Accountig for Fixed Assets

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

Accounting for Fixed Assets Fixed Asset Ever Every y busin busines esss acqui acquire ress vari variou ouss types types of fixed fixed asse assets ts such such as land land & build buildin ing, g, plan plantt & machin machinery ery,, furnit furniture ure,, vehicle vehicless etc. etc. These These assets assets are used used to derive derive produc productio tion n capaci capacity ty.. Therefore, they are also known as earning assets. Fixed assets are purchased for continued and long-term use in earning profit in a business. They are written off against profits over their  anticipated life by charging an annual amount calculated so as to eliminate the original cost, less scrap, over that period.

The life of fixed assets spans over several years. Therefore, the business needs to make long term investment in fixed assets.

Depreciation Except land, all fixed assets have a limited life. During such period, due to continuous use and/or  lapse of time, the value of some assets starts decreasing. Such a gradual decrement of value of  assets assets is called called Depreciati Depreciation. on. Hence, depreciation depreciation can be defined as a decline in the value of an asset due to constant use.

Since these assets have limited life, sooner or later they have to be replaced. At the time of  replacement, the business incurs heavy cash outflow which can create liquidity problem in that year. In order to avoid such problem, a fixed amount out of profit is set aside as depreciation account. By the time the fixed asset expires, sufficient amount of fund will be accumulated in depreciation account which, then can be used to buy new asset. Hence, the process of setting aside a fixed amount as expense in depreciation account is called Depreciation. Characteristics of Depreciation The following are some of the features of depreciation: 1. Depreci Depreciati ation on may be phys physica icall and functi functiona onal. l. 2. Depreci Depreciati ation on is a gradua gradual/p l/perm ermane anent nt and contin continuous uous decreas decreasee in the utility utility value value of a fixed asset and it continues till the end of useful life of an asset. 3. Depreciati Depreciation on arises arises due to the the use of assets assets in producti productive ve activitie activities. s. 4. The primary primary object object of depreciat depreciation ion is to allocat allocatee expire expired d cost cost of fixed fixed assets assets against against a number of accounting periods. 5. Depr Deprec ecia iati tion on is char charged ged in resp respec ectt of fixe fixed d asse assets ts only only i.e. i.e.,, build buildin ing, g, mach machin iner ery, y, equipment and furniture etc. 6. Depreci Depreciati ation on is a charg chargee against against prof profit it.. 7. Total deprecia depreciation tion of an asset asset can not exceed exceed its its depreciable depreciable value value (cost less less scrap scrap value). value). Causes of Depreciation Depr Deprec ecia iati tion on is a meas measur uree of redu reduct ctio ion n in the the useuse-val value ue of an asse asset. t. It can can be physi physica call deterioration or decrease in the market value. The primary causes of depreciation are as follows: 1. Wear and Tear: Due to constant use, assets get worn or torn out. 2. Exhaustion: Exhaustion is the depletion of some assets due to continuous use and lapse of time. In case of mines and oil wells, the continuous extraction of minerals or oil, a

1

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

stage comes when the mine or well gets completely exhausted an nothing is left. 3. Obsolescence: Some assets are discarded before they are completely worn out because of  changed changed condit condition ions. s. This This is the case when when an asset asset becomes becomes usefulnes usefulnesss because because of  technological advancement, new invention, change in style etc. in that asset. 4. Efflux of time: Certain assets get decreased in their value with the passage of time. This is true in case of assets like leasehold properties, patents and copyrights etc. 5. Accidents: Accidents can cause depreciation in the value of the asset.

Objectives of making provision for depreciation Depreciation accounting is a must for every business for attaining the following objectives: 1. To asc ascer erta tain in net net pro profi fitt Depreciation is the expense for the business. Hence to ascertain the net profit, it must be included in the total cost of sales. 2. To depict depict the the true finan financia ciall position position of of the busine business ss The balance sheet depicts true financial position of a business at a point of time. To depict the true financial position of the business the assets should be shown in balance sheet not in its original cost but at the depreciated cost. That is all fixed assets should be shown at cost less the amount of depreciation suffered by them till the date of the balance sheet. 3. To asc ascert ertain ain cost cost of pro produc ductio tion n Depreciation is an expense. Hence it is necessary to charge depreciation in the total cost of production to fix true sales price of the goods and service. 4. Repl Replac acem emen entt of ass asset etss One of the primary objectives of depreciation is the provision for the replacement cost on the retirement of original assets. 5. To follow follow the the com compa pany ny act According to company act, it is compulsory to charge depreciation on fixed assets.

6. To ascertain income tax If depreciation is not charged, the operation will show more profit. As a result, the taxa taxabl blee inco income me will will be high higher er.. Henc Hence, e, depr deprec ecia iati tion on is char charge ged d for for the the corr correc ectt ascertainment of total taxable income. Accounting Treatment for Depreciation Since depreciation is an expense it must be charged to Profit & Loss a/c. The entire process  begins with the purchase of fixed asset. In the next step, the following journal entries have to be  passed for recording depreciation on assets. 1. For For purc purchas hasee of fixed fixed ass assets ets Fixed assets a/c Dr. To, Cash/Bank a/c

……………… ………………

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Accounting for Fixed Assets, Financial Accounting  Rabin Hada

(For purchase of fixed assets) 2. For charg charging ing depre depreciat ciation ion at the the end end of the the year year Depreciation a/c D r. ……………… To, Fixed asset a/c ……………… (For depreciation on asset) 3. For transfer transferring ring depr deprecia eciation tion to PL PL a/c a/c Profit & Loss a/c D r. ……………… To, Depreciation a/c ……………… (For transfer of depreciation to P/L a/c)

Additional Entries 4. For For sale sale of of fixe fixed d asse assets ts Cash/Bank a/c D r. To, Fixed asset a/c (For sale of fixed asset) 5. For For gain gain on on sale sale of of fixe fixed d asset assetss Fixed asset a/c D r. To, Profit & Loss a/c (For gain on sale of fixed asset) 6. For For loss loss on on sale sale of of fixe fixed d asset asset Profit & Loss a/c D r. To, Fixed asset (For loss on sale of fixed asset)

……………… ………………

……………… ………………

……………… ………………

Methods of Depreciation There are a number of different methods of providing depreciation for the assets. The method of  depreciatio depreciation n depends on a number of factors such as type of asset, asset, life, life, policy policy organization organization etc. The following are the list of methods of depreciation: d epreciation: 1. Fixe Fixed d insta install llme ment nt meth method od 2. Dimi Dimini nish shin ing g Balan Balance ce meth method od 3. Sum of the year year digits digits method method 4. Annu Annuiity metho ethod d 5. Depr Deprec ecia iati tion on Fun Fund d meth method od 6. Insu Insura rance nce polic policy y met metho hod d 7. Reva Revalu luat atio ion n meth method od 8. Depl Deplet etio ion n met metho hod d 9. Mach Machin inee hour hour rate rate meth method od 10. Double declini declining ng methods methods 11. MACRS (Modified Accelerated Cost Recovery System) method

As per the syllabus of BIM 4th Semester, we will discuss following 3 methods only:

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Accounting for Fixed Assets, Financial Accounting  Rabin Hada

1. Stra Straig ight ht Line Line Meth Method od 2. Wr Writ itte ten n Down Down Met Metho hod d 3. Depr Deprec ecia iati tion on Fun Fund d Meth Method od Straight Line Method This method is also known as Fixed Installment Method, Equal Installment Method, Original Cost Method, Simple or Historical Cost Method. Under this method, a fixed proportion of  original cost of the asset is written-off annually so that by the time asset is worn out, its value in the books is reduced to zero or residual value.

The amount of depreciation to be charged each year can be found out as follows: Annual Depreciati on

Original Cost of  fixed asset =

−

estimated scrap value

Life of  asset

Advantages 1. It is simp simples lestt to unders understan tand d and easy easy to apply apply.. 2. The value value of asset asset can be reduced reduced to zero zero or its its scrap scrap value. value. Disadvantages 1. This This method method does does not take in account account the effectiv effectivee utilizat utilization ion of the asset. asset. The same amount of depreciation is charged from year to year, irrespective of use of the asset. 2. With With the passage passage of time, time, efficien efficiency cy of asset asset decrease decreasess but the amount amount of deprec depreciat iation ion remains the same, which does not seem to be justified. Accounting Treatment 1. Pass Pass the the neces necessar sary y journ journal al entr entries ies 2. Fixe Fixed d asse assett acco accoun untt 3. Depr Deprec ecia iati tion on accou account nt

Illustration 1

A machine was bought on January 1, 1990 for Rs.8,000. It cost Rs.1,000 Rs.1,000 for transporta transportation tion and Rs.1000 for installation. The scrap value of the machine is estimated to be Rs.1,000 at the end of  its three years of working life. Prepare plant account with the help of journal entries for 3 years after charging depreciation according to Straight Line Method. Solution: Tota Totall cos costt of of mac machi hine ne = Rs. Rs.8, 8,00 000 0 + 1,00 1,000 0 + 1,00 1,000 0 = Rs.10,000 Estimated sc scrap va value Annual Depreciati on

= Rs Rs.1,000 000 Total cost of  machine

=

−

estimated scrap value

Life of  asset

4

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

10,000 =

1,000

−

3

= Rs.3,000 Journal Entries Date Jan Jan 1, 1990 1990

Dec. 31, 1990

Dec. 31, 1990

Dec. 31, 1991

Dec. 31, 1991

Dec. 31, 1992

Dec. 31, 1992

Dec. 31, 1992

Dr. Date Dec.31, 1990

Dec.31, 1991

Particular

LF

Mach Machin inee a/c a/c Dr. Dr. To, Bank a/c (For purchase of machine) Depreciation a/c Dr. To, Machine a/c (For For char chargi ging ng depr deprec eciiati ation on machine) Profit & Loss a/c Dr. To, Depreciation a/c (For transfer of depreciation to P/L a/c) Depreciation a/c Dr. To, Machine a/c (For For char chargi ging ng depr deprec eciiati ation on machine) Profit & Loss a/c Dr. To, Depreciation a/c (For transfer of depreciation to P/L a/c) Depreciation a/c Dr. To, Machine a/c (For For char chargi ging ng depr deprec eciiati ation on machine) Profit & Loss a/c Dr. To, Depreciation a/c (For transfer of depreciation to P/L a/c) Cash/Bank a/c Dr. To, Machine a/c (For realization of scrap value)

Particular To, Machine a/c

To, Machine a/c

Depreciation Account LF Amount Date 3,000 Dec.31, 1990 3,000 3,000 Dec.31, 1991 3,000

5

Debit 10,000

Credit

10,000 3,000 3,000

3,000 3,000

3,000 3,000

3,000 3,000

3,000 3,000

3,000 3,000

1,000 1,000

Particular By, P/L a/c

By, P/L a/c

Cr. LF Amount 3,000

3,000 3,000 3,000

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

Dec.31, 1992

To, Machine a/c

3,000

Dec.31, 1992

By, P/L a/c

3,000 Dr. Date Dec.31, 1990

Particular To, Bank a/c

Dec.31, 1991

To, Bal b/d

Dec.31, 1992

To, Bal b/d

3,000 3,000

Machine Account LF Amount Date 10,000 Dec.31, 1990 10,000 7,000 Dec.31, 1991 7,000 4,000 Dec.31, 1992 4,000

Particular By, Dep. a/c By, Bal c/d

By, Dep. a/c By, Bal c/d By, Dep. a/c By, Bank a/c

Cr. LF Amount 3,000 7,000 10,000 3,000 4,000 7,000 3,000 1,000 4,000

Problem A trader bought machinery on 1st January, 1993 for Rs.1,25,000 whose useful life has been estimated 5 years. After the expiry of useful life the scrap will realize Rs.25,000. Prepare machinery account and depreciation account, charging depreciation by fixed installment method for 5 years. Also pass necessary journal entries.

Addition and sale of assets during the year During the accounting period, a firm can buy and/or sale its fixed assets. The additional purchase of assets increase the amount of depreciation whereas sales of existing assets decrease the amount of depreciation at the end of the period. Addition of asset The depreci depreciati ation on for the additi additional onal assets assets purcha purchased sed during during the account accounting ing period period may be  provided on either of the following two basis: 1. Depreci Depreciati ation on may be provided provided for a year year for the additi additional onal assets assets irresp irrespect ective ive of use  period. That is, depreciation may be provided for a year even if assets are added in middle or near to end of accounting period. 2. Depr Deprec ecia iati tion on may may be prov provid ided ed on asse assets ts adde added d for for the the use use peri period od only only.. That That is, is, depr deprec ecia iati tion on shou should ld be provi provide ded d for for the the perio period d of the the date date of purcha purchase se to end end of  accounting period, i.e., for use period only. Note:   If date of addition and method of charging deprecation is given in the problem, then depreciation on additional assets should be provided for use period only.

Illustration 2 The financial year of a firm is closed on December 31, each year. It purchased the following machinery: On January 1, 1996 Machine costing Rs.30,000

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Accounting for Fixed Assets, Financial Accounting  Rabin Hada

On July 1, 1996 Machine costing Rs.20,000 On April 1, 1997 Machine costing Rs.10,000 The machinery is to be depreciated by fixed installment method at 10% p.a. Show the machinery account for 1996 and 1997. Solution: Year Particular Machine Total Depreciation 1 2 3 1996 Cost 30,000 20,000 Depreciation 3,000 1,000 4,000 1997 Bal b/d 27,000 19,000 10,000 Depreciation 3,000 2,000 750 5,750 Balance 24,000 17,000 9,250 Note: - Depreciation for 1st machine is provided for a year in 1996 and 1997. - Depreciation on 2nd machine is provided only for 6 months in 1996 and for a year in 1997. - Depreciation on 3rd machine is provided for 9 months in 1997.

Dr. Date Jan 1, 1996 July 1, 1996

Jan 1, 1997 April 1, 1997

Particular To, Bank a/c

To, Bank a/c

Machinery Account LF Amount Date 30,000 Dec.31, 1996 20,000

To, Bal b/d

50,000 46,000

To, Bank a/c

10,000

Dec.31, 1991

56,000

Particular By, Dep. a/c By, Bal c/d

By, Dep. a/c By, Bal c/d

LF

Cr. Amount 4,000 46,000

50,000 5,750 50,250

56,000

Problem On 1st January 1999 a company purchased a plant and machinery costing Rs.1,00,000. It is estimated that the working life of the plant is 10 years after which its break up value will be zero.

Additions are made on 1st April, 2000 to the value of Rs.50,000. Its probable life was estimated at 5 years and scrap value at the end of life is Rs.10,000. More additions are made on 1st July, 2001 to the value of Rs.44,000 (Break up value Rs.4,000). The working life was estimated at 4 years. It was decided to write off depreciation by Straight Line Method. The accounts are closed on 31st December each year. Required: Show the plant and machinery account acc ount for the first 4 years.

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Accounting for Fixed Assets, Financial Accounting  Rabin Hada

Sale of assets During the accounting period, the firm may sell its partial or whole assets due to various reasons  before the expiry of their useful life. In such a case, the depreciation should be provided on those assets up to their date of sales. The assets can be sold at book value (original cost – accumulated depreciation) or at a profit or at loss. The gain or loss should be accounted accordingly. Illustration 3 Clinton maintains his books of accounts on calendar year basis. He purchased on 1.1.94 a machine for Rs.40,000. He purchased another machine on 1st October 1994 for Rs.20,000 and on 1st July 1995 for Rs.10,000. On 1st July, 1996 one fourth of the machine installed on 1st January, 1994 became obsolete and was sold for Rs.6,800.

Show hoe the machinery account will appear in the books of Clinton for all the 3 years under  fixed installment method. Depreciation is to be charged at 10% per annum. Solution: Year

1994 1995 1996

Dr. Date 1.1.94 1.10.94

Particular

Cost Depreciation Balance & cost Depreciation Balance Depreciation

Particular To, Bank a/c To, Bank a/c

1.1.95 1.7.96

To, Bal b/d To, Bank a/c

1.1.96

To, Bal b/d

1 40,000 4,000 36,000 4,000 32,000 3000+500

Machine 2 20,000 500 19,500 2,000 17,500 2,000

Machinery Account LF Amount Date 40,000 31.1 1.12.94 20,000 60,000 55,500 31.1 1.12.95 10,000 65,500 59,000 31.12.96

59,000

3

Total Depreciation

10,000 500 9,500 1,000

Particular By, Dep Dep.. a/ a/c By, Bal c/d

By, Dep Dep.. a/ a/c By, Bal c/d By, Bank a/c By, Dep. sold machine By, P/L a/c (loss) By, Dep. a/c By, Bal c/d

4,500 6,500 6,500

LF

Cr. Amount 4,500 55,500 60,000 6,500 59,000 65,500 6,800 500

700 6,000 45,000 59,000

Problem A machine was purchased for Rs.10,000 on 1st January, January, 1988. It was decided to depreciate depreciate it at

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Accounting for Fixed Assets, Financial Accounting  Rabin Hada

the rate of 10% on original cost method. On 1st July, 1989 another machinery was purchased for  Rs.20,000. On 1st Januar January, y, 1990 the machin machinery ery bought on 1st Januar January, y, 1998 was sold sold for  Rs.8,500. Prepare machinery account for 3 years, assuming that the books are closed on 31st December  each year. (Ans: Profit on sale of machinery Rs.500; Balance on machinery account on 31st Dec, 1990, Rs.17,000).

Written Down Method This method is also known as Diminishing Balance method, Reducing Balance method. Under  this method, a fixed percentage of depreciation is charged on the reducing balance of asset (cost depreciation) till the amount is reduced to scrap value. Since a constant percentage rate is being applied to the written down value, the amount of depreciation charged every year decreases over  the life of the asset. This method assumes that an asset should be depreciated more in earlier  years of use than later years because the maximum loss of an asset occurs in the early years of  use.

The fixed percentage rate, to be applied to the allocation of net cost as depreciation, can be obtained by following formula –  Rate of  Depreciati

on

1- n

=

Scrap Value Depreciabl

e cost of  asset

Where, n = Estimated useful life of the asset Example The cost of asset is Rs.2,16,000 and salvage value at the end of useful life is Rs.27,000. The estimated useful life of asset is three years. It is decided to depreciate the asset under written down value method. Required: Rate of Depreciation Solution: Rate of  Depreciati

on

Rate of  Depreciati

on

1- n

=

1- 3

=

Scrap Value Depreciabl e cost of  asset 27,000 2,16,000

= 50% Advantages 1. The amount amount of deprecia depreciati tion on decreas decreases es continuo continuousl usly y with the gradual gradual decreas decreasee in the service potential of asset. 2. When additions additions are are made to the the asset, asset, fresh fresh calculation calculation of depreci depreciation ation is not required. required. 3. Under Under this method method larger larger amount amount of depreci depreciati ation on is provid provided ed in earlie earlierr years years and thus method minimizes the impact of obsolescence.

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Accounting for Fixed Assets, Financial Accounting  Rabin Hada

Disadvantages 1. Amount of depreci depreciation ation expenses expenses decreases decreases even even if the efficienc efficiency y of asset is mainta maintained ined  by way of repairs and maintenance. 2. Heavy depreci depreciation ation expenses expenses will will be charged charged to profit profit and loss loss account in in earlier earlier years. years. 3. Even after after becoming becoming obsolete obsolete,, the book value of asset can never be zero.

Illustration An asset was purchased for Rs.50,000 on 1st January, 1998. Assuming annual depreciation to be 10%, show the asset account for 3 years under written down value method. Solution:

Calculating depreciation for 3 years Year Balance of asset 1 50,000 2 45,000 3 40,500

Date 1.1.1998

1.1.98

1.1.98

Particular To, Bank a/c

LF

Dep reciation 5,000 4,500 4,050

Asset Account Amount Date 50,000 31.12.98

Particular By, Dep. a/c By, Bal c/d

To, Bal b/d

50,000 45,000

31.12.98

By, Dep. a/c By, Bal c/d

To, Bal b/d

45,000 40,500

31.12.98

By, Dep. a/c By, Bal c/d

40,500 Dr. Date 31.12.98

Particular To, Asset

31.12.98

To, Asset

31.12.98

To, Asset

Depreciation Account LF Amount Date 5,000 31.12.98 5,000 5,000 31.12.98 5,000 5,000 31.12.98 5,000

Particular By, P/L a/c

By, P/L a/c By, P/L a/c

LF

Amount 5,000 45,00 50,000 4,500 40,500 45,000 4,050 36,450 40,500

Cr. LF Amount 5,000 5,000 5,000 5,000 5,000 5,000

Problem A firm purchased plant and machinery on 1st April 1993 for Rs.50,000. Depreciation is writtenoff at the rate of 10% per annum. Show 5 years plant and machinery account and depreciation account under reducing balance method. The firm closes its books on 31st December each year. [Ans: Balance 30,344]

