Notes-Class-11-Commerce-Book Keeping and Accountancy-Chapter-7-Depreciation-Maharashtra Board

Topics to be Learn :  Meaning, Definition and Importance of Depreciation. Factors of Depreciation. Methods of Depreciation : Straight Line Method. Written Down Value Method. Difference between Fixed Instalment Method and Written Down Value Method. Accounting Treatment for Depreciation.

Meaning and Definition of Depreciation :

The word Depreciation is derived from the Latin word 'Depretium' which means reduction. Every business concern acquires fixed assets for its trading activity — these are purchased for permanent use and not for resale.

Reduction in the value of fixed assets due to Wear and Tear or actual use is called Depreciation.

In short: "Depreciation is defined as shrinkage in the value of an asset due to wear and tear, passage of time or obsolescence."

Key Definitions from Authorities :

1. Gradual decrease in the value of an asset from any cause: N. Carter
2. Gradual deterioration in the value due to use: G. Williams
3. Permanent and continuing diminution in the quality, quantity or the value of an asset: William Pickles
4. A measure of wearing out, consumption or other loss of value arising from use, effluxion of time or obsolescence through technology and market changes: ICAI
5. Allocation of the depreciable amount of an asset over its estimated useful life — charged to income either directly or indirectly: ICAC (International Accounting Standard)

 

IMPORTANT NOTES

1. Land is NEVER depreciated — many times it is appreciated. The area of Land neither increases nor decreases.

2. Depreciation is charged EVERY YEAR whether the business concern is earning profit or suffering a loss.

 

Causes of Depreciation :

1. Normal and Natural Wear and Tear : Value of a fixed asset reduces due to its actual use. More the use, more the wear and tear
2. Passage of Time : Fixed assets depreciate with the passage of time even if not in use (e.g., Patents, Trademarks, Copyrights, Leases, Software)
3. Obsolescence : Technological development causes old assets to become out-dated. e.g., older computers replaced by newer models:
4. Depletion : Decrease in value of wasting assets such as Forests, Oil-wells, Mines, Quarries.
5. Natural Calamities / Impairment : Price decreases due to earthquakes, storms, cyclones, fire, floods, or accidents.
6. Invention : When new machines are invented, earlier assets lose utility and value. e.g., iPhone 8 reduced value of iPhone 7.
7. Market Value : Market value of an asset changes according to prevailing conditions. When market value falls below cost, it causes depreciation.

Need and Importance of Depreciation :

• True Profit and Loss: Depreciation is charged to Profit & Loss A/c as it is an element of Cost. It helps ascertain true net Profit or Loss during a particular accounting period.
• It is a non-cash expenditure and a Nominal Account.
• Financial Position: Without depreciation, assets would be overvalued and the financial position would not be true and fair.
• Asset Replacement: Depreciation is necessary to make provision for replacement of old assets — without it, the business may lack sufficient funds.
• Tax Compliance: It enables the business to compute and pay the correct amount of tax to the Government.
• Ensures equivalent funds are set aside each year so that at the end of an asset's life, it can be easily replaced.

Factors to Consider While Charging Depreciation :

Three basic factors must be considered when determining the annual depreciation amount:

• Cost of Asset (Historical Cost): This includes the purchase price plus all expenses necessary to put the asset into operation, such as transportation, transit insurance, custom duty, installation charges, and reconditioning costs for second-hand assets.

Original Cost = Purchase Price + Incidental Charges

• Estimated Economic Life: The period (usually in years) during which the business expects to derive useful service and profit from the asset.
• Estimated Terminal Value (Scrap/Residual Value): The net realisable value of the asset at the end of its economic life, calculated by deducting disposal and removal costs from the sale price.

Methods of Depreciation :

Various methods are used depending on the nature of the asset, its use, and necessity:

1. Fixed Instalment (Straight Line / Original Cost) Method
2. Diminishing / Reducing Balance (Written Down Value) Method
3. Annuity Method
4. Depreciation Fund Method
5. Revaluation Method
6. Insurance Policy Method
7. Machine Hour Rate Method

(1) Fixed Instalment / Straight Line / Original Cost Method :

Under this method, depreciation is charged at a specific percentage on the ORIGINAL COST of the asset every year, reducing the asset account to nil (or scrap value) by the end of its estimated life.

