore, it may get depreciated in its value.

On the basis of the above causes, it can he said that depreciation is the decrease or depletion in the value of an asset due to wear and tear, lapse of time, obsolescence, exhaustion and accidents.

BASIC FEATURES OF DEPRECIATION

  1. The term depreciation is used only in respect of fixed assets. Of course. the current assets may also lose their value. Loss on account of fall in their value is taken care of by valuing them for Balance Sheet purposes "at cost or market price whichever is less.”
  1. Depreciation is a charge against profits. This means that true profit of the business cannot he ascertained without charging depreciation.

3. Depreciation is different from maintenance. Maintenance expenses are incurred for keeping the machine in a state of efficiency. However, any degree of maintenance cannot assure that the asset will never reach a state. of scrap, Of course, good maintenance delays this stage but it cannot absolutely prevent it.

4. All fixed assets, with certain possible exceptions e.g., land. and antiques etc., suffer depreciation although the process may he invisible or gradual.

DEPRECIATION, DEPLETION, AMORTIZATION AND DILAPIDATIONS

The term 'depreciation' is to be distinguished from other terms such as depletions, amortization, etc., though they are used often interchangeably.

Depletion

Depletion implies removal of an available but irreplaceable resource„ g Coal from a coal mine or oil out of an oil well.

Amortization

The process of writing off intangible assets is termed as amortization. Some intangible assets like patents, copyrights, leasehold, have limited useful life. Hence, their cost must be written off over such periods.

The American Institute of Certified Public Accountants (AICPA) has put the difference between depreciation, depletion, and amortization in the following words.. "Depreciation can be distinguished from other terms with specialised meaning used by accountants to describe the assets cost allocation procedures, Depreciation is concerned with charging the cost of man-made fixed assets to operation (and not with determination of asset value for the balance sheet). Amortization relates to cost allocation for intangible assets such as patent and leaseholds. The use of the term depreciation should also be avoided in connection with the valuation procedures for securities and investments”

Dilapidations

The term dilapidation refers to damage done to a building or other property during tenancy. When a property is taken on lease, is returned to the landlord he may ask the lessee as per agreement to put it in as good condition as it was at the time it was leased out. In order to meet cost such dilapidation, a provision may be created by debiting the property account with the estimated amount of dilapidation and crediting the provision for dilapidation account. Depreciation may then he charged on the total coat of the asset so arrived at. Any payment made later on dilapidation may be debited to the provision for dilapidation account. The balance, if any, may he transferred to profit and loss account.

MEANING OF DEPRECIATION ACCOUNTING

Depreciation Accounting is mainly concerned with a rational and systematic distribution of cost over the estimated useful life of the asset. According to the American Institute of Certified Public Accountants, Depreciation Accounting is 'a system of accounting which aims to distribute the cost or other basic values of the tangible capital assets less salvage Of any) over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is the process of allocation and not of valuation". The objective of Depreciation Accounting is to absorb the cost of using the assets to different accounting periods in a way so as to give the true figure of profit or loss made by the business.

OBJECTIVES OF PROVIDING DEPRECIATION

The following are objectives of providing depreciation

  1. Ascertainment of true profits

When an asset is purchased, it is nothing more than a payment in advance for an expense, For example, if a building is purchased for Rs.10,000 for business, the effect of such a purchase will be saving in the cost of rent in the future. But, after a certain number of years, the building will become useless. The cost of building is, therefore, nothing except paying rent in advance for a period of years. If the rent had been paid, it would have been charged as an expense for determination of the true profits, made by the business during a particular period. The amount paid for the purchase of building should, therefore, be charged Over a period of time for which the asset would be serviceable.

  1. Presentation of true financial position

The assets get depreciated in their value over a period of time on account of various factors as explained before. In order to present a true state of affairs of the business, the assets should' be shown in the Balance sheet, at their proper values.

  1. Replacement of assets

Assets used in the business need replacement after the expiry of their service life. By providing depreciation a part of the profits of the business is kept in the business which can be used for purchase of new assets on the old fixed assets becoming useless.

