METHODS FOR CHARGING DEPRECIATION - Accounts and Finance for Managers

There are various methods of depreciation:

  1. Straight line method
  2. Depletion or Output method
  3. Machine hour rate method
  4. Diminishing Balance or Written down method
  5. Sum of digits method
  6. Annuity method
  7. Sinking fund method
  8. Insurance policy method

Among the above mentioned methods, Straight line method and Diminishing balance or written down method are more important methods. These two methods are preferable and renowned methods among the industrialists in charging the depreciation on the fixed assets. The first method is as follows

Straight Line Method

This method, depreciation is calculated as a fixed proportion on the original value of the asset. The depreciation is charged as fixed in volume on the original value of the asset at which it was purchased. The original value of the asset is nothing but the purchase value of the asset.

Illustration 1

Cost of Machine – Rs. 1, 00, 000
Estimated life of the machine – 5 years
Scrap value-Nil

Depreciation=
Cost of the machine -Scrap value
Economic Life period of the asset in years


According to the concept of depreciation, the value of the asset is dispersed throughout the life of the period in order to match against the respective earnings of the year after year The purchase value of the asset is an expenditure to be stretched to many number of years in order to equate with the revenues. To equate the revenues, the scrap value of the asset at the end of the life period is realized should be deducted and apportioned to the total number of the economic life period of the asset. The aim of deducting the scrap value of the asset is reducing the original value of the investment

From the above table, Rs. 20,000 is charged on every year to recover Rs. 1,00,000 during its life period i.e. 5 years

Illustration 2

Original value of the investment- Rs. 1, 00, 000
Scrap value – Rs. 10, 000
Life of the asset -5 years

The scrap value of the asset is expected to realize only at the end of the life period of the asset i.e. 5 years.

Illustration 3

Mr.Shankar purchased machine for Rs. 90, 000 on 1st April 1999. It probable working life was estimated at 5 years and its probable scrap value at the end of that time is Rs. 10,000. You are required to prepare necessary account based on straight line method of depreciation for five years
To prepare the various accounts of the enterprise connected to depreciation is as follows

The depreciation charge process is carried out in three stages

  • The asset to be initially purchased- Purchase entry has to be carried out. How the purchase is made ? While making the purchase there are two different accounts get affected which are normally known as real accounts. At the moment of purchase on one side the asset is coming inside the firm ; on the other side the cash resources are depleted due to the payment of purchase bill of the asset.
  • The next account involved in the process of accounting is depreciation account. Before transacting the depreciation entry in the books of accounts, we must find the amount of depreciation to be charged against on every year’s revenue.
  • The amount of depreciation is to be calculated as follows:
  • Depreciation is a fixed charge to be calculated on the value of the asset on every year and deducted from the original value. Depreciation is nothing but charged as an expenditure against the revenues in accordance with the matching concept. Hence the depreciation non recurring expenditure account and the plant & machinery account should be debited and credited respectively
  • For the accounting entry I year depreciation
  • For the accounting entry II year depreciation
  • For the accounting entry III year depreciation
  • For the accounting entry IV year depreciation
  • For the accounting entry V year depreciation
  • The next account involved is the scrap value account which amounted Rs 10, 000 While selling the residual portion of the asset, the firm is able to receive Rs. 10,000 as receipt as cash. The sale of residual part of the machinery leads to bring cash resources inside the firm and inturn the plant and machinery is going out of the firm.
  • For the accounting entry of scrap value
  • The next transaction is the final transaction pertaining to the posting of depreciation accounting balance under the P& L account
  • It is nothing but the transfer of Depreciation accounting balance into P&L account At the end of every year immediately after finalizing the accounting balance of depreciation is regularly posted under the P&L account.
  • The journal entry transfer is carried out as follows
  • For the I year depreciation transfer to P&L A/c
  • For the II year depreciation transfer to P&L A/c
  • For the III year depreciation transfer to P&L A/c
  • For the IV year depreciation transfer to P&L A/c
  • For the V year depreciation transfer to P&L A/c

The preparation of Plant & Machinery account : It is very simple to prepare the machinery Ledger account

Illustration 4

M/s Muruganand &Co is a trader bought furniture costing Rs 2,20,000 for his new branch on 1st April, 2000. As the furniture bought was superior quality material. The auditors estimated its residual valued at Rs. 20,000 after a working life of ten years. Further additions were made into the same category on 1st Oct, 2001 and 1st April, 2002 which costing Rs 16,800 and Rs. 19,000 (with a scrap value of Rs 800 and Rs. 1000 respectively). The trader closed his accounts on 31st Mar every year and wanted to apply straight line method of depreciation. Show the furniture a/c for four years.

First step is to find out the depreciation of the furniture for various number of years i-e 4 years. The depreciation is to be calculated on every year.
The most important point to be borne in our mind while calculating depreciation, the following points to be taken into consideration
First, is there any % of depreciation charge given. If given, the depreciation to be calculated on the volume of available balance at the end.
Secondly, if the % of depreciation charge is not given in our problem, How the volume of depreciation can be calculated ?
The depreciation can be calculated as follows

Depreciation=
Original value of the asset -Scrap value
Life period of the asset


In this problem, due to absence of depreciation %, the above illustrated formula should have to be applied throughout the problem

ACCOUNTING ENTRIES FOR THE ACCOUNTING YEAR 2000-2001

ACCOUNTING ENTRIES FOR THE ACCOUNTING YEAR 2001-2002

ACCOUNTING ENTRIES FOR THE ACCOUNTING YEAR 2002-2003

ACCOUNTING ENTRIES FOR THE ACCOUNTING YEAR 2003-2004

Merits

  • It is simple to calculate only due to fixed depreciation charge on the value of the asset
  • The value of the asset is depleted to either zero or scrap value of the asset
  • This method is most suited for patents trade marks and so on

Demerits

  • The utility of the asset is not considered at the moment of charging constant depreciation over the asset
  • During the later years of the asset, the efficiency will automatically come down and simultaneously the maintenance cost of the asset will rigger up which is illogical in charging fixed charge throughout the life period of the asset

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