What is Depreciation | Methods | Examples

Depreciation feature imageDepreciation feature image

What is Depreciation?

It means the decrease in the value of Fixed assets by passing time. It is charged only on fixed assets (except Land) Because every fixed asset has a life more than one year but will not last indefinitely and The land has an indefinitely life so it will be appreciated. Depreciation is treated as indirect expenses of the business and transferred to the income statement of the company and profit/loss account of the business.

The following three type of decrease in the value of an asset is used to refer to a different category of fixed assets.

  1. Depreciation
  2. Depletion
  3. Amortization

1. Depreciation is used for the Tangible fixed asset. Such as Building, Plant, Machinery, Furniture, Fixture, Vehicle, Computer, etc.

2. Depletion is used in referring to physical exhaustion of natural resources. Such as oil well, Coal mine, etc.

3. Amortization is used for the Intangible fixed asset. Such as Goodwill, Patents, trademarks, leaseholds, etc.

The following topic Cover in this article – jump directly by selecting the name of the topic:

  1. Why do we need to calculate
  2. Journal entries
  3. Methods of Depreciation

 

1. Why do we need to calculate depreciation on the fixed assets?

We will explain this topic with help of following points :

  1. To know the actual net profit of the business we have to record all the expenses related to earn that profit. We had to use our fixed assets to produce and store our product, So we have to record the diminished value of these assets in our books to find out an actual net profit of the business
  2. Show the actual value of assets in the books of the accounts this is called the book value of an asset.
  3. We have to purchase new assets against old when it becomes scrap, so to arrange the funds for replacement of assets we have to contribute some value of assets year by year from the profit.
  4. The Indian Companies Act, 1956 has made it the statutory requirement for joint stock companies under section 205.

2. Journal entries for Depreciation:

We can treat Depreciation in two way as following:

1. When net book value of assets shown on the Balance sheet after deducting an amount of depreciation from the opening book value of an asset. 

Example:

Depreciation charged on building @ 10% on Rs 10,00,000/-.

We will treat two account

  1. Depreciation Account -> is Expenses -> N/A -> All Expenses -> Debited

  2. Building Account -> is an Assets -> R/A -> Goes out -> Credited

Date    Depreciation A/c    Dr.      1,00,000

To Building A/c                        1,00,000

(Being Dep charge on the building)

“After that, at the end of the year, we will transfer all income and expenses to Profit and loss account or income statement to get the actual profit or loss of the business for this we post this following transaction.”

Depreciation transferred to Profit and Loss account or income statement

  1. Depreciation Account -> is Expenses -> closing this account has a debit balance so now credited it.

  2. Profit and Loss Account -> is Statement -> getting balances of  Expenses so now Debited it

Date    Profit and Loss A/c    Dr.      1,00,000

To Depreciation A/c                        1,00,000

(Being amount of dep transferred to Profit or loss account)

Note: If you did not know how to apply this rules of accounting please check this link 

The Golden rules of Accounting

2. When the original book value of assets shown on the Balance sheet and Accumulated depreciation/Provision for depreciation account opened and shown on the liability side of the balance sheet. 

Depreciation charged on building @ 10% on Rs 10,00,000/-.

We will treat two account

  1. Depreciation Account -> is Expenses -> N/A -> All Expenses -> Debited

  2. Provision for Depreciation on Building Account -> it will also be treated as an Assets -> R/A -> Goes out -> Credited

(the account of Provision have credit balance so it will be shown on the liability side of the Balance Sheet.

Date    Depreciation A/c    Dr.      1,00,000

To Provision for Dep on Building A/c                        1,00,000

(Being Dep charged and provision account opened )

Date    Profit and Loss A/c    Dr.      1,00,000

To Depreciation A/c                        1,00,000

(Being Depreciation transferred to Profit and Loss account or income statement)

3. Methods of Depreciation:

1. Straight Line Method 

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In this method, we calculate a fixed amount of depreciation on the original cost of an asset and charge until the book value of an asset will equal to zero or its scrap value. This method is also called the original cost method and fixed cost method.

2. Diminishing Balance Method

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We calculate the depreciation under this on the closing value of an asset and charge until the book value of an asset will equal to its scrap value. It is also called written down value and reducing value method.

3. Annuity Method

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 In this method, we calculate a fixed amount of depreciation on the original cost of an asset but also calculate interest on the invested amount of capital on the purchase of this asset with help of annuity table.

4. Sinking Fund Method

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This method will provide us with depreciation as well as provide funds for the replacement of this asset when an asset need replacement like the end of life of an asset. Under this method, we charged depreciation on the value of asset but will not be credited to the asset account instead we will credit to sinking fund account. This account will be shown on the liabilities side of the Balance Sheet(Because it is a funds account) and an asset will be shown on the original value on the assets side of the Balance Sheet. At the end of each accounting year, the total amount of sinking fund credited in a year will be invested in the outside marketable security to provide cash for the replacement of an asset when needed.

5. Insurance Policy Method

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In this method, An endowment policy is taken from an insurance company for an amount which is sufficient for the replacement of an asset. It is similar to the sinking fund method only difference is we take insurance instead of investment. The term of insurance policy will equal the life of an asset.

6. Sum of Digits Method

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The Sum of digits method is formed due to the decrease in the productivity of an asset with the passage of time. It means that an asset has more useful life in the earlier year. So, that’s why we have to charge depreciation more in the earlier year as compared with the subsequent year of life of an asset. It is slightly similar to the written down value method. In written down value the amount of depreciation will continue to decrease every year in this method also.

7. Revaluation Method

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Where we did not know the accurate life of an asset or where the life of an asset is uncertain and depreciation cannot be calculated with any other method then we will revalue an asset at the end of the financial year when balance sheet prepared, So if any decrease in the book of an asset will be treated as amount of dep. or if any increase then it will be ignored.

8. Machine Hour Rate Method

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This method is applicable to those assets on which we record their life in hours like Plant and Machine. So we have to keep the record of the total working hour of a machine consumed in a single financial year and the total amount of working hours consumed within the financial year is depreciation for that financial year. We will calculate depreciation by firstly calculate Machine Hour Rate then we multiply it by total working hours of the machine within a single financial year.

9. Mileage or Kilometer Method

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 This method is very much similar to the Machine hour rate method. But it is applied on the vehicle instead of the machine. So the life of the vehicle can be measured into total kilometres will be covered by it. Rate per mile or kilometres can we determine when the total cost of an asset divided by to kilometres it can run in its whole life. The amount of annual dep will be calculated by multiplying total kilometres run during the financial year by the rate of per kilometre.

10. Depletion Method

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 It is used for wasting assets like coal, mines, well and etc. The rate of dep is calculated by dividing the cost of an asset by the estimated quantity of product likely to be available. The amount of the dep can be calculated when we multiplying the total output of the financial year with the rate of depreciation.
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2 thoughts on “What is Depreciation | Methods | Examples”

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