 

Depreciation (p.a.) = \(\frac{\text{Original Cost - Scrap Value}}{\text{Estimated Life of Asset (in years)}}\)

Depreciation (p.a.) = \(\frac{\text{Cost of Asset × Rate of Depreciation}}{100}\)

 

Example :

Machine cost: Rs. 15,000

Installation: Rs. 3,000

Life: 10 years

Scrap: Rs. 2,000

Depreciation = \(\frac{15000+3000-2000}{100}\) = Rs. 1,600 p.a.

 

Illustration (SLM @ 10% on Rs. 80,000) :

Year	Depreciation (Rs.)	WDV at Year End (Rs.)
1st Year	8,000	72,000
2nd Year	8,000	64,000
3rd Year	8,000	56,000
4th Year	8,000	48,000

 

KEY FEATURE

In SLM, depreciation is charged every year on ORIGINAL COST. The amount remains CONSTANT.

When plotted on a graph, the curve runs PARALLEL to the X-axis — hence 'Straight Line Method'.

(2) Diminishing / Reducing Balance / Written Down Value Method :

Under this method, depreciation is calculated at a certain percentage each year on the BALANCE (Written Down Value) carried forward from the previous year.

The amount of depreciation goes on DECREASING every year. Charges are higher in initial years and lower in later years.

Illustration (WDV @ 10% on Rs. 80,000) :

Year	Depreciation (Rs.)	WDV at Year End (Rs.)
1st Year (on 80,000)	8,000	72,000
2nd Year (on 72,000)	7,200	64,800
3rd Year (on 64,800)	6,480	58,320
4th Year (on 58,320)	5,832	52,488

 

KEY FEATURE

Depreciation in year 1 is on Original Cost; from year 2 onwards it is on the WDV (Opening Balance).

The value of the asset can NEVER reduce to zero under WDV.

When plotted on a graph, the curve SLOPES DOWNWARD from left to right.

 

Difference Between Fixed Instalment and Written Down Value Methods :

Points of Difference	Fixed Instalment Method (SLM)
Points	Fixed Instalment (SLM)	Written Down Value (WDV)
Meaning	Depreciation is charged at a fixed percentage on the original cost of a fixed asset every year is called Fixed Instalment Method	Depreciation is charged at a fixed percentage on the written down value or book value of the fixed asset at the beginning of each year is called 'Written Down Value Method'.
Depreciation charged Basis	On original cost of the asset	On reduced (WDV) balance of the asset
Amount	Remains the same each year	Goes on decreasing each year
Value to Zero?	Yes — value can reduce to zero	No — value can never reach zero
Profits	More in earlier years than later years	Less in earlier years, more in later years
Tax Recognition	Not recognised by Income Tax law	Recognised by Income Tax / law
Suitability	Where repair charges are less and obsolescence is infrequent	Where repair charges are more in later years and obsolescence is higher
Graph Curve	Parallel to X-axis (horizontal line)	Slopes downward from left to right
Complexity	Simple to calculate	Slightly more complex

 

Accounting Treatment for Depreciation :

The accounting treatment for depreciation involves recording specific journal entries to account for the acquisition, usage, and eventual disposal of a fixed asset. According to the sources, the journal entries remain the same whether a business uses the Straight Line Method or the Written Down Value Method.

(i) In the Year of Purchase

When an asset is first acquired, the following entries are made:

• For Purchase of Asset for Cash: Debit the Asset Account and credit the Cash or Bank Account.
• For Purchase of Asset on Credit: Debit the Asset Account and credit the Supplier’s or Party’s Account.
• For Incidental Expenses: Any costs incurred to put the asset into operation (like installation or transportation) are debited to the Asset Account and credited to the Cash or Bank Account.
• For Charging Depreciation: At the end of the year, the Depreciation Account is debited and the Asset Account is credited.
• Transfer to Profit and Loss: Because depreciation is a nominal account and an element of cost, its balance is transferred by debiting the Profit and Loss Account and crediting the Depreciation Account.

(ii) Second Year Onwards

In subsequent years, the routine accounting process continues:

• Charging Depreciation: The Depreciation Account is debited and the Asset Account is credited for that year's specific amount.
• Year-End Transfer: The depreciation balance is again transferred to the Profit and Loss Account.

