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Depreciation

Published in: Accountancy | B.Com Tuition | MBA
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Explains the Concept of Depreciation and Various Methods of Charging and Recording Depreciation.

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    Depreciation, Provisions and
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    Chapter Objectives ' Understand the concept of depreciation ' Identify the causes of depreciation ' Explain the meaning of depreciation accounting ' Compute depreciation according to different methods of providing depreciation ' Explain the role of depreciation policy 1/10/2018 Dr, Amit Gupta
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    Depreciation ' Depreciation is defined as the gradual decrease in the value of an asset. ' Causes of depreciation are: — Wear and tear — Exhaustion — Obsolescence — Efflux of time — Accidents 1/10/2018 Dr, Amit Gupta
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    Features of Depreciation ' It is applicable to all fixed assets except some assets like land and antique. ' It is a charge against profits and true profit of a business can only be computed after charging depreciation. ' It differs from maintenance expenses, which are incurred for keeping the machines in a workable state. 1/10/2018 Dr, Amit Gupta
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    Depreciation Accounting ' Depreciation accounting is concerned with distributing the cost of a tangible asset over its estimated useful life. Objectives of depreciation accounting are: — To determine true profit of business — To provide true financial position of business — To provide funds for the purchase of new assets 1/10/2018 Dr, Amit Gupta
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    Fixation of Depreciation Amount ' Depreciation amount of a particular asset is computed and is charged to the profit and loss account. ' Depreciation amount in respect to a particular asset depends upon the following factors: — Cost of asset — Estimated scrap value — Estimated useful life 1/10/2018 Dr, Amit Gupta
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    Methods for Providing Depreciation The methods used for computing depreciation are classified into three categories: — Uniform charge methods — Declining charge or accelerated depreciation methods — Other methods 1/10/2018 Dr, Amit Gupta
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    Uniform Charge Methods ' In these methods a uniform depreciation amount is charged every year. The various uniform charge methods are: — Fixed installment method: It is also known as Straight Line Method (SLM). It provides a fixed amount of depreciation every year. In this, depreciation is computed by dividing the difference of original cost of asset and estimated scrap value by the estimated life of the asset in yea r S. 1/10/2018 Dr, Amit Gupta
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    Uniform Charge Methods (contd.) — Depletion method: It is also known as productive output method. In this, depreciation depends upon the actual cost of the asset and actual and estimated quantities of output to be produced using the asset. — Machine hour rate method: It is also known as service hours method. In this, depreciation depends upon the running time of the asset. Depreciation is computed by dividing the difference of asset and scrap value by the life of the asset in hours. 1/10/2018 Dr, Amit Gupta
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    Declining Charge Depreciation Methods ' In these methods, the depreciation amount to be charged decreases with the expected life of the asset. The various declining charge depreciation methods are: — Diminishing balance method: Depreciation is computed on the book value of the asset. Depreciation rate is obtained using the formula: 1/10/2018 Dr, Amit Gupta 10
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    Declining Charge Depreciation Methods (contd.) — Sum of years digits method: It is similar to the diminishing balance method. Depreciation is computed as the product of remaining life of asset divided by the sum of n digits, where n is the estimated life of asset in year, and original cost. 1/10/2018 Dr, Amit Gupta
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    Other Methods Group depreciation method: In this, the homogeneous assets having similar average life are grouped together under a common summary account. The depreciation rate is computed from the expected average life and the scrap values of assets of a group. ' Inventory system depreciation: In this, depreciation is computed for the assets whose expected life cannot be determined. Depreciation amount is computed by subtracting the cost of asset at the end of the accounting period from the total cost of the asset available at the beginning and purchased during the accounting period. 1/10/2018 Dr, Amit Gupta
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    Other Methods (contd.) ' Annuity method: In this, depreciation is computed by considering the cost of asset and the interest on the actual cost of the asset that the business would have earned if the amount have been invested in some investment. ' Depreciation fund method: In this, the depreciation amount is invested in some securities. This helps in the business to gather funds for the purchase of new assets. 1/10/2018 Dr, Amit Gupta 13
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    Other Methods (contd.) ' Insurance policy method: In this, the business takes an insurance policy for a particular amount and pays a fixed amount of premium every year. At the end of the duration of insurance policy, the insurance company pays the insured amount, which is used by the business to buy new assets. 1/10/2018 Dr, Amit Gupta 14
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    Depreciation Policy Objectives of depreciation policy: — To recover the amount invested in purchasing an asset before the expiry of the economic life of the asset. — To ensure that a uniform rate of return on investment is achieved. — To generate funds for purchasing of new asset after the expiry of an old asset. — To determine correct profit and loss information of the business. 1/10/2018 Dr, Amit Gupta 15
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    Depreciation Policy (contd.) Aspects that should be considered while developing the depreciation policy: — An appropriate method for computing depreciation should be selected depending upon the nature of assets and objectives of the management. — The provisions for depreciation should be periodically reviewed. — The depreciation policy should be evaluated in the context of tax, price level changes and Government regulations. 1/10/2018 Dr, Amit Gupta 16
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    Methods of Recording Depreciation ' To record the depreciation in the books of account, two methods are used: — Using Provision for Depreciation account — Without using Provision for Depreciation account 1/10/2018 Dr, Amit Gupta 17
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    Methods of Recording Depreciation (contd.) Using Provision for Depreciation account: — The Provision for Depreciation account is credited with the depreciation amount chargeable in a year. — The Asset account provides the original cost of asset. — The Provision for Depreciation account is transferred to the Asset account, when the asset is sold. Without using Provision for Depreciation account: — The Depreciation account is debited with the depreciation amount chargeable in a year and the same amount is credited to the Asset account. — The Depreciation account is transferred to the Profit and Loss account. 1/10/2018 Dr, Amit Gupta 18
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    Methods of Recording Depreciation (contd.) ' In both the methods, when the asset is sold: — On profit, the balance of Asset account is transferred to the Profit and Loss account. — On loss, the amount realized on account of sale is transferred to the Asset account. 1/10/2018 Dr, Amit Gupta
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    Provision ' Provision is the amount that is set aside from the profits of the business for providing: — Depreciation, renewals and decrease in the value of assets. — An known liability, which cannot be determined. ' It is a charge against profits and is created by debiting the Profit and Loss account. ' It cannot be distributed as profits. ' Examples: Provision for bad debts, provision for repairs and renewals and provision for discount. 1/10/2018 Dr, Amit Gupta 20
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    Reserve ' Reserve is the portion of earnings and receipts of a business that is kept aside for a specific purpose other than a provision for depreciation. ' It is an appropriation of profits that ultimately results to an increase in the funds of the proprietor. ' It can be distributed as profits, if required. ' It is shown on the liability side of the Balance Sheet under the heading Reserves and Surplus. 1/10/2018 Dr, Amit Gupta
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    Reserve Funds ' Reverse funds are the reserves that are kept for investment outside the business. ' Types of reserve funds: — Revenue reserves: They are created out of revenue profits of the business. — Capital reserves: They are created out of capital profits of the business. — Secret reserves: They are the reserves that are not shown on the Balance Sheet. 1/10/2018 Dr, Amit Gupta 22

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