METHODS FOR PROVIDING DEPRECIATION

The following are various methods for providing depreciation:

  1. Uniform charge methods

(a) Fixed instalment method

(b) Depletion method

(c) Machine hour rate method

2. Declining charge or accelerated depreciation methods

(a) Diminishing balance method

(b) Sum of years digits method

(c) Double declining method

3. Other methods

(a) Group depreciation method

(b) Inventory system of depreciation

(c) Annuity method

(d) Depreciation fund method

(e) Insurance policy method

FIXATION OF DEPRECIATION AMOUNT

Following are the three important factors which should be considered for determining the amount of depreciation to be charged to the Profit and Loss Account in respect of a particular asset.

  1. Cost of the asset

The cost of the asset includes the invoice price of the asset, less any trade discount plus all costs essential to bring the asset to a useable condition. It should he noted that financial charges, such as interest on money borrowed for the purchase of the asset, should not be included in the cost of the asset.

  1. Estimated scrap value

The term scrap value means the residual or the salvage value which is estimated to be realised on account of the sale of the asset at the end of its useful life. In determining the scrap value, the cost to be incurred in the disposal or removing of the asset should be deducted out of the total realisable value.

  1. Estimated useful life

This is also termed as economic life of the asset. This may be calculated in terms of years, hours, units of output or other operating measures such as kilometers in case of a taxi or a truck.

DEPRECIATION POLICY

The management has to adopt a suitable depreciation policy keeping in view the following objectives:

  1. Recovery of the original investment, i.e., the acquisition cost of the asset, before the expiry of the economic life of the asset.
  2. Ensuring a uniform rate of return on investments.
  3. Generating sufficient funds for the replacement of the asset after the expiry of its economic life.
  4. Deriving maximum tax benefit.
  5. Ascertainment of correct profit or loss.

The above objectives can be considerably achieved if the management takes care of the following aspects in fanning its depreciation policy.

  1. Selection of an appropriate method

The management should select an appropriate method keeping in view the nature of the asset and the prime objective of the management

  1. Periodic review of provision

The choice of the method determines the amount of the management. the depreciation and the mode of its recording. However, the management must review periodically whether the provision for depreciation which is being made is proper or not. Any under or over provision in the context of changed circumstances should property be adjusted in the books of accounts

  1. Evaluation and disclosure of depreciation policy

The depreciation policy being. followed by the business should be evaluated in the context of tax , incidence of price level changes, government regulation etc. The effect of any change in the depreciation policy in an accounting period should be quantified and disclosed in the financial statement of the business.

MACHINERY ACCOUNT

DATE

PARTICULARS

AMOUNT(RS)

DATE

PARTICULARS

AMOUNT(RS)

1994

1994

1/1

To bank A/c (M1)

58,200

31/12

By depreciation A/c

7,000

1/1

To bank A/c (erection)

1,800

M1=6,000

1/7

To bank A/c (M2)

20,000

M2=1,000

31/12

By balance c/d

73,000

M1=54,000

M2=19,000

80,000

80,000

1995

1995

1/1

To balance b/d

73,000

31/12

By depreciation A/c

7,300

M1=54,000

M1=5,400

M2=19,000

M2=1,900

31/12

By balance c/d

65,700

M1=48,600

M2=17,100

73,000

73,000

1996

1996

1/1

To balance b/d

65,700

1/7

By bank (sale price)

28,600

M1=48,600

1/7

By depreciation on

2,430

M2=17,100

Machinery sold (6 m)

1/7

To bank A/c (M3)

40,000

1/7

By P&L A/c (loss)

17,570

31/12

By depreciation A/c

3,710

M1=1,710

M3=2,000

31/12

By balance c/d

53,390

M2=15,390

M3=38,000

1,05,700

1,05,700

1997

1997

1/1

To balance b/d

53,390

31/12

By depreciation A/c

6,000

M2=15,390

M2=2,000

M3=38,000

M3=4,000

31/12

By balance c/d

47,390

M2=13,390

M3=34,000

53,390

53,390

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