Vu Accounting Lesson 18

Financial Accounting - I – MGT101

VU Lesson # 18

METHODS OF CHARGING DEPRECIATION (Continued) It is a systematic allocation of the cost of a depreciable asset to expense over its useful life”. Grouping of Fixed Assets Major groups of Fixed Assets: • • • • • •

Land Building Plant and Machinery Furniture and Fixtures Office Equipment Vehicles

No depreciation is charged for ‘Land’. In case of ‘Leased Asset/Lease Hold Land’ the amount paid for it is charged over the life of the lease and is called Amortization. Recording of Journal Entries Purchase of fixed asset: Debit: Credit:

Relevant asset account Cash, Bank or Payable Account

For recording of depreciation, following two heads of accounts are used: • •

Depreciation Expense Account Accumulated Depreciation Account

Depreciation expense account contains the depreciation of the current year. Accumulated depreciation contains the depreciation of the asset from the financial year in which it was bought. Depreciation of the following years in which asset was used is added up in this account. In other words, this head of account shows the cost of usage of the asset up to the current year. Depreciation account is charged to profit & loss account under the heading of Administrative Expenses. In the balance sheet, fixed assets are presented at written down value i.e. WDV = Actual cost of fixed asset – Accumulated Depreciation. Journal entry for the depreciation is given below: Debit: Credit:

Depreciation Account Accumulated Depreciation Account © Copyright Virtual University of Pakistan

140

Financial Accounting - I – MGT101 Methods of Calculating Depreciation

VU

There are several methods of calculating depreciation. At this stage, we will discuss only two of them namely: • •

Straight line method Reducing balance method

Straight Line Method In this method, a fixed amount is calculated by a formula. That fixed amount is charged every year irrespective of the written down value of the asset. The formula for calculating the depreciation is given below: Depreciation = (cost – Residual value) / Expected useful life of the asset Residual value is the cost of the asset after the expiry of its useful life. Reducing Balance Method In this method, depreciation is calculated on written down value. In the first year, depreciation is calculated on cost. Afterwards written down value is calculated by deducting accumulated depreciation from the cost of that asset (cost – accumulated depreciation) and depreciation is charged on that value. Cost of Asset – Price at which the asset was initially recorded Written Down Value / Book Value – Cost minus Accumulated Depreciation. In reducing balance method, a formula is used for calculation the depreciation rate i.e. Rate = 1 – n RV / C Where: “RV” = Residual Value “C” = Cost “n” = Life of Asset Calculate the rate if: Cost Residual Value (RV) Life Rate =

1–3

= 100,000 = 20,000 = 3 years 20000/100000

= 42% Year 1 Cost 100,000 Depreciation 100,000 x 42% (42,000) WDV (Closing Balance) 58,000 © Copyright Virtual University of Pakistan

141

Financial Accounting - I – MGT101 Year 2 WDV (Opening Balance) Depreciation 58,000 x 42% WDV (Closing Balance)

VU 58,000 (24,360) 33,640

Year 3 WDV (Opening Balance) Depreciation 33,640 x 42% WDV (Closing Balance)

33,640 (14,128) 19,511

Disposal of Asset Cost of Asset Life of the Asset Depreciation Method Residual Value Sale Price after Five Years

= 100,000 = 5 Years = Straight Line = Rs.10000 = Rs.15000

Depreciation per year = (100000-10000) / 5 = Rs.5000 per year Total Depreciation in Five Years

= 18,000 x 5 = 90,000

Book Value after Five Years

= 100,000- 90,000 = 10,000

Profit on Disposal

= 15,000 – 10,000 = Rs.5000

Recording of Disposal: Debit Credit

Fixed Asset Disposal A/c Fixed Asset Cost A/c (With the cost of asset)

100,000 100,000

Debit Credit

Accumulated Dep. A/c 90,000 Fixed Asset Disposal A/c 90,000 (With the depreciation accumulated to date)

Debit Credit

Cash / Bank / Receivable A/c Fixed Asset Disposal A/c (With the price at which asset is sold)

15,000 15,000

[Note: one group to appear at a time]

© Copyright Virtual University of Pakistan

142

Financial Accounting - I – MGT101 Disposal of Asset Account

VU

Fixed Asset Disposal Account Debit Cost Account P & L Account ( Balancing Figure) Total

Credit 100,000 Acc. Dep. Account

90,000

Cash / Bank

15,000

5000 105000

Total

105000

Policy for Depreciation: The management of the business selects the policy for charging depreciation. There is no law binding on the management. The management is free to choose method of depreciation and policy of charging depreciation. Normally two policies are commonly used: • •

Depreciation on the basis of use In the year of purchase, full year’s depreciation is charged; where as, in the year of sale no depreciation is charged.

