Depreciation and its Accounting for JAIIB/DBF Paper 2 (Module A) Unit 4

Depreciation and its Accounting: Jaiib /DBF Paper 2 (Module A) Unit 4

Dear bankers,

As we all know that  is Depreciation and its Accounting for JAIIB Exam. JAIIB exam conducted twice in a year. So, here we are providing the Depreciation and its Accounting (Unit-4), Business Mathematics and Finance (Module A), Accounting Finance for Bankers-Paper 2.

♦Depreciation

Depreciation is a charge to profit and loss account for the fall in value of an asset during each year of its use.

  • Depreciation is a part of the opening cost.
  • It is a reduction in the value of the asset.
  • The decrease in the value of an asset is due to its use, caused by wear and tear, or by other reasons.
  • The decrease in the value of an asset is gradual and continuous.

♦Causes of Depreciation

  • Wear and tear due to actual use
  • Obsolescence
  • Accidents
  • Fall in market price
  • Efflux of time

♦Need for Depreciation

  • To know the correct profit
  • To show correct financial position
  • To make provision for replacement of asset

♦Factors of Depreciation

For calculating depreciation, the basic factors are:

  • The cost of the asset;
  • The estimated resident or scrap value at the end of its life;
  • The estimated number of year of its commercial life.

♦Methods of Depreciation

The following are the various methods for providing depreciation:

  • Fixed percentage on original cost or fixed instalment or straight line method.
  • Fixed percentage on diminishing balance or reducing instalment methods or written down value method.
  • Sum of years digits method.

♦Accounting Entries

The accounting entries to be made on account of providing depreciation are:

Depreciation account – Dr.  3000

To asset account- 3000

The depreciation account goes to the debit of profit and loss account and the asset appears at its reduced value in the balance sheet. An alternative entry is:

Depreciation account – Dr. 3000

To provision for depreciation Account- Dr. 3000

In this case, depreciation account goes to the debit of profit and loss account. The value of assets continue to be the same for every year in the balance sheet and the provision for depreciation is deducted from the value of asset and net value of asset is shown in the balance sheet. In other words, the provision for depreciation may appear in the balance sheet.

♦Straight line Method

  • According to the Straight line method, the cost of the asset is written off equally during its useful life. Therefore, an equal amount of depreciation is charged every year throughout the useful life of an asset. After the useful life of the asset, its value becomes nil or equal to its residual value. Thus, this method is also called Fixed Installment Method or Fixed percentage on original cost method.
  • When the amount of depreciation and the corresponding period are plotted on a graph it results in a straight line. Hence, it is known as the Straight line method (SLM).
  • This method is more suitable in case of leases and where the useful life and the residual value of the asset can be calculated accurately. However, where the repairs are low in the initial years and increase in subsequent years, this method will increase the charge on profit.
  • Also, while applying this method, the period of use of the asset should be considered. If an asset is used only for 3 months in a year then depreciation will be charged only for 3 months. However, for the Income Tax purposes, if an asset is used for more than 180 days full years’ depreciation will be charged.

Advantages

  • It is the simplest method of calculating depreciation.
  • It is easy to understand, as there is no variation in the amount of depreciation charged from year to year.

Disadvantages

  • The depreciation is equal for all the year, however, the expenditure on repairs and renewal goes on increasing as the asset gets older, resulting in higher amount charged to profit and loss account on account of deprecation and repairs in the subsequent years.

Formula:

Amount of Depreciation = (Cost of Asset – Net Residual Value) / Useful Life

The rate of Depreciation = (Annual Depreciation x 100) / Cost of Asset

Journal Entries for Straight Line Method of Depreciation

Date                                            Particulars Amount (Dr.) Amount (Cr.)
1. Purchase  of asset Asset A/c Dr.  xx
To Cash/ Bank/ Creditor’s A/c  xx
(Being asset purchased)
2. Charge Depreciation Depreciation on Asset A/c Dr.  xx
To Asset A/c  xx
(Being depreciation charged on asset)
3. Transfer Depreciation Profit & Loss A/c Dr.  xx
To Depreciation on Asset A/c  xx
(Being depreciation on asset transferred to profit and loss account)

 Example

Abhinav purchased a machine on 1 Apr 2015 for ₹400000. The useful life of the machine is 3 years and its estimated residual value is ₹40000. At the end of its useful life, the machine is sold for 50000. Prepare the necessary ledger accounts in the books of Abhinav for the year ending 31stDecember every year. Use SLM.

Ans: In the books  of Abhianv

Machinery A/c

Date Particulars Amount   Date Particulars Amount
2015 2015
1 Apr To Cash A/c 400000 31 Dec By Depreciation A/c 90000
31 Dec By balance c/d 310000
400000 400000
2016 2016
1 Jan To balance b/d 310000 31 Dec By Depreciation A/c 120000
31 Dec By balance c/d 190000
310000 310000
2017 2017
1 Jan To balance b/d 190000 31 Dec By Depreciation A/c 120000
31 Dec By balance c/d 70000
190000 190000
2018 2018
1 Jan To balance b/d 70000 31Mar By Depreciation A/c 30000
31 Mar By Cash A/c 40000
70000 70000

Depreciation A/c

Date Particulars Amount   Date Particulars Amount
2015 2015
31 Dec To Machinery A/c 90000 31 Dec By Profit & Loss A/c 90000
90000 90000
2016 2016
31 Dec To Machinery A/c 120000 31 Dec By Profit & Loss A/c 120000
120000 120000
2017 2017
31 Dec To Machinery A/c 120000 31 Dec By Profit & Loss A/c 120000
120000 120000
2018 2018
31 Mar To Machinery A/c 30000 31 Dec By Profit & Loss A/c 30000
30000 30000

Working Notes:

Calculation of amount of depreciation

Depreciation =  (Cost of Asset – Net Residual Value )/Useful life

= (400000 – 40000)/3 = 120000 p.a.

♦Diminishing Balance Method or Written-down Value Method

  • According to the Diminishing Balance Method, depreciation is charged at a fixed percentage on the book value of the asset. As the book value reduces every year, it is also known as the Reducing Balance Method or Written-down Value Method.
  • Since the book value reduces every year, hence the amount of depreciation also reduces every year. Under this method, the value of the asset never reduces to zero.
  • When the amount of depreciation charged under this method and the corresponding period are plotted on a graph it results in a line moving downwards.
  • This method is based on the assumption that in the earlier years the cost of repairs to the assets is low and hence more amount of depreciation should be charged. Also, in the later years, the cost of repairs will increase and therefore less amount of depreciation shall be provided. Hence, this method results in an equal burden on the profit every year during the life of the asset.

Amount of depreciation=Book Value× Rate of Depreciation/100

Advantage

  • This method is recognised under the Income-Tax Act and the Companies Act.
  • The total expenditure on repairs and renewal and depreciation on asset are equal in all year, as in the initial years the depreciation will be more and less and in later years the expenditure on repairs will be high and depreciation less, through both may not exactly compensate the decrease/increase in the other.

Disadvantage

  • The asset can never be reduced to zero value on the books
  • Difficult to understand, as there is variation in the depreciation charged from year to year.

Journal entry for Diminishing Balance Method of Depreciation

Date                                            Particulars Amount (Dr.) Amount (Cr.)
1. Purchase of asset Asset A/c Dr.  xx
To Cash/ Bank / Creditor’s A/c  xx
(Being asset purchased)
2. Charge Depreciation Depreciation on Asset A/c Dr.  xx
To Asset A/c  xx
(Being depreciation charged on book value of  asset)
3. Transfer Depreciation Profit & Loss A/c Dr.  xx
To Depreciation on Asset A/c  xx
(Being depreciation on asset transferred to profit and loss account)

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