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Accounting for Fixed Assets, Financial Accounting  Rabin Hada

Purchases of asset Illustration A mach machin inee was was bough boughtt for for Rs.4 Rs.40,0 0,000 00 with with an esti estima mate ted d life life of 10 year years. s. Wr Writ itee off off 10% 10% depreciation each on diminishing balance system and show the ledger account for the first five years. At the commencement of third year a new machine worth Rs.5,000 was added. Solution: Journal Entries Date 1st year

At the end of 1st year 

At the end of 2nd year 

In the beg. of 3rd year  At the end of 3rd year 

At the end of 4th year 

Particular

LF

Machine a/c Dr. To, bank a/c (Being purchase of machine) Depreciation a/c Dr. To, Machine a/c (Being depreciation charged at 10%) Profit & Loss a/c Dr. To, Dep. a/c (Being (Being trans transfer fer of deprec depreciat iation ion to P/L a/c) Depreciation a/c Dr. To, Machine a/c (Being depreciation charged at 10%) Profit & Loss a/c Dr. To, Dep. a/c (Being (Being trans transfer fer of deprec depreciat iation ion to P/L a/c) Machine a/c Dr. To, Bank a/c (Being purchase of new machinery) Depreciation a/c Dr. To, Machine a/c (Being depreciation charged at 10%) Profit & Loss a/c Dr. To, Dep. a/c (Being (Being trans transfer fer of deprec depreciat iation ion to P/L a/c) Depreciation a/c Dr. To, Machine a/c (Being depreciation charged at 10%) Profit & Loss a/c Dr. To, Dep. a/c (Being (Being trans transfer fer of deprec depreciat iation ion to P/L a/c)

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Debit 40,000

Credit

40,000 4,000 4,000 4,000 4,000

3,600 3,600 3,600 3,600

5,000 5,000 3,740 3,740 3,740 3,740

3,366 3,366 3,366 3,366

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

At the end of 5th year 

Dr. Date 1st year

nd

2 year

Depreciation a/c Dr. To, Machine a/c (Being depreciation charged at 10%) Profit & Loss a/c Dr. To, Dep. a/c (Being (Being trans transfer fer of deprec depreciat iation ion to P/L a/c)

Particular To, Bank

To, Bal b/d

Machinery Account LF Amount Date 40,000 1st year

40,000 36,000

3 year

To, Bal b/d To, Bank 

4th year

To, Bal b/d

36,000 32,400 5,000 37,400 33,660

To, Bal b/d

33,660 30,294

To, Bal b/d

30,294 27,265

rd

th

5 year

th

6 year

3,029 3,029 3,029 3,029

Particular By, Dep. a/c By, Bal c/d

2nd year

By, Dep. a/c By, Bal c/d

3rd year

By, Dep. a/c By, Bal c/d

4th year

By, Dep. a/c By, Bal c/d

5th year

By, Dep. a/c By, Bal c/d

Cr. LF Amount 4,000 36,000 40,000 3,600 32,400 36,000 3,740 33,660 37,400 3,366 30,294 33,660 3,029 27,265 30,294

Sale of assets On January 1991 a company acquired machinery for Rs.120,000 and on June 30th, 1992 it  purchased additional machinery at cost of Rs.20,000. On March 31, 1993 one of the original machines which cost Rs.5,000 was found to have become obsolete and was sold as scrap for  Rs.500 Rs.500.. On that that date date it purcha purchased sed a new machine machine costin costing g Rs.8,0 Rs.8,000. 00. Depreciat Depreciation ion is to be st  provided at the rate of 15% per annum on written down value on December 31 of each year. You are asked to write up machinery account for four years.

[Ans: Balance Rs.7,932]

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Accounting for Fixed Assets, Financial Accounting  Rabin Hada

Depreciation Fund Method Under this method, a fixed amount of depreciation is transferred to a fund called Depreciation fund or Sinking fund to accumulate the amount required to replace an asset. This fund is then invested into easily realizable securities. This method takes into account the time value of  money. It is based on the concept of present value.

Under this method, a fund is created by debiting Depreciation account and crediting Sinking fund account. Depreciation account is ultimately transferred to Profit and Loss account. An amount equivalent to depreciation charged is invested outside this business or other securities and is allowed to accumulate at compound interest so as to produce the required amount to replace the asset after a specified period of time. The main advantage of this method is that it avoids strain on working capital, if substantial sums are withdrawn from the business to replace the asset at the end of its life. However, during inflation, the depreciable cost of an asset is likely to be less than the replacement cost of the asset. The asset is shown in balance sheet every year, at its original value. Sinking fund is shown on the liabilities side and sinking fund investment is shown on the asset side of the balance sheet. At the end of the useful life of the asset, all investments are sold away. The proceeds are utilized for   purchasing the new asset. The asset account is closed by setting it off against the Sinking fund account. It should be noted that profit or loss on sale of investment is also transferred to the Sinking fund account. Advantages 1. This method method of depreciati depreciation on assists assists the business business to provide provide funds for for the replacement replacement of  asset when it gets worn out. 2. As the the amou amount nt equal equal to depr deprec ecia iati tion on is invest invested ed outs outsid idee the the busi busines ness, s, it resu result ltss into into generation of extra income on account of interest received. 3. As the amount amount of annual annual depreciati depreciation on remains remains the same same thus each year’s year’s profit profit and and loss account is burdened uniformly. Disadvantages 1. Each year’s year’s depreciat depreciation ion is required required to be investe invested d in purchase purchase of investments investments,, interest interest is required to be collected and in the last year of life of asset these investments are to be sold, all these activities involve lot of time and labour cost. 2. If the market market price price of investment investment falls falls,, it will result result in in loss to the the business. business. 3. In order to to purchase purchase investment investmentss each year, year, funds are are required required to be arranged. arranged. 4. From accounti accounting ng point of view view also this this method method is quite quite time consumi consuming ng and complex. complex.

Amount of Depreciation The equal amount of cash to be invested each year is ascertained from the sinking fund table. It can be calculated as follows:

Amount of Depreciation = Original cost – Scrap value Future value of Annuity of Re.1 for given period at given rate

13

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

For e.g.: ABC Co. purchased a machine costing Rs.13500 with an estimated scrap value of Rs.1000. The estimated estimated life of the machine is 5 years. The rate of interest interest on the investment investment is 4%. Calculate Calculate the amount of depreciation to be charged each year. Sol:

Original cost Less: Scrap Value Depreciable value Amount of depreciation

= Rs.13500 = Rs.1000 = Rs.12500 = Depreciable value FVIFA4%,5yrs = Rs.12500 5.4163 = Rs.2307.88

Journal Entries 1. At the end end of of the the first first year year a. For setting setting aside aside the the requir required ed amou amount  nt  Depreciation a/c Dr. To, Dep. fund a/c b. For transfer transferring ring depreci depreciatio ation n to P/L P/L a/c a/c Profit and Loss a/c Dr. To, Depreciation a/c c. For For inve invest stin ing g the the amou amount  nt  Dep. Fund Investment a/c To, Bank a/c

Dr.

2. Secon Second d and and subs subsequ equen entt years years a. For intere interest st on on inve investm stment  ent  Bank a/c D r. To, Interest on Dep. Fund Investment a/c

Interest on Dep. Fund Investment a/c To, Dep. Fund a/c

D r.

b. For settin setting g asid asidee the the amo amount  unt  Dep. a/c Dr. To, Dep. Fund a/c c. For transf transferri erring ng Deprec Depreciati iation on to Profi Profitt and Loss Loss a/c a/c Dep. a/c Dr. To, P/L a/c

14

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

d. For invest investing ing (amoun (amountt of deprecia depreciation tion plus plus interes interest) t) Dep. Fund Investment a/c Dr. To, Bank a/c

3. Last Ye Year a. For intere interest st on on inve investm stment  ent  Bank a/c D r. To, Interest on Dep. Fund Investment a/c

Interest on Dep. Fund Investment a/c To, Dep. Fund a/c b. For settin setting g asid asidee the the amo amount  unt  Dep. a/c Dr. To, Dep. Fund a/c c. For For sal salee of of inv inves estm tmen ent  t  Bank a/c D r. To, Dep. Fund Investment a/c d. For transf transferri erring ng profit profit or loss loss on sale sale of invest investmen ment  t  (i) For Profit Dep. Fund Investment a/c Dr. To, Dep. Fund a/c (ii) For Loss Dep. Fund a/c Dr. To, Dep. Fund Investment a/c e. For For sal salee of of scr scrap ap Bank a/c To, Asset a/c

D r.

f. For For clos closin ing g Dep Dep.. Fun Fund d acc accou ount nt Dep. Fund a/c D r. To, Asset a/c g. For For clos closin ing g Ass Asset et acco account unt If there is any balance in the asset account, it is transferred to Profit & Loss account.

Illustration Sanjay Bros. bought a machine whose estimated life was 5 years. The date of purchase was 1st January 1990 and its cost was Rs.13500, with a scrap value of Rs.1000. They decided to

15

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

depreciate the machine by sinking fund method. The rate of interest on investments is 4% per  annum. At the end of 1994 the investments realized Rs.9700. Show the entries and prepare necessary accounts.  Note: Table shows that Re.0.18463 invested each year at 4% interest amounts to Re.1 after 5 years. Solution: Cost of machine Rs.13500 Less: Scrap Value Rs.1000 Amount to be written-off Rs.12500 Annu Annual al amou amount nt of depr deprec ecia iati tion on = 0.18 0.1846 463 3 X Rs. Rs.12 1250 500 0 = Rs.2 Rs.230 307. 7.88 88 Journal Entries  At the time of machine purchase 1.1.90 Machine a/c To, Bank  (Purchase of machine)

Dr  

Rs.13500

 At the end of first year  31.12.90 Dep. a/c Dr. To, Dep. Fund a/c (Annu (Annual al depre depreci ciat atio ion n credi credite ted d to Dep. Fund a/c) 31.12.90 Profit & Loss a/c Dr. To, Dep. a/c (Depreciation charged to PL a/c) 31.12.90 Dep. Fund Investment a/c Dr. To, Bank a/c (Investment purchased) purchased)  Second years 31.12.91

31.12.91

31.12.91

31.12.91

31.12.91

Rs.13500

Bank a/c Dr. To, Interest on Dep. Fund Investment a/c (Interest received) Interest on Dep. Fund Inv. a/c Dr. To, Dep. Fund a/c (Interest credited to Dep. Fund a/c) Dep. a/c Dr. To, Dep. Fund a/c (Depreciated credited to Dep. Fund a/c) Profit & Loss a/c Dr. To, Dep. a/c (Depreciation debited to PL a/c) Dep. Fund Investment a/c Dr.

