Accounting Concept of Depreciation

The fixed assets are long-term assets. They help in the production of goods and services. However, when an asset is in use its value decreases due to the normal wear and tear, efflux of time and obsolescence. This reduction in the value of a fixed asset is known as depreciation. Let’s understand the concept of depreciation.

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Accounting Concept of Depreciation

The assets which are held by a business for the production and supply of goods and services, expected to be used for more than an accounting year and have a limited useful life are known as Depreciable Assets.

On purchasing a fixed asset we record it at its original cost or purchase price in the books of accounts. An organization uses this fixed asset to earn or generate revenues for a number of accounting years until it sells or discards the asset.

Hence, it becomes necessary to allocate a part of the purchasing cost or the acquisition cost to every accounting year until we use it. We call this allocation of cost as Depreciation. Depreciation is an expense of an organization.

For example, Setu enterprises purchases machinery for ₹2000000 and it sells it after using it for 10 years for ₹400000. Therefore, the cost of machinery for its use in business will be ₹1600000 (₹2000000 – ₹400000). Now, we need to allocate this cost of ₹1600000 as an expense of the business for each of the 10 accounting years for which we have been using the machine. This expense is depreciation which comes to ₹160000 (1600000/10).

In other words, the concept of depreciation is the cost of obtaining services from the use of an asset. We need to match the depreciation cost of the fixed asset against the revenues of the years over which we use it. Thus, we charge depreciation as an expense to the Profit and Loss A/c.

Browse more Topics under Depreciation Accounting

• Uniform Charge Methods
• Declining Charge Methods
• Other Methods

Purpose of Accounting for Depreciation

The main purpose of the concept of depreciation and its accounting is the allocation of the cost of a fixed asset. Depreciation expense does not involve any outflow of cash. Hence, the funds that we charge to the Profit and Loss A/c every year remain in the business itself and thus, we can use them at the time of replacement of the asset.

Therefore, the concept of depreciation and its accounting is the process of allocating or apportioning the cost of the fixed assets over their useful life. Its aim is to distribute the cost of the depreciable asset over its useful life and charge the depreciation to the Profit and Loss A/c in order to arrive at the correct profit or loss for the year.

 

Journal entries for depreciation:

1. When we charge depreciation directly to the asset

Date	Particulars		Amount (Dr.)	Amount (Cr.)
1. On charging depreciation	Depreciation A/c	Dr.	XXX
	To Asset A/c	Cr.		XXX
	(Being charging of depreciation on the asset)
2. Transfer of depreciation to P&L A/c	Profit and Loss A/c	Dr.	XXX
	To Depreciation A/c	Cr.		XXX
	(Being transfer of depreciation to Profit and Loss A/c)

 

In the above case, the asset will appear in the Balance Sheet at a reduced value.

Balance Sheet (extract)

Liabilities	Amount	Assets	Amount
		Fixed Asset
		Less: Depreciation

 

2. When we maintain Provision for Depreciation A/c

Date	Particulars		Amount (Dr.)	Amount (Cr.)
1. On charging depreciation	Depreciation A/c	Dr.	XXX
	To Provision for Depreciation A/c	Cr.		XXX
	(Being charging of depreciation on the asset)
2. Transfer of depreciation to P&L A/c	Profit and Loss A/c	Dr.	XXX
	To Depreciation A/c	Cr.		XXX
	(Being transfer of depreciation to Profit and Loss A/c)
3. At the time of sale of the asset	Provision for Depreciation A/c	Dr.	XXX
	To Asset A/c	Cr.		XXX
	(Being transfer of Provision for Depreciation to the asset A/c at the time of sale)

 

 

In this case, the asset continues to appear at its original cost in the books. We show the Provision for Depreciation A/c as a deduction from the asset in the Balance Sheet. Alternatively, we can also show the Provision for Depreciation A/c on the liabilities side in the Balance Sheet.

Balance Sheet (extract)

Liabilities	Amount	Assets	Amount
		Fixed Asset	XXX
		Less: Provision for Depreciation

 

Alternatively,

Balance Sheet (extract)

Liabilities	Amount	Assets	Amount
Provision for Depreciation	XXX	Fixed Asset	XXX

Solved Question on Concept of Depreciation

MN Ltd. purchases machinery costing ₹500000. The useful life of the machinery is 4 years and residual value is ₹20000. The company maintains the provision for depreciation A/c. It sells the machinery at the end of its useful life. Pass necessary journal entries to record the depreciation.

Answer –

Journal Entries

In the books of MN Ltd.

Date	Particulars		Amount (Dr.)	Amount (Cr.)
Year 1	Machinery A/c	Dr.	500000
	To Bank A/c	Cr.		500000
	(Being purchase of machinery)
	Depreciation A/c	Dr.	120000
	To Provision for Depreciation A/c	Cr.		120000
	(Being charging of depreciation on the asset)
	Profit and Loss A/c	Dr.	120000
	To Depreciation A/c	Cr.		120000
	(Being transfer of depreciation to Profit and Loss A/c)
Year 2	Depreciation A/c	Dr.	120000
	To Provision for Depreciation A/c	Cr.		120000
	(Being charging of depreciation on the asset)
	Profit and Loss A/c	Dr.	120000
	To Depreciation A/c	Cr.		120000
	(Being transfer of depreciation to Profit and Loss A/c)
Year 3	Depreciation A/c	Dr.	120000
	To Provision for Depreciation A/c	Cr.		120000
	(Being charging of depreciation on the asset)
	Profit and Loss A/c	Dr.	120000
	To Depreciation A/c	Cr.		120000
	(Being transfer of depreciation to Profit and Loss A/c)
Year 4	Depreciation A/c	Dr.	120000
	To Provision for Depreciation A/c	Cr.		120000
	(Being charging of depreciation on the asset)
	Profit and Loss A/c	Dr.	120000
	To Depreciation A/c	Cr.		120000
	(Being transfer of depreciation to Profit and Loss A/c)
	Provision for Depreciation A/c	Dr.	480000
	To Machinery A/c	Cr.		480000
	(Being transfer of Provision for Depreciation to the asset A/c at the time of sale)
	Bank A/c	Dr.	20000
	To Machinery A/c	Cr.		20000
	(Being sale proceeds of machinery)

 

Working Notes:

Calculation of depreciation

$$ \text{Depreciation} = \frac{\text{Original Cost –  Salvage Value}}{\text{Useful Life}} = \frac{500000 – 20000}{4} = 120000 $$