Depreciation

Methods of Depreciation

Depreciation is the reduction or the decrease in the value of fixed assets due to the normal wear and tear, efflux of time and obsolescence of technology. We use the word depreciation for the reduction in the value of fixed and tangible assets whereas amortization for the reduction in value of intangible assets. However, there are various Methods of Depreciation that an organization can adopt depending on its needs and circumstances. Let us study how to calculate depreciation.

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Methods of Depreciation and How to Calculate Depreciation

Learn how to calculate depreciation here.

Fixed Installment or Equal Installment or Original Cost or Straight line Method

Under this method, we deduct a fixed amount every year from the original cost of the asset and charge it to the profit and loss A/c.

Formula:

Depreciation = \(\frac{Cost of asset – Residual value}{Useful life}\)

Rate of depreciation = \(\frac{Amount of depreciation}{Original cost of asset}\) x 100

Diminishing balance or Written down value or Reducing balance Method

Under this method, we charge a fixed percentage of depreciation on the reducing balance of the asset. The amount of depreciation reduces every year under this method.

Formula: 

$$\text{Depreciation} = \text{Book Value} \times \frac{\text{Rate of Depreciation}}{100}$$

$$\text{Rate of Depreciation} =1 –  \left( \frac{s}{c}  \right)^{\frac{1}{n}} \times 100$$

Where n = useful life

s = scrap value

c = cost of an asset

 

Learn more about Depreciation and Causes of Depreciation here in detail.

Annuity Method

This method considers the cost of the asset and also the amount of interest lost on the capital expenditure on the fixed asset.

Thus, it not only allocates the cost of the asset but also the amount of interest on it should over the useful life of the asset.

Formula:

Depreciation = (Cost of asset – Residual Value) x Annuity factor

Sinking fund or Depreciation fund Method

Under this method, we transfer the amount of depreciation every year to the sinking fund A/c. We then invest this amount in Government securities along with the interest earned on these securities. Thus, we calculate depreciation after considering the element of interest.

Depreciation = (Cost of asset – Residual Value) x Present value of ₹1 at sinking fund tables for the given rate of interest.

Depletