Depreciation | ISC Class 11 Accounts Notes

This note covers depreciation: its meaning, need, causes, objectives, characteristics and the factors affecting its amount; the straight line and written down value methods of calculating depreciation with their advantages and limitations; the differences between the two methods; the two ways of recording depreciation in the books (charging it to the asset account, and maintaining a provision for depreciation/accumulated depreciation account); and how the purchase and sale of assets are recorded under both methods, with and without an asset disposal account.

What is depreciation and what are its characteristics?

Fixed assets, technically called depreciable assets, are used in a business for more than one accounting year and tend to lose value once they are put to use.

Depreciation means the decline in the value of a fixed asset due to use, passage of time or obsolescence.

As an accounting term, it is that part of the cost of a fixed asset which has expired on account of its usage and/or lapse of time, so it is a charge against the revenue of a given accounting period.

Definition: Depreciation (AS-6). Accounting Standard-6 issued by the Institute of Chartered Accountants of India (ICAI) defines depreciation as "a measure of the wearing out, consumption or other loss of value of depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change. Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is pre-determined".

The Institute of Cost and Management Accounting, London (ICMA) describes depreciation more briefly: "The depreciation is the diminution in intrinsic value of the asset due to use and/or lapse of time." AS-6 further explains that depreciable assets are those which are expected to be used during more than one accounting period, have a limited useful life, and are held for use in production or supply of goods and services, for rental to others, or for administrative purposes, and not for sale in the ordinary course of business.

The features of depreciation, drawn together from these ideas, are:

1. It is a decline in the book value of fixed assets, based on cost and not on market value.
2. It includes loss of value due to effluxion of time, usage or obsolescence.
3. It is a continuing process that occurs throughout the asset's life.
4. It is an expired cost and must be deducted before calculating taxable profits.
5. It is a non-cash expense; it does not involve any cash outflow, being merely the process of writing off capital expenditure already incurred.

What are the causes of depreciation?

The causes of depreciation are set out, as part of the AS-6 definition, under four heads.

1. Wear and tear due to use or passage of time. Deterioration arises from an asset's use in business operations for earning revenue, which reduces its technical capacity. An asset also deteriorates simply with the passage of time, even if not used, especially where it is exposed to weather, wind or rain.
2. Expiration of legal rights. Certain assets, such as patents, copyrights and leases, lose their value once the agreement governing their use comes to an end after a pre-determined period.
3. Obsolescence. This means an existing asset becoming out-of-date because a better type of asset is available. It arises from technological changes, improvements in production methods, changes in market demand for the asset's output, or legal or other restrictions.
4. Abnormal factors. Accidents such as fire, earthquake or floods may cause a decline in usefulness. Such accidental loss is permanent but not continuing or gradual, for example a car repaired after an accident will not fetch the same price even though it has not been used further.

Why is depreciation needed?

Charging depreciation in the accounting records arises from conceptual, legal and practical business considerations.

1. Matching of costs and revenue. Since assets are used to earn revenue and inevitably undergo wear and tear, depreciation is as much a cost as salary, carriage or postage, and must be deducted before arriving at net profit under Generally Accepted Accounting Principles.
2. Consideration of tax. Depreciation is a deductible cost for tax purposes, though tax rules for calculating the amount need not be the same as current business practice.
3. True and fair financial position. If depreciation is not provided, assets will be overvalued and the balance sheet will not show the correct financial position; this is not permitted by established accounting practice or by specific provisions of law.
4. Compliance with law. Apart from tax regulations, certain specific legislations indirectly compel organisations such as corporate enterprises to provide depreciation on fixed assets.

What are the objectives of providing depreciation?

The objectives of providing depreciation are the purposes that the annual charge serves in the accounts. They are closely related to the need for depreciation but are stated separately, because a question may ask for the objectives or advantages of providing depreciation.

1. To ascertain the true profit or loss. Depreciation is a charge against profit, so profit is not overstated by ignoring the expired cost of the asset.
2. To show a true and fair financial position. The asset is shown at its book value, so the balance sheet does not overstate the assets of the business.
3. To provide for the replacement of the asset. The amount charged year after year is retained in the business, so that funds are available to replace the asset when its useful life ends.
4. To match costs with revenue. The cost of the asset is spread over the periods that enjoy its benefit, in line with the matching principle.
5. To comply with legal requirements. Tax regulations and specific legislations require depreciation to be provided on fixed assets.

Note: The objectives and the need for depreciation overlap. The need explains why the charge cannot be avoided; the objectives state what the charge achieves in the profit and loss account and the balance sheet.

What factors affect the amount of depreciation?

The amount of depreciation to be charged depends on three parameters: cost, estimated useful life and probable salvage value.