(III) During the Year of Sale

If an asset is sold, the accounting treatment requires several steps to close out its value:

1. Depreciation to Date of Sale: Depreciation is charged for the period from the start of the accounting year until the actual date of the sale by debiting the Depreciation Account and crediting the Asset Account.
2. Recording the Sale:
   • At Book Value: Debit the Bank Account and credit the Asset Account.
   • At a Profit: Debit the Bank Account, credit the Asset Account (for its Written Down Value), and credit the Profit on Sale of Asset Account.
   • At a Loss: Debit the Bank Account, debit the Loss on Sale of Asset Account, and credit the Asset Account.
3. Transferring Results:
   • Any profit from the sale is transferred by debiting the Profit on Sale of Asset Account and crediting the Profit and Loss Account.
   • Any loss is transferred by debiting the Profit and Loss Account and crediting the Loss on Sale of Asset Account.
4. Final Year-End Entries: If any part of the asset remains, depreciation is charged on the remaining portion, and the total Depreciation Account balance for the year is transferred to the Profit and Loss Account.

Journal entries :

(I) In the Year of Purchase

#	Particulars	Dr. Amount (Rs.)	Cr. Amount (Rs.)
1	Asset A/c   Dr.   To Cash/Bank A/c   (Being asset purchased for cash)	XXX	XXX
2	Asset A/c   Dr.   To Supplier's/Party's A/c   (Being asset purchased on credit)	XXX	XXX
3	Asset A/c   Dr.   To Cash/Bank A/c   (Being incidental/installation charges paid)	XXX	XXX
4	Depreciation A/c   Dr.   To Asset A/c   (Being depreciation charged)	XXX	XXX
5	Profit & Loss A/c   Dr.   To Depreciation A/c   (Being depreciation transferred to P&L A/c)	XXX	XXX

 

(II) Second Year Onwards :

Depreciation A/c   ……Dr.

To Asset A/c  

(Being depreciation charged)

Profit & Loss A/c   …….Dr.  

To Depreciation A/c  

(Being depreciation transferred)

(III) During the Year of Sale

Depreciation A/c   …..Dr.  

To Asset A/c  

(Depreciation up to date of sale)

Bank A/c   ……………….Dr.  

To Asset A/c  

(Sale at Book Value)

Bank A/c   ……………..Dr. 

To Asset A/c (WDV) + To Profit on Sale A/c  

(Sale at Profit)

Profit on Sale of Asset A/c   …Dr.  

To Profit & Loss A/c  

(Transfer profit)

Bank A/c + Loss on Sale of Asset A/c   ….Dr.  

To Asset A/c (WDV)  

(Sale at Loss)

Profit & Loss A/c   ……Dr.  

To Loss on Sale of Asset A/c  

(Transfer loss)

 

Key Formulas & Rules :

SLM Formula :

Annual Depreciation = \(\frac{\text{Cost - Scrap Value}}{\text{Estimated Useful Life (years)}}\)

Rate-based SLM :

Annual Depreciation = \(\frac{\text{Cost of Asset X Rate%}}{100}\)

 

Profit / Loss on Sale :

WDV at date of sale = Cost - Total depreciation charged till date

Profit on Sale = Selling Price - WDV  (if Selling Price > WDV)

Loss on Sale = WDV - Selling Price  (if WDV > Selling Price)

 

Illustrative Summary — SLM vs WDV Comparison :

Asset Cost: Rs. 80,000 | Rate: 10% p.a. | Financial Year: 1 April to 31 March

Year	SLM Dep. (Rs.)	SLM WDV (Rs.)	WDV Dep. (Rs.)	WDV Book Value (Rs.)
1	8,000	72,000	8,000	72,000
2	8,000	64,000	7,200	64,800
3	8,000	56,000	6,480	58,320
4	8,000	48,000	5,832	52,488
5	8,000	40,000	5,249	47,239

Observation: Under SLM depreciation stays at Rs. 8,000 each year; under WDV it falls from Rs. 8,000 to Rs. 5,249 by year 5.

 Important Points to Remember :

• Depreciation is always calculated for the period the asset was ACTUALLY USED in the accounting year (pro-rated for months).
• Land is NEVER depreciated.
• Depreciation is charged even in a loss year.
• Under SLM: depreciation amount is constant; under WDV: depreciation amount decreases.
• WDV is recognised by Income Tax law; SLM is not.
• Original cost = Purchase price + All incidental charges (freight, installation, custom duty, etc.).
• Profit on sale of asset is CREDITED to Profit & Loss A/c; Loss on sale is DEBITED to Profit & Loss A/c.
• Depreciation account is a NOMINAL account.
• The balance of Depreciation A/c is transferred to Profit & Loss A/c at the end of the year.

For proportionate depreciation: if asset bought on 1st Oct and year ends 31st March, charge only 6 months' depreciation.