Depreciation and its Accounting | PAPER III – ACCOUNTING & FINANCIAL MANAGEMENT FOR BANKERS | MODULE B: FINANCIAL STATEMENTS AND CORE BANKING SYSTEMS

Depreciation and its Accounting

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Meaning of Depreciation

Depreciation refers to the reduction in the value of a fixed asset due to wear and tear, passage of time, obsolescence, or other factors.

Causes of Depreciation

• Wear and tear
• Obsolescence
• Effluxion of time
• Depletion (for natural resources)

Need for Depreciation

• To ascertain true profit or loss
• To show true financial position
• To make provisions for replacement
• For tax purposes

Factors Affecting Depreciation

• Cost of asset
• Estimated useful life
• Estimated residual value
• Usage pattern

Accounting Entries

• For charging depreciation:
  Depreciation A/c Dr.
    To Asset A/c
• For transferring to Profit & Loss A/c:
  Profit & Loss A/c Dr.
    To Depreciation A/c

Methods of Depreciation

Straight Line Method (SLM)

Depreciation is charged equally every year.
Formula: (Cost – Residual Value) / Useful Life

Advantages:

• Simple to apply
• Easy to understand

Disadvantages:

• Does not consider asset usage
• Maintenance cost increases over time

Diminishing Balance Method / Written Down Value (WDV)

Depreciation is charged at a fixed percentage on the reducing balance of asset value.

Advantages:

• Considers wear and tear
• Suitable for income tax

Disadvantages:

• Complex calculations
• Asset value never becomes zero

Units of Production Method

Depreciation is based on usage or output. Formula: (Cost – Salvage Value) / Total Estimated Units

Sum of the Years’ Digits Method

An accelerated depreciation method using a declining fraction based on the years of asset life.

Replacement of Fixed Asset

When an asset is replaced, the old asset is written off and new asset capitalized.

Sinking Fund Method

A fixed amount is invested every year in a fund to replace the asset after its useful life.

Amortisation of Intangible Assets

Similar to depreciation but applied to intangible assets like patents, trademarks, etc., over their useful life.

MCQs on Depreciation and its Accounting

1. Depreciation is a process of:
   a) Valuation
   b) Allocation
   c) Apportionment
   d) None of the above
   Answer: b) Allocation
2. Which of the following is not a cause of depreciation?
   a) Obsolescence
   b) Wear and Tear
   c) Appreciation
   d) Efflux of time
   Answer: c) Appreciation
3. Straight Line Method charges:
   a) Varying amount
   b) Constant amount
   c) Reducing amount
   d) No depreciation
   Answer: b) Constant amount
4. Which method is accepted for income tax purposes in India?
   a) SLM
   b) WDV
   c) Units of Production
   d) None
   Answer: b) WDV
5. Amortisation is related to:
   a) Current assets
   b) Intangible assets
   c) Tangible assets
   d) Investments
   Answer: b) Intangible assets
6. Depreciation is shown on the:
   a) Liability side
   b) Asset side
   c) Debit of P&L A/c
   d) Credit of P&L A/c
   Answer: c) Debit of P&L A/c
7. In WDV method, depreciation is charged on:
   a) Original cost
   b) Book value
   c) Scrap value
   d) Market value
   Answer: b) Book value
8. Which of these is a method of depreciation?
   a) FIFO
   b) LIFO
   c) SYD
   d) NPV
   Answer: c) SYD (Sum of the Years’ Digits)
9. Provision for replacement is made under:
   a) Amortisation
   b) Revaluation
   c) Sinking Fund
   d) Reserve Fund
   Answer: c) Sinking Fund
10. Depreciation reduces:
    a) Liability
    b) Revenue
    c) Assets
    d) Capital
    Answer: c) Assets

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Depreciation & Its Accounting: Mathematical Examples

1. Straight Line Method (Simple)

Cost of asset: ₹1,00,000
Residual value: ₹10,000
Useful life: 5 years

Formula: (Cost – Residual value) / Useful life
Depreciation: (1,00,000 – 10,000) / 5 = ₹18,000 per year

2. Written Down Value Method (Medium)

Cost of asset: ₹2,00,000
Depreciation rate: 20%

• Year 1: ₹2,00,000 × 20% = ₹40,000 → Book Value = ₹1,60,000
• Year 2: ₹1,60,000 × 20% = ₹32,000 → Book Value = ₹1,28,000
• Year 3: ₹1,28,000 × 20% = ₹25,600 → Book Value = ₹1,02,400

3. Units of Production Method (Medium)

Cost: ₹5,00,000
Residual Value: ₹50,000
Total Estimated Units: 90,000
Actual Output (Year 1): 30,000

Depreciation per Unit: (5,00,000 – 50,000) / 90,000 = ₹5
Year 1 Depreciation: 30,000 × ₹5 = ₹1,50,000

4. Sum of the Years’ Digits Method (Hard)

Cost: ₹1,00,000
Residual Value: ₹10,000
Useful Life: 5 years
Depreciable Amount: ₹90,000
SYD: 5 + 4 + 3 + 2 + 1 = 15

• Year 1: (5/15) × ₹90,000 = ₹30,000
• Year 2: (4/15) × ₹90,000 = ₹24,000
• Year 3: (3/15) × ₹90,000 = ₹18,000
• Year 4: (2/15) × ₹90,000 = ₹12,000
• Year 5: (1/15) × ₹90,000 = ₹6,000

5. Sinking Fund for Replacement (Hard)

Asset cost: ₹5,00,000
Life: 5 years
Interest rate: 10% annually (compounded)

Formula: A = S / [((1 + r)^n – 1) / r]

A = ₹5,00,000 / [((1.1)^5 – 1) / 0.10] = ₹5,00,000 / 6.1051 = ₹81,907.51
Annual investment: ₹81,907.51

6. Amortisation of Intangible Asset (Simple)

Patent Cost: ₹1,20,000
Useful Life: 6 years

Annual Amortisation = ₹1,20,000 / 6 = ₹20,000