JAIIB AFM Module-A Unit 6 : Depreciation and Its Accounting

18/08/2023

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JAIIB Paper 3 AFM Module A Unit 6 : Depreciation and Its Accounting (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for JAIIB Exam 2023. Following the format of the current exam, JAIIB 2023 will have now four papers. The JAIIB Paper 3 (Accounting and Financial Management for Bankers) includes an important topic called “Depreciation and Its Accounting”. Every candidate who are appearing for the JAIIB Certification Examination 2023 must understand each unit included in the syllabus. In this article, we are going to cover all the necessary details of JAIIB Paper 3 (AFM) Module A (ACCOUNTING PRINCIPLES AND PROCESSES ) Unit 6 : Depreciation and Its Accounting Aspirants must go through this article to better understand the topic, Depreciation and Its Accounting and practice using our Online Mock Test Series to strengthen their knowledge of Depreciation and Its Accounting. Unit 6 : Depreciation and Its Accounting

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.
Units of production method
Sum of years digits method

Straight line Method

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 Instalment Method or Fixed percentage on original cost method.

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

Example

Q.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 40000. Prepare the necessary ledger accounts in the books of Abhinav for the year ending 31^stDecember every year. Use SLM.

Ans: In the books of Abhinav

Working Notes:

Calculation of amount of depreciation

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

= (400000 – 40000)/3 = 120000 p.a.

Machinery A/c

Depreciation A/c

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.

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

Example on Diminishing Balance method

Q. M/s. Srivastav and sons purchased a machine on 1 Apr 2015 for ₹400000 from ABC & Co. and paid ₹100000 on its installation. The useful life of the machine is 3 years and its estimated residual value is ₹40000. On 31^stMarch 2018, M/s. Srivastav and sons sell the machinery for 250000.

Charge depreciation as per the W.D.V. method @10 % p. a. Prepare the necessary ledger accounts in the books of Anil for the year ending 31^st December every year.

Ans: In the books of M/s. Srivastav and sons

Machinery A/c

Working Notes:

Calculation of amount of depreciation

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

2015: Depreciation = 500000 x 10/100 x 9/12 = 37500
2016: Depreciation = 462500 x 10/100 = 46250
2017: Depreciation = 416250 x 10/100 = 41625
2018: Depreciation = 374625 x 10/100 x 3/12 = 9366

Calculation of loss on sale of machinery

Loss = Book Value on 1 Jan 2018 – depreciation for 3 months – cash received

= 374625 – 9366- 250000 = 115259

Units Of Production Method

Accounting Standards in India (AS-10 and Ind AS-16) recognise 3 methods of calculating depreciation.
These are Straight line method, Diminishing Balance method and the Units of Production method.
This method is a usage based method.
The depreciation amount is not based on passage of time but actual use of the asset.
This method is suited to those assets which depreciate in proportion to their use rather than having a useful life measured in number of years.
In this method, the useful life is measured in term of production output or number of units which an asset is capable of producing during its lifetime. This method gives very accurate measure of the depreciation but suffers from the drawback of the need to maintain elaborate records.

FORMULA:

Depreciation amount during a period = (Actual production or usage during the period / of Total Expected Production or Usage during the asset life of the asset )× Total depreciable amount

Example;

Company ABC Ltd. Purchases a pen production machine. This machine can manufacture 1,000,000 pens after which it will have to be scrapped. The purchase price of the machine is Rs. 100,000 and the scrap value is estimated at Rs. 10,000. During the first year of production, the machine produced 200,000 pens.
The depreciation amount in the first year will be; = (200,000/1,000,000) × (100,000 – 10,000) = 0.2 × 90,000 = 18,000

Sum Of the Years Digits Method

According to SOYD method, to calculate the depreciated value we have to take the expected life of an asset (in years0 count back to one and add the figures together. This is a method of calculating deprecation of an asset that assumes a higher depreciation charge and a greater tax benefit in the early years of an asset’s life.

Example

A new machine was purchased for Rs. 3 lac with 5 years economic life. What is WDV at the end of 3rd year as per SOYD method?

Sum of Years Digit total = 5+4+3+2+1=15

Depreciation for 3 years = 12/15*300000=240000

WDV at the end of 3rd year = 300000-240000=60000

Example;

Company ABC Ltd. Purchases a pen production machine. This machine can manufacture 1,000,000 pens after which it will have to be scrapped. The purchase price of the machine is Rs. 100,000 and the scrap value is estimated at Rs. 10,000. During the first year of production, the machine produced 200,000 pens.

The depreciation amount in the first year will be; = (200,000/1,000,000) × (100,000 – 10,000) = 0.2 × 90,000 = ` 18,000

Replacement Of A Fixed Asset And Creation Of Sinking Fund

Since depreciation expense is a non-cash expense (i.e. cash is usually paid out in the year the asset is acquired, but the expense is distributed over several years),
it is important to plan for the replacement of fixed assets as they wear out or become obsolete.
For example, some organisations set aside an amount of cash equal to the amount of their yearly depreciation expense so that money will be available to purchase a new asset once the current one is fully depreciated.
Under this method, a ‘Depreciation Fund’ or ‘Sinking Fund’ is created and the amount is invested in readily saleable securities.
At the end of the life of the asset, the securities are sold and the sale proceeds of the old assets are used for replacement of the asset.

Amortisation Of Intangible Assets

Many of the intangible assets (e.g. patents, licences, trademarks, etc.) also have a limited useful life.
Therefore, it is logical to reduce their value in every accounting year before carrying them to the new accounting year. This is called amortisation.
Our discussion about depreciation, in this chapter, is equally applicable to amortization.
Indian Accounting Standard (Ind AS) 38, which deals with intangible assets, describes amortisation as under; “Amortisation is the systematic allocation of the depreciable amount of an intangible asset over its useful life.”
This Standard defines an intangible asset as, “an identifiable non-monetary asset without physical substance”.
Some other examples of intangible assets are; Scientific or technical knowledge, design and implementation of new process or systems, intellectual property, copyrights, computer software, motion picture films, marketing rights, fishing licences etc.

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JAIIB AFM Module A Unit 6-Depreciation and Its Accounting (Ambitious Baba)