Now it is up to the management to decide, what method and what policy is better and effective for their business. Disposal of Fixed Asset When depreciable asset is disposed off at any time during the financial year, an entry should be made to give effect of the disposal. Since, the residual value of asset is only estimated; it is common for asset to be sold at price that differs from its book value at the date of disposal. When asset is sold, any profit or loss is computed by comparing book value with the amount received from sale. As you know, book value is obtained by deducting accumulated depreciation from original cost of the asset. A sale price in excess of the book value produces profit; a sale price below the book value produces loss. This profit or loss should be shown in the profit & loss account. Entries for Recording Disposal Debit Credit Debit Credit Debit Credit

Fixed Asset Disposal A/c Fixed Asset Cost A/c (With the cost of asset) Accumulated Dep. A/c Fixed Asset Disposal A/c (With the depreciation accumulated to date) Cash / Bank / Receivable A/c Fixed Asset Disposal A/c (With the price at which asset is sold) © Copyright Virtual University of Pakistan

143

Financial Accounting - I – MGT101 Example: • • • •

VU

An asset is purchased for Rs. 500,000 on Nov. 01, 2001. Depreciation rate is 10% p.a. The Asset is sold on Apr. 30, 2004. Financial Year is July 1 to June 30

Question: •

Calculate the WDV For both policies

Depreciation is charged on the Basis of Use Year

On the Basis of Use

Rs.

1-11-2001

Cost

500,000

2001-2002

Dep. 500,000 x 10% x 8 / 12

(33,333)

30-6-2002

WDV

466,667

2002-2003

Dep. 466,666 x 10%

(46,667)

30-6-2003

WDV

420,000

2003-2004

Dep. 420,000 x 10% x 10 / 12

(35,000)

30-4-2004

WDV

385,000

Full Depreciation in the Year of Purchase Year

Full Dep. in year of Purchase

Rs.

1-11-2001

Cost

500,000

2001-2002

Dep. 500,000 x 10%

(50,000)

30-6-2002

WDV

450,000

2002-2003

Dep. 450,000 x 10%

(45,000)

30-6-2003

WDV

405,000

2003-2004

Dep. 00 in the year of sale

30-6-2004

WDV

00 405,000

Contents of Fixed Assets Register • Different record for each class of assets • Date of purchase • Detailed particulars of asset • Location of asset • Record of depreciation © Copyright Virtual University of Pakistan

144

Financial Accounting - I – MGT101 Illustration: Cost of asset Life of the asset Depreciation method Residual value Sale price after 5 years

VU Rs. 200,000 5 years Straight line Rs. 20,000 30,000

Calculate profit/Loss on the sale of the asset? Solution: Written down value = 200,000 – 20,000 = 180,000 Depreciation/year = 180,000/5 = 36,000 (Straight line method) Particulars

Depreciation (Rs)

Depreciable cost Dep. Of the 1st year Dep. Of the 2nd year Dep. Of the 3rd year Dep. Of the 4th year Dep. Of the 5th year

(36,000) (36,000) (36,000) (36,000) (36,000)

Book value after five years Sale price Profit on sale

Written Down Value (Rs.) 200,000 164,000 128,000 92,000 56,000 20,000

Rs. 20,000 Rs. 30,000 Rs. 10,000 (30,000 – 20,000)

Same illustration is solved by reducing balance method Cost of asset Residual value Estimated useful life

Rs. 200,000 Rs. 20,000 5 years

Calculation of depreciation rate ____ Depreciation Rate = 1 – √Rv/c _____________ = 1 - 5√20,000/200,000 = 37% Allocation of depreciation is given below: n

© Copyright Virtual University of Pakistan

145

Financial Accounting - I – MGT101 Particulars

Depreciation (Rs)

Depreciable cost Dep. Of the 1st year 200,000 x 37% Dep. Of the 2nd year 126,000 x 37% Dep. Of the 3rd year 79,380 x 37% Dep. Of the 4th year 50,009 x 37% Dep. Of the 5th year 31,506 x 37%

VU Accumulated Depreciation (Rs.)

Written Down Value (Rs.) 200,000

74,000

74,000

126,000

46,620

120,620

79,380

29,371

149,991

50,009

18,503

168,494

31,506

11,657

180,151

19,849

Book value after five years Sale price

Rs. 19,849 Rs. 30,000

Profit on sale

Rs. 10,151 (30,000 – 19,849)

© Copyright Virtual University of Pakistan

146