16

2307.88 2307.88

2307.88 2307.88 2307.88 2307.88

92.32 92.32

92.32 92.32 2307.88 2307.88

2307.88 2307.88 2400.20

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

To, Bank a/c (Investment purchased) Third year  31.12.92

31.12.92

31.12.92

31.12.92

31.12.92

Fourth year  31.12.93

31.12.93

31.12.93

31.12.93

31.12.93

Fifth year  31.12.94

2400.20

Bank a/c Dr. To, Interest on Dep. Fund Investment a/c (Interest received) Interest on Dep. Fund Inv. a/c Dr. To, Dep. Fund a/c (Interest credited to Dep. Fund a/c) Dep. a/c Dr. To, Dep. Fund a/c (Depreciated credited to Dep. Fund a/c) Profit & Loss a/c Dr. To, Dep. a/c (Depreciation debited to PL a/c) Dep. Fund Investment a/c Dr. To, Bank a/c (Investment purchased)

Bank a/c Dr. To, Interest on Dep. Fund Investment a/c (Interest received) Interest on Dep. Fund Inv. a/c Dr. To, Dep. Fund a/c (Interest credited to Dep. Fund a/c) Dep. a/c Dr. To, Dep. Fund a/c (Depreciated credited to Dep. Fund a/c) Profit & Loss a/c Dr. To, Dep. a/c (Depreciation debited to PL a/c) Dep. Fund Investment a/c Dr. To, Bank a/c (Investment purchased)

Bank a/c To, Interest on Dep. Fund Investment a/c (Interest received)

Dr.

188.32 188.32

188.32 188.32 2307.88 2307.88

2307.88 2307.88 2496.20 2496.20

288.16 288.16

288.16 288.16 2307.88 2307.88

2307.88 2307.88 2596.04 2596.04

392.01 392.01

17

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

31.12.94

31.12.94

31.12.94

Interest on Dep. Fund Inv. a/c Dr. To, Dep. Fund a/c (Interest credited to Dep. Fund a/c) Dep. a/c Dr. To, Dep. Fund a/c (Depreciated credited to Dep. Fund a/c) Profit & Loss a/c Dr. To, Dep. a/c (Depreciation debited to PL a/c)

 At the sale of Investment  31.12.94 Bank a/c Dr. To, Dep. Fund Investment a/c (Investment sold) 31.12.94 Dep. Fund a/c Dr. To, Dep. Fund Investment a/c (Loss on sale of Investment transferred to Dep. Fund a/c) 31.12.94 Bank a/c Dr. To, Machine a/c (Scrap value of machine) 31.12.94 Dep. Fund a/c Dr. To. Machine a/c (Balance of Dep. Fund transferred to Machine a/c) 31.12.94 Profit & Loss a/c Dr. To, Machine a/c (Balance of machine a/c transferred to PL a/c)

392.01 392.01 2307.88 2307.88

2307.88 2307.88

9700.00 9700.00 100.32 100.32

1000.00 1000.00 12500.00 12500.00

100.11 100.11

Problem 1 A company purchased a plant for Rs.11000. It estimated the turn in value Rs.1000 and useful life 8 years. It decided to make provision for depreciation by means of sinking fund. Show necessary ledge ledgerr accou account ntss for for the the firs firstt thre threee year years. s. It is asce ascert rtai aine ned d from from sinki sinking ng fund fund tabl tablee that that Re.0.10472181 invested annually at 5% per annum at compound interest will provide Re.1 a the end of 8 years.

[Ans: Annual depreciation Rs.1047.22; Balance at the end to 3rd year Rs.3301.36]

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Accounting for Fixed Assets, Financial Accounting  Rabin Hada