Cost of the asset

Also called the original cost or historical cost, this includes the invoice price plus costs necessary to put the asset into use, such as freight, transit insurance, installation and registration costs and commission paid on purchase.

For a second-hand asset it also includes initial repair cost to make it workable. For example, a photocopy machine bought for ₹50,000 with ₹5,000 spent on transport and installation has an original cost of ₹55,000.

Estimated net residual value

Net residual value (also called scrap value or salvage value) is the estimated net realisable value of the asset at the end of its useful life, after deducting expenses necessary for its disposal.

For example, if a machine costing ₹50,000 is expected to have a sale value of ₹6,000 at the end of ten years, less ₹1,000 disposal expenses, its net residual value is ₹5,000.

Depreciable cost

Depreciable cost equals cost less net residual value. Continuing the example above, the depreciable cost of the machine is ₹50,000 minus ₹5,000, that is ₹45,000, and this amount is what gets distributed and charged as depreciation over the asset's useful life.

If the total depreciation charged is less than the depreciable cost, the capital expenditure is under-recovered and the matching principle is violated.

Estimated useful life

Useful life is the estimated economic or commercial life of the asset, not its physical life, since an asset may still exist physically but no longer be capable of commercially viable production.

Useful life is usually expressed in years but can also be expressed in output units or working hours, and it depends on legal or contractual limits, the number of shifts worked, repair and maintenance policy, technological obsolescence and innovation in production methods.

Definition: Depreciable cost. The historical cost of an asset, or other amount substituted for historical cost, less its estimated net residual (salvage) value, distributed as depreciation over its useful life.

How is depreciation calculated under the straight line method?

The straight line method assumes equal usage of the asset over its entire life, so a fixed and equal amount is charged as depreciation in every accounting period.

It is called straight line because, if the depreciation amount is plotted against time, it produces a straight line, and it is also called the fixed instalment method or the fixed percentage on original cost method.

Annual Depreciation = (Cost − Residual Value) ÷ Useful Life

Rate of Depreciation = (Annual Depreciation ÷ Cost) × 100

For example, an asset costing ₹2,50,000, with a useful life of 10 years and a net residual value of ₹50,000, gives annual depreciation of (₹2,50,000 − ₹50,000) ÷ 10 = ₹20,000, and a rate of (₹20,000 ÷ ₹2,50,000) × 100 = 8%.

Years are plotted on the horizontal axis and the amount of depreciation on the vertical axis. Because the same amount is charged every year, the plotted points lie on a straight horizontal line.

Advantages of the straight line method

• It is very simple, easy to understand and apply, which makes it popular in practice.
• The asset can be depreciated up to its net scrap value or to zero, so the full depreciable cost can be spread over its useful life.
• The same amount is charged as depreciation each year, which makes comparison of profits across years easy.
• It suits assets whose useful life can be estimated accurately and whose use is consistent from year to year, such as leasehold buildings.

Limitations of the straight line method

• It rests on the faulty assumption that an asset gives the same utility in every accounting year.
• As the asset ages, its efficiency falls and repair expenses rise, so the total charge on account of depreciation and repairs taken together is not uniform over the asset's life; it keeps increasing from year to year.

How is depreciation calculated under the written down value method?

Under the written down value method, depreciation is charged on the book value of the asset at the beginning of each accounting period, using a pre-determined percentage.

Since the book value keeps reducing by the annual depreciation charge, this method is also called the reducing balance, reducing instalment or diminishing value method, and the amount of depreciation goes on reducing year after year.

For example, with an original cost of ₹2,00,000 and depreciation at 10% per annum on written down value: Year 1 depreciation is 10% of ₹2,00,000 = ₹20,000, leaving a written down value of ₹1,80,000.

Year 2 depreciation is 10% of ₹1,80,000 = ₹18,000, leaving ₹1,62,000. Year 3 depreciation is 10% of ₹1,62,000 = ₹16,200, leaving ₹1,45,800.

Years are plotted on the horizontal axis and the amount of depreciation on the vertical axis. Because the same rate is applied to a shrinking balance, the plotted curve starts high and falls each year, flattening out as the balance becomes smaller.

Advantages of the written down value method

• It rests on the more realistic assumption that an asset's benefits diminish with the passage of time, so higher depreciation is charged in earlier years when the asset's utility is higher.
• It produces an almost equal combined burden of depreciation and repair expenses on the profit and loss account every year.
• The Income Tax Act, 1961 in India accepts this method for tax purposes, unlike the straight line method.
• Because a large portion of cost is written off in earlier years, the loss from obsolescence is reduced.
• It suits fixed assets that last long and need rising repair and maintenance expense with time, or where the rate of obsolescence is high.

Limitations of the written down value method

• Because depreciation is calculated at a fixed percentage of written down value, the depreciable cost of the asset can never be fully written off; its value can never become zero.
• It is difficult to arrive at a suitable rate of depreciation.

How do the straight line and written down value methods differ?

The two methods differ on several points, summarised below.

The basis of charging depreciation is the first difference: under the straight line method depreciation is always worked out on the original (historical) cost of the asset, whereas under the written down value method it is worked out on the book value, that is original cost less depreciation charged till date, at the beginning of each year.

This difference in basis explains the second point, the annual depreciation charge. It stays fixed and constant every year under the straight line method, but it declines year after year under the written down value method, since each year's charge is calculated on a shrinking balance.

The third point concerns the total charge against profit and loss on account of depreciation and repairs taken together. Repair and maintenance expenses are generally accepted to increase as an asset grows older. Because the straight line charge stays fixed while repairs rise, the combined charge becomes unequal and increases in later years. Under the written down value method, the falling depreciation charge offsets the rising repair charge, so the combined total remains almost equal every year.

Fourthly, on recognition by income tax law, the straight line method is not recognised for this purpose, while the written down value method is recognised.

Finally, on suitability, the straight line method suits assets with low repair charges, low obsolescence and a scrap value that depends mainly on the time period involved, such as freehold land, buildings, patents and trade marks, while the written down value method suits assets affected by technological change that need more repair expense with the passage of time, such as plant, machinery and vehicles.

How is depreciation recorded in the books?

There are two arrangements for recording depreciation on fixed assets: charging it directly to the asset account, or creating a provision for depreciation (also called an accumulated depreciation account).

Charging depreciation to the asset account

Here, depreciation is deducted from the cost of the asset (credited to the asset account) and charged to the profit and loss account.

1. On purchase (only in the year of purchase): Asset A/c Dr. (with cost including installation, freight, and so on), To Bank/Vendor A/c.
2. At the end of every year, to deduct depreciation from the asset's cost: Depreciation A/c Dr., To Asset A/c.
3. At the end of every year, to charge depreciation to profit and loss: Profit and Loss A/c Dr., To Depreciation A/c.
4. In the balance sheet, the asset appears at its net book value (cost less depreciation charged till date), not at its original cost.

Creating a provision for depreciation (accumulated depreciation) account

This method accumulates depreciation in a separate account, usually called "Provision for Depreciation" or "Accumulated Depreciation", so that the asset account need not be disturbed and continues to show the asset at original cost over its life.

1. On purchase (only in the year of purchase): Asset A/c Dr. (with cost including installation and other expenses), To Bank/Vendor A/c.
2. At the end of every year, to credit depreciation to the provision account: Depreciation A/c Dr., To Provision for Depreciation A/c.
3. At the end of every year, to charge depreciation to profit and loss: Profit and Loss A/c Dr., To Depreciation A/c.
4. In the balance sheet, the asset continues to appear at original cost, while depreciation charged till date appears in the provision for depreciation account, shown either on the liabilities side or as a deduction from the asset's original cost on the asset side.

Definition: Provision for depreciation. A separate account that accumulates the depreciation charged on an asset year after year, leaving the asset account itself undisturbed at its original cost.

How are the purchase and sale of assets recorded with depreciation?

Disposal of an asset can take place either at the end of its useful life or during its useful life, due to obsolescence or another abnormal factor.

Where no asset disposal account is used and the asset is simply charged to the asset account, the amount realised on sale is credited to the asset account and the resulting balance is transferred to profit and loss: in case of profit, Asset A/c Dr., To Profit and Loss A/c; in case of loss, Profit and Loss A/c Dr., To Asset A/c.

Where a provision for depreciation account has been maintained, its balance must first be transferred to the asset account, by Provision for Depreciation A/c Dr., To Asset A/c, before these sale entries are passed.

Sale of an asset without a disposal account

When the asset account is being written down directly, the sale is recorded in the asset account itself. The sale proceeds are credited to the asset account, and the balance left in the account is the profit or loss on sale, which is transferred to profit and loss.

1. For the sale proceeds: Bank A/c Dr. (with the amount realised), To Asset A/c.
2. If a balance remains on the debit side of the asset account (a loss): Profit and Loss A/c Dr., To Asset A/c.
3. If the credit side exceeds the debit side (a profit): Asset A/c Dr., To Profit and Loss A/c.
4. Where a provision for depreciation account is kept, first transfer the accumulated depreciation on the asset sold: Provision for Depreciation A/c Dr., To Asset A/c. The asset account then shows the book value, and the sale entries above follow.

Using an asset disposal account

An asset disposal account is used, generally when part of an asset is sold and a provision for depreciation account exists, to bring together the original cost of the asset, the accumulated depreciation on it, the sale price, and the resulting profit or loss on disposal in one place.

1. Asset Disposal A/c Dr. (with the original cost of the asset sold), To Asset A/c.
2. Provision for Depreciation A/c Dr. (with the accumulated depreciation on the asset sold), To Asset Disposal A/c.
3. Bank A/c Dr. (with the net sale proceeds), To Asset Disposal A/c.
4. If the account shows a debit balance (loss on disposal): Profit and Loss A/c Dr., To Asset Disposal A/c. If it shows a credit balance (profit on disposal): Asset Disposal A/c Dr., To Profit and Loss A/c.

Worked example 1. M/s Singhania and Bros. purchased a plant for ₹5,00,000 on 1 April and spent ₹50,000 on its installation. The salvage value after its useful life of 10 years is estimated at ₹10,000.

The firm charges depreciation to the asset account using the straight line method. Calculate the annual depreciation.

Answer: Original cost = ₹5,00,000 + ₹50,000 = ₹5,50,000. Depreciable cost = ₹5,50,000 − ₹10,000 = ₹5,40,000. Annual depreciation = ₹5,40,000 ÷ 10 = ₹54,000. Each year: Depreciation A/c Dr. ₹54,000, To Plant A/c ₹54,000; and Profit and Loss A/c Dr. ₹54,000, To Depreciation A/c ₹54,000.

Worked example 2. The original cost of an asset is ₹2,00,000 and depreciation is charged at 10% per annum on written down value. Calculate depreciation and written down value for the first three years.

Answer: Year 1: depreciation = 10% of ₹2,00,000 = ₹20,000; written down value = ₹2,00,000 − ₹20,000 = ₹1,80,000. Year 2: depreciation = 10% of ₹1,80,000 = ₹18,000; written down value = ₹1,80,000 − ₹18,000 = ₹1,62,000.

Year 3: depreciation = 10% of ₹1,62,000 = ₹16,200; written down value = ₹1,62,000 − ₹16,200 = ₹1,45,800.

Worked example 3. M/s Mehra and Sons acquired a machine for ₹1,80,000 on 1 October and spent ₹20,000 on its installation. The firm writes off depreciation at 10% on original cost every year, and maintains a provision for depreciation account.

Books close on 31 March every year. Calculate the balance of the provision for depreciation account at the end of each of the first three years.

Answer: Original cost = ₹1,80,000 + ₹20,000 = ₹2,00,000. Annual depreciation (full year) = 10% of ₹2,00,000 = ₹20,000. Year 1 (6 months from October to March) = ₹20,000 × 6/12 = ₹10,000; provision balance = ₹10,000.

Year 2: depreciation = ₹20,000; provision balance = ₹10,000 + ₹20,000 = ₹30,000. Year 3: depreciation = ₹20,000; provision balance = ₹30,000 + ₹20,000 = ₹50,000. The machine account remains at ₹2,00,000 throughout, since the provision method is used.

Worked example 4. Karan Enterprises had machinery with a gross value of ₹6,00,000 and a provision for depreciation of ₹2,50,000 as on 31 March.

A machine purchased for ₹1,00,000, with accumulated depreciation of ₹60,000, was sold on 1 April for ₹35,000. Prepare the machinery disposal account and find the profit or loss on sale.

Answer: Machinery Disposal A/c Dr. side: Machinery ₹1,00,000. Credit side: Provision for Depreciation ₹60,000, Bank (sale proceeds) ₹35,000, balance ₹5,000 debited to Profit and Loss as loss on sale.

Book value of the machine sold = ₹1,00,000 − ₹60,000 = ₹40,000. Sale price = ₹35,000. Loss on sale = ₹40,000 − ₹35,000 = ₹5,000.

Worked example 5. A machine was purchased on 1 April 2015 for ₹1,00,000. Depreciation is charged at 10% per annum on written down value, and the asset account is written down directly. The machine was sold on 1 April 2017 for ₹70,000. Calculate the profit or loss on sale.

Answer: Depreciation for 2015-16 = 10% of ₹1,00,000 = ₹10,000; written down value on 31 March 2016 = ₹90,000. Depreciation for 2016-17 = 10% of ₹90,000 = ₹9,000; written down value on 31 March 2017 = ₹81,000.

Sale proceeds = ₹70,000. Loss on sale = ₹81,000 − ₹70,000 = ₹11,000. Entries: Bank A/c Dr. ₹70,000, To Machine A/c ₹70,000; and Profit and Loss A/c Dr. ₹11,000, To Machine A/c ₹11,000.

Worked example 6. A machine purchased for ₹1,00,000 on 1 April 2014 was sold on 1 April 2016 for ₹60,000. Depreciation is charged at 10% per annum on written down value and accumulated in a provision for depreciation account. Prepare the disposal account.

Answer: Depreciation for 2014-15 = ₹10,000; for 2015-16 = 10% of ₹90,000 = ₹9,000; accumulated depreciation = ₹19,000; book value = ₹1,00,000 − ₹19,000 = ₹81,000.

Disposal account: debit Machine A/c ₹1,00,000; credit Provision for Depreciation ₹19,000, Bank ₹60,000, and Profit and Loss (loss on sale) ₹21,000, since ₹81,000 − ₹60,000 = ₹21,000.

Worked example 7. R.S. Limited purchased a vehicle for ₹4,00,000. After 4 years its salvage value is estimated at ₹40,000. Depreciation is charged on the straight line basis and accumulated in a provision for depreciation account. The vehicle is sold at the end of the fourth year for ₹50,000. Calculate the annual depreciation and the profit or loss on sale.

Answer: Annual depreciation = (₹4,00,000 − ₹40,000) ÷ 4 = ₹3,60,000 ÷ 4 = ₹90,000. Accumulated depreciation after 4 years = ₹90,000 × 4 = ₹3,60,000. Book value at the end of the fourth year = ₹4,00,000 − ₹3,60,000 = ₹40,000.

Sale proceeds = ₹50,000. Profit on sale = ₹50,000 − ₹40,000 = ₹10,000. No disposal account is used, so the accumulated depreciation is first transferred to the asset account: Provision for Depreciation A/c Dr. ₹3,60,000, To Vehicle A/c ₹3,60,000. The vehicle account now shows the book value of ₹40,000. Then: Bank A/c Dr. ₹50,000, To Vehicle A/c ₹50,000; and Vehicle A/c Dr. ₹10,000, To Profit and Loss A/c ₹10,000, which closes the vehicle account.

Worked example 8. Khosla Transport Co. purchased five trucks for ₹20,000 each on 1 January 2015. Depreciation is provided at 10% per annum on the straight line method and accumulated in a provision for depreciation account. On 1 January 2016 one truck was sold for ₹15,000. Prepare the truck disposal account and find the profit or loss on sale.

Answer: Cost of the truck sold = ₹20,000. Depreciation for the year 2015 = 10% of ₹20,000 = ₹2,000, so accumulated depreciation on it at the date of sale = ₹2,000. Book value on 1 January 2016 = ₹20,000 − ₹2,000 = ₹18,000.

Truck Disposal A/c: debit Truck A/c ₹20,000; credit Provision for Depreciation ₹2,000, Bank (sale) ₹15,000, and Profit and Loss (loss on sale) ₹3,000, since ₹18,000 − ₹15,000 = ₹3,000.

Worked example 9. A machine was purchased on 1 April 2023 for ₹2,40,000. Depreciation is charged at 10% per annum on the straight line method, the machine account is written down directly, and the books close on 31 March every year. The machine was sold on 30 September 2025 for ₹1,70,000. Calculate the depreciation for the part of the year up to the date of sale and the profit or loss on sale.

Answer: Annual depreciation = 10% of ₹2,40,000 = ₹24,000. Book value on 31 March 2024 = ₹2,40,000 − ₹24,000 = ₹2,16,000; on 31 March 2025 = ₹2,16,000 − ₹24,000 = ₹1,92,000.

Depreciation is charged up to the date of sale: 1 April to 30 September 2025 is 6 months, so depreciation = ₹24,000 × 6/12 = ₹12,000, and the book value on the date of sale = ₹1,92,000 − ₹12,000 = ₹1,80,000.

Loss on sale = ₹1,80,000 − ₹1,70,000 = ₹10,000. Entries: Depreciation A/c Dr. ₹12,000, To Machinery A/c ₹12,000; Bank A/c Dr. ₹1,70,000, To Machinery A/c ₹1,70,000; Profit and Loss A/c Dr. ₹10,000, To Machinery A/c ₹10,000. Note: forgetting the depreciation for the months before the sale overstates the loss by ₹12,000.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it.

How is depreciation distinguished from depletion and amortisation?

Depletion is used for the exhaustion of natural resources such as mines and quarries as the material is extracted, for example a coal mine bought for ₹10,00,000 whose value falls as coal is extracted.

Amortisation refers to writing off the cost of intangible assets such as patents, copyrights, trade marks, franchises and goodwill over their useful life, for example a patent bought for ₹10,00,000 with a ten-year useful life is written off over those ten years.

Depletion and amortisation are given similar accounting treatment to depreciation because, in each case, the service potential of an asset expires over time.

How is the rate of depreciation worked out under the written down value method?

The rate of depreciation under this method can itself be worked out from the cost, scrap value and useful life:

WDV Rate = [1 − (s ÷ c)^(1/n)] × 100

where WDV Rate is the rate of depreciation, n is the expected useful life, s is the scrap value and c is the cost of the asset. For example, a truck costing ₹9,00,000 with a net salvage value of ₹50,000 after 16 years gives a rate of approximately 16.5% (rounding the bracket to 1 − 0.834 first gives 16.6%).

What other methods of calculating depreciation exist?

Besides the straight line and written down value methods, other methods of calculating depreciation exist, such as the annuity method, the depreciation fund method, the insurance policy method, the sum of years digit method and the double declining method. The choice among these, and between the two main methods used for the purchase-and-sale problems covered here, depends on the type of the asset, the nature of its use and the circumstances prevailing in the business, and once a method is chosen it should be applied consistently from period to period.

How are additions and extensions to an asset depreciated?

An existing asset may also require additions or extensions to remain suitable for operations. Such additions or extensions may or may not become an integral part of the existing asset. Where an addition or extension becomes an integral part of the asset, it is capitalised, that is treated as capital expenditure rather than a revenue expense, and depreciated over the remaining useful life of that asset, and may be charged at the same rate as the existing asset.

Where an addition or extension retains a separate identity and is capable of being used even after the existing asset is disposed of, depreciation is instead provided independently on the basis of its own useful life. This amount is in addition to the usual repair and maintenance expenses, which remain a revenue expense and are charged separately to profit and loss rather than being written off as depreciation.

Glossary

• Depreciation — the part of the cost of a fixed asset that has expired due to use and/or passage of time, charged against revenue of the period.
• Depreciable asset — a fixed asset expected to be used for more than one accounting period, with a limited useful life, held for use and not for resale.
• Obsolescence — an asset becoming out of date because a better asset, technology or production method becomes available.
• Original cost — the invoice price of an asset plus all costs needed to bring it into working condition, such as freight and installation.
• Net residual value — the estimated net realisable (scrap or salvage) value of an asset at the end of its useful life, after disposal costs.
• Depreciable cost — original cost less net residual value, the amount that is spread over the asset's useful life as depreciation.
• Useful life — the period over which an asset is expected to be used commercially, which may be shorter than its physical life.
• Straight line method — a method charging a fixed, equal amount of depreciation in every accounting period over an asset's life.
• Written down value method — a method charging depreciation as a fixed percentage of the book value at the start of each year.
• Provision for depreciation — a separate account accumulating depreciation charged on an asset, leaving the asset account at original cost.
• Asset disposal account — an account bringing together an asset's original cost, accumulated depreciation and sale proceeds to find profit or loss on sale.
• Book value — the value of an asset as shown in the books, being original cost less depreciation charged to date.

Common errors and misconceptions

• Misconception: Depreciation is a decline in the market value of an asset. Correct: Depreciation is based on the cost of the asset consumed in the business, not on its market value.
• Misconception: Depreciation is charged on current assets as well as fixed assets. Correct: Depreciation applies to depreciable fixed assets used over more than one accounting period, not to current assets.
• Misconception: If adequate maintenance expenditure is incurred, depreciation need not be charged. Correct: Depreciation must still be charged, since it reflects the expiry of cost through use, time and obsolescence, regardless of maintenance.
• Misconception: Under the written down value method, the asset's value eventually reaches zero. Correct: Because a fixed percentage is applied to a shrinking balance, the asset's book value can never become exactly zero under this method.
• Misconception: The straight line method is accepted for income tax purposes in India. Correct: The straight line method is not recognised by income tax law, whereas the written down value method is.
• Misconception: When a provision for depreciation account is maintained, the asset account shows the asset's reducing book value. Correct: The asset account continues to show the original cost; the accumulated depreciation appears separately in the provision account.
• Misconception: Depreciation is a cash expense that reduces the business's bank balance. Correct: Depreciation is a non-cash expense; it is merely the writing off of capital expenditure already incurred.

Exam-style questions with model answers

Q1. Choose the correct option. Depreciation is charged on: (a) current assets (b) depreciable fixed assets (c) the market value of an asset (d) only on cash purchases. [1 mark]

1. (b) depreciable fixed assets. Depreciation applies to fixed assets held for use over more than one accounting period, and it is based on cost, not market value.

Q2. State the correct order of the steps in recording depreciation when a provision for depreciation account is maintained, and give a reason for the order. Steps: (P) charge Depreciation A/c to Profit and Loss A/c (Q) debit Depreciation A/c and credit Provision for Depreciation A/c (R) debit the Asset A/c on purchase. [2 marks]

1. The correct order is R, Q, P: the asset is first recorded at cost, then depreciation is credited to the provision account, and only then is the depreciation charge closed to profit and loss.
2. The reason is that the provision account must receive the year's depreciation before the expense is transferred to profit and loss, so that the asset account stays at original cost.

Q3. Assertion: Under the written down value method the book value of an asset can never become zero. Reason: Depreciation is charged at a fixed percentage of the reducing book value. Choose the correct option: (a) both true, reason explains assertion (b) both true, reason does not explain assertion (c) assertion true, reason false (d) both false. [1 mark]

1. (a) both true, and the reason explains the assertion. A fixed percentage applied to a shrinking balance always leaves some positive value.

Q4. Distinguish between the straight line method and the written down value method on the basis of charging depreciation and the annual charge. [3 marks]

1. Basis of charging depreciation: the straight line method charges depreciation on the original (historical) cost, while the written down value method charges it on the book value at the beginning of the year.
2. Annual depreciation charge: it remains fixed and constant every year under the straight line method, but it is highest in the first year and declines in later years under the written down value method.
3. Reason for the difference: the straight line method applies the same rate to an unchanged cost, while the written down value method applies a fixed percentage to a balance that shrinks each year.

Q5. Explain the need for providing depreciation in the accounting records. [4 marks]

1. Matching of costs and revenue: the cost of the asset is spread over the periods that enjoy its benefit, so depreciation is as much a cost as salary or carriage.
2. Consideration of tax: depreciation is a deductible cost for tax purposes, though tax rules for calculating the amount need not match business practice.
3. True and fair financial position: without depreciation the assets would be overvalued and the balance sheet would not show the correct position.
4. Compliance with law: apart from tax regulations, certain specific legislations indirectly compel organisations such as corporate enterprises to provide depreciation on fixed assets.

Q6. A machine was purchased for ₹2,40,000 on 1 April. Installation cost ₹10,000 was also incurred. Its estimated useful life is 8 years and its estimated residual value is ₹10,000. Calculate the annual depreciation and the rate of depreciation under the straight line method. [4 marks]

1. Original cost of the machine = ₹2,40,000 + ₹10,000 = ₹2,50,000.
2. Depreciable cost = ₹2,50,000 − ₹10,000 (residual value) = ₹2,40,000.
3. Annual depreciation = ₹2,40,000 ÷ 8 years = ₹30,000.
4. Rate of depreciation = (₹30,000 ÷ ₹2,50,000) × 100 = 12%.

Q7. On 1 April 2015, a firm purchased a machine for ₹2,00,000. Depreciation is charged at 10% per annum on written down value, and the asset account is written down directly. The machine was sold on 1 April 2018 for ₹1,30,000. Calculate the profit or loss on sale and state the entries for the sale. [5 marks]

1. Depreciation for 2015-16 = 10% of ₹2,00,000 = ₹20,000; written down value on 31 March 2016 = ₹1,80,000.
2. Depreciation for 2016-17 = 10% of ₹1,80,000 = ₹18,000; written down value on 31 March 2017 = ₹1,62,000.
3. Depreciation for 2017-18 = 10% of ₹1,62,000 = ₹16,200; written down value on 31 March 2018 = ₹1,45,800.
4. Sale proceeds = ₹1,30,000, so loss on sale = ₹1,45,800 − ₹1,30,000 = ₹15,800.
5. Entries: Bank A/c Dr. ₹1,30,000, To Machine A/c ₹1,30,000; and Profit and Loss A/c Dr. ₹15,800, To Machine A/c ₹15,800.

Q8. A machine was purchased on 1 April 2014 for ₹1,00,000. Depreciation is charged at 10% per annum on written down value and accumulated in a provision for depreciation account. The machine was sold on 1 April 2016 for ₹60,000. Prepare the machinery disposal account and calculate the profit or loss on sale. [6 marks]

1. Depreciation for 2014-15 = 10% of ₹1,00,000 = ₹10,000; written down value on 31 March 2015 = ₹90,000.
2. Depreciation for 2015-16 = 10% of ₹90,000 = ₹9,000; accumulated depreciation = ₹19,000; book value on 31 March 2016 = ₹81,000.
3. Machinery Disposal A/c Dr. side: Machinery ₹1,00,000.
4. Credit side: Provision for Depreciation ₹19,000 and Bank ₹60,000.
5. Loss on sale = book value ₹81,000 − sale proceeds ₹60,000 = ₹21,000.
6. The balance of ₹21,000 is debited to Profit and Loss A/c, so both sides of the disposal account total ₹1,00,000.

