Issues in Income Determination

Effect of Policies of Depreciation

Learning Objectives• Concept of Depreciation• Meaning and Definition of Depreciation• Objectives of Depreciation Accounting• Features of Depreciation• Causes of depreciation • Objectives of providing Depreciation• Determination of Depreciation Amount• Methods for providing Depreciation• Accounting policies in relation to Depreciation

Concept of Depreciation

• Fixed assets wear out, are consumed or lose their value either because of use, efflux of time or obsolescence due to technology and market change.

• Depreciation is viewed as a measurement of the diminution in the value of the fixed assets.

Meaning of Depreciation

• It is the allocation of the cost of an asset to the periods that are expected to benefit from its use.

• It is the gradual conversion of the cost of an asset into expense.

• AS – 6 requires that depreciation to be charged on a “systematic basis” to each accounting period during the life of an asset.

Definition - AICPA• A system of accounting which aims to

distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit in a systematic and rational manner.

• It is a process of allocation, not of valuation.

Objective of Depn Accounting

• To absorb the cost of using the assets to different accounting periods in a way so as to give the true figure or profit or loss

made by the business.

Features

1. All tangible assets except land have a limited useful life.

2. It is allocation of cost of asset to the period that benefit from the service of that asset.

3. It is not a process of valuation.4. It is used only in respect of fixed assets.5. It is charge against profits6. It is different from maintenance.

Causes of depreciation • Wear and Tear• Exhaustion• Obsolescence• Efflux of time• Accidents

Objectives of providing Depreciation

• Ascertainment of true profits• Presentation of true financial

position• Replacement of assets

Determination of Depn Amount

• Cost of the asset• Estimated scrap value• Estimated useful life

Methods for providing Depreciation

• Uniform Charge Methods• Straight line/Fixed installment • Depletion method• Machine Hour rate method

• Declining Charge/accelerated Depreciation• Diminishing Balance/WDV method• Sum of Years Digits method• Double Declining method

• Other Methods• Inventory system• Annuity method• Depreciation Fund • Insurance policy

Straight Line Method• Under the SLM, the depreciable amount of the asset

is distributed equally over the life of the asset.• It is based on the assumption that depreciation

arises solely from the passage of time, and the effect of usage on the service value of the asset is insignificant.

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Example:• A machine costs Rs 8,00,000 and is expected to

realize Rs 80,000 at the end of its estimated useful life of six years. Calculate the annual depreciation and show the depreciation schedule for the asset.

• Solution: Depreciation = (Rs 8,00,000 – Rs 80,000)/ 6

years = Rs 1,20,000 p.a.

Depreciation Schedule: SLM

Year Cost (Rs)

Yearly Depn(Rs)

Accumulated Depn (Rs)

Ending Book Value (Rs)

1 8,00,000

1,20,000 1,20,000 6,80,000

2 8,00,000

1,20,000 2,40,000 5,60,000

3 8,00,000

1,20,000 3,60,000 4,40,000

4 8,00,000

1,20,000 4,80,000 3,20,000

5 8,00,000

1,20,000 6,00,000 2,00,000

6 8,00,000

1,20,000 7,20,000 80,000

Critical Evaluation of SLM

• Merits: – Simple to understand and easy to apply/compute– Asset value can be reduced to zero/scrap value– Used particularly in case of leasehold properties,

patents, etc..• Demerits:

– Same amount is charged irrespective of the usage.– Total charge for use of asset goes on increasing i.e.

repairs and depreciation.

Diminishing Balance Method

• Depn is computed at a fixed rate % of the book value of the asset at the beginning of an accounting period.

• Thus, the depn expense for year 1 will be a certain % of the beginning book value (cost).

• From year 2 onwards, the depn charge would be related to the cost of the asset, less accumulated depn at the beginning of the year.

• Since the fixed % rate is applied to the beginning book value, the depn expense will keep decreasing from year to year.

• It is also known as Written-Down Value Method

Critical Evaluation of WDV

• Merits:– Amount of depn decreases every year, so charge to

asset is almost equal by adding repairs and depn.– Simple to understand and easy to follow

• Demerits:– Asset value can not be brought down to zero.

Accounting Policies in Relation to Depreciation

• Accounting policies have a great role to play in determining the amount of depreciation charged and ultimately influence the income figure.

• Depreciation charged also depends on the method adopted by the management. But, whatever method is selected, must be applied consistently.

Problem:• ABC Ltd purchases a machinery for Rs. 16,000.

Its estimated life is 5 years, at the end of which, it will have a scrap value of Rs. 1,244. The asset has to be depreciated at 40% on diminishing balance method. If the profits, before depreciation, are Rs. 10,000 p.a., show what will be the amount of profits after depreciation under (1) Straight line method and (20) Diminishing balance method.

Solution:• Effect of change in method of Depreciation on

profitability

• Under SLM, the amount of Depn and profits after Depn are constant for each of the years.

• Under WDV method, the depn charged is heavy in the earlier years resulting in reduced profits.

YearDepn Profit after Depn Depn Profit after Depn

1 2,951 7,049 6,400 3,6002 2,951 7,049 3,840 6,1603 2,951 7,049 2,304 7,6994 2,951 7,049 1,382 8,6185 2,951 7,049 830 9,170

Total profit for the period 35,244 35,244Total Depn charged 14,756 14,756Add: Scrap value 1,244 1,244Cost of the Asset 16,000 16,000

WDV MethodSLM