Question Objective Type Questions: 1. State State which which of the follo following wing alter alternati natives ves is corre correct ct a. The main main object objective ive of provi providin ding g depreci depreciati ation on is i. To cal calcu cula late te tru truee prof profit it ii. To show show true true financi financial al positi position on in the balance balance sheet iii. iii. To redu reduce ce tax tax bur burde den n iv. To provide provide funds for replacement replacement of fixed fixed assets assets b. Deprecia Depreciation tion arises arises because because of: i. Fall Fall in the mark market et valu valuee of an an asset asset ii. ii. Phys Physic ical al wear wear and and tea tear  r  iii. iii. Fall Fall in in the the valu valuee of mon money ey c. Under Under the straight straight line line method method of charg charging ing deprec depreciati iation, on, it: i. Incr Increa ease sess every every year  year  ii. ii. Decr Decreas eases es ever every y yea year  r  iii. iii. Is con const stant ant ever every y yea year  r  d. Under the diminishing diminishing balance method, depreciation depreciation is calculated calculated on: i. The The ori origi gina nall cos costt ii. ii. Wr Writ itte ten n down down val value ue iii. iii. The The scr scrap ap valu valuee e. A dim diminis inishi hing ng bala balanc ncee meth method od of prov provid idin ing g for for depr deprec ecia iati tion on is one, one, according to which: i. The amount amount on which which depreciat depreciation ion is calcul calculate ated, d, is reduced reduced from year year to year  ii. ii. The The rate rate per cent declin declines es from year year to year, year, at whic which h depre depreci ciat atio ion n is charged iii. The rate rate per cent as well as amount amount reduces reduces every year  f. The amount amount of of depreci depreciatio ation n charged charged on mach machiner inery y will be debit debited ed to i. Mach Machin iner ery y acc accou ount nt ii. ii. Depr Deprec ecia iati tion on acco account unt iii. Cas Cash acco accoun untt g. Loss on the sale sale of plant plant and and machinery machinery should be written written of of against: against: i. Shar Sharee pre premi mium um acco account unt ii. ii. Depr Deprec ecia iati tion on fund fund accou account nt h. Deprecia Depreciation tion on the diminis diminishing hing balanc balancee method method on a machine machinery ry of Rs.2000 Rs.2000 at the rate of 10% per annum after three years will be: i. Rs.1400 ii. Rs.145.8 iii. Rs.542 iv. iv. None None of the the abo above ve i. Depr Deprec ecia iati tion on is is proc proces esss of: of: i. Valuati ation ii. All Allocat ocatiion iii. iii. Both Both valua valuatio tion n and and alloc allocati ation on iv. None None of thes thesee

19

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

 j. If the cost cost of the asse assett is Rs.21 Rs.2100 000 0 and the scrap scrap value value is Rs.100 Rs.1000 0 then the the amoun amountt of dep depre recia ciatio tion n @10% @10% p.a. p.a. for for the year year un unde derr the stra straigh ightt line line method would be: i. Rs.2100 ii. Rs.2000 iii. Rs.2200 2. Fill Fill up the the bla blank nks: s: a. Depreciati Depreciation on refers refers to to ……………… ………………… … in the value value of assets. assets.  b. When depreciat depreciation ion is charged, charged, asset asset account account is is ………………… ………………… and and depreciatio depreciation n account is ………………… c. Depreci Depreciati ation on is provid provided ed on ……………… ………………… … assets assets.. d. The sales sales value value of an asset asset after after it becomes becomes useless useless is called called ………………… ………………… e. Discarding Discarding the the old machiner machinery y due to new new invention invention is is called called ………………… …………………

3. Short a.  b. c. d. e.

Questions: What What is depr depreci eciati ation? on? What What are are its its causes causes?? How does dimini diminishing shing balance balance method method differ differ from fixed fixed install installment ment method? method? What is is Depreciati Depreciation on Fund method? method? What What are the objective objectivess of this this method? method? Is it compulsor compulsory y to provide provide depreciati depreciation on on fixed assets assets in a sole sole trading trading concern? concern? What are are the factors factors to be considere considered d while while calculati calculating ng depreciat depreciation? ion?

4. Prac Practi tica call Prob Proble lems ms:: a. Stra Straig ight ht L Lin inee Met Metho hod d i. A company company purcha purchased sed a plant plant for Rs.4000 Rs.4000.. The useful useful life life of the plant plant is 10 years and the estimated scrap value is Rs.400. Determine the rate of  depreciation when the management wants to depreciation it by straight line method. [Ans. 9%]

ii. On 1st January, 1990 an asset was purchased for Rs.35000. The estimated life of the asset is 5 years after which its break up value will be Rs.5000 only. Prepare the asset account for the first three years, by straight line method assuming that the books are closed on 31st December. [Ans: Balance of machinery account 31st Dec. 1992, Rs.19500] b. Wr Writ itte ten n Down Down Met Metho hod d i. The origin original al cost of furnit furniture ure and fixture fixturess amounted amounted to Rs.4000 Rs.4000 and it is divided to write off 5% on the diminishing value of asset as depreciated at the end of the each year. Show the ledger account as it will appear during the first four years. [Ans: Balance of machinery account after four years, Rs.3258.03] ii. A plant plant is purchase purchased d for Rs.25600 Rs.25600.. Depreciati Depreciation on is to be provided provided at 25% 25%  pa. on written down value method. The turn in value of plant at the end of  its economic life of 4 years is expected to be Rs.8100. You are required to show plant account for 4 years.

20

Accounting for Fixed Assets, Financial Accounting  Rabin Hada

[Ans: The balance in plant account Rs.8100] c. Depre Deprecia ciatio tion n Fund Fund Metho Method d i. A compan company y purcha purchased sed a leas leasee for Rs.3000 Rs.30000 0 on 1st January 1989. It is to be renewed at the end of three years. For this purpose a depreciation fund is established. The depreciation fund investments will realize 5%. Sinking fund table shows that Re.0.317208 must be invested each year to obtain Re.1 at the end of o f 3 years, the rate of interest being 5%.

On 31st Dec., 1991, the investments investments were realized realized Rs.19400. Rs.19400. A new lease was purchased on the same date for Rs.35000. The balance at the bank   before realization of investments was Rs.20000. Give journal entries in the  books of the company. [Ans: Loss on sale of investments Rs.108.29]

End of the Chapter

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