Q9. Furniture costing ₹1,00,000 was purchased on 1 April. Depreciation is charged at 10% per annum on original cost under the straight line method, and a provision for depreciation account is maintained. Explain, with the journal entries and the provision account balances for the first two years, how this is recorded. [6 marks]

1. On purchase: Furniture A/c Dr. ₹1,00,000, To Bank A/c ₹1,00,000.
2. At the end of year 1, to record depreciation: Depreciation A/c Dr. ₹10,000, To Provision for Depreciation A/c ₹10,000.
3. At the end of year 1, to charge depreciation to profit and loss: Profit and Loss A/c Dr. ₹10,000, To Depreciation A/c ₹10,000.
4. At the end of year 2, the same pair of entries is repeated for ₹10,000, so the provision for depreciation account balance rises from ₹10,000 to ₹20,000.
5. Throughout, the Furniture account continues to show the asset at its original cost of ₹1,00,000, undisturbed by the yearly depreciation entries.
6. In the balance sheet, the furniture is shown at ₹1,00,000, with the provision for depreciation of ₹20,000 shown as a deduction from it (or on the liabilities side), so that the net book value disclosed is ₹80,000 at the end of year 2.

Q10. A firm bought a machine for ₹1,00,000 on 1 April 2015. Depreciation is charged at 10% per annum on original cost under the straight line method and accumulated in a provision for depreciation account. The machine was sold on 1 April 2017 for ₹70,000. Prepare the machinery disposal account and calculate the profit or loss on sale. [6 marks]

1. Annual depreciation = 10% of ₹1,00,000 = ₹10,000.
2. Depreciation for 2015-16 = ₹10,000 and for 2016-17 = ₹10,000, so accumulated depreciation at the date of sale = ₹20,000.
3. Book value on 1 April 2017 = ₹1,00,000 − ₹20,000 = ₹80,000.
4. Machinery Disposal A/c Dr. side: Machinery ₹1,00,000.
5. Credit side: Provision for Depreciation ₹20,000 and Bank (sale proceeds) ₹70,000.
6. Loss on sale = ₹80,000 − ₹70,000 = ₹10,000, debited to Profit and Loss A/c, so both sides of the disposal account total ₹1,00,000.

Key takeaways

• Depreciation is the expired cost of a fixed asset, caused by wear and tear, expiry of legal rights, obsolescence or abnormal factors.
• Depreciation is charged to match costs with revenue, to compute tax correctly, to show a true and fair financial position, and to comply with the law.
• The objectives of providing depreciation include ascertaining true profit, showing a true and fair position and providing for replacement of the asset.
• The amount of depreciation depends on original cost, estimated net residual value and estimated useful life.
• Under the straight line method, a fixed equal amount is charged each year on original cost; under the written down value method, a fixed percentage is charged on the reducing book value.
• The written down value method is recognised by income tax law; the straight line method is not.
• Depreciation may be recorded either by charging it directly to the asset account, or by crediting it to a separate provision for depreciation account.
• When an asset is sold, any gain or loss is found by comparing its book value with the sale proceeds, and transferred to profit and loss.
• An asset disposal account brings the asset's original cost, accumulated depreciation and sale proceeds together to calculate profit or loss on disposal.

Test yourself

Why is depreciation called a non-cash expense?

Because it does not involve any outflow of cash; it is simply the process of writing off capital expenditure that has already been incurred, by charging a part of it against revenue each year.

Why does the written down value method never reduce an asset's value to zero?

Because depreciation is calculated each year as a fixed percentage of a shrinking book value, so however small the balance becomes, applying the same rate always leaves some residual value.

How does the asset account look different under the two recording methods?

Where depreciation is charged to the asset account, the asset shows its reducing net book value; where a provision for depreciation account is maintained, the asset continues to appear at original cost.

What entry is needed before recording a sale if a provision for depreciation account has been maintained?

The accumulated balance in the provision for depreciation account must first be transferred to the asset account, by debiting Provision for Depreciation A/c and crediting the Asset A/c.

When is an asset disposal account generally used?

It is generally used when part of an asset is sold and a provision for depreciation account exists, bringing the original cost, accumulated depreciation and sale proceeds together in one account.

Give one advantage of the straight line method and one advantage of the written down value method.

The straight line method is simple and charges the same amount every year, aiding comparison; the written down value method matches rising repair costs with falling depreciation as the asset ages.

How is the loss on sale of an asset recorded when no disposal account is used and the asset account is written down directly?

The sale proceeds are credited to the asset account, and the remaining debit balance, being the loss, is transferred by debiting Profit and Loss A/c and crediting the Asset A/c.

How is depreciation on an asset sold under the straight line method with a provision account worked out up to the date of sale?

The same fixed annual amount is charged for each full year the asset was held, and the total is credited to the provision for depreciation account, so the book value is cost less that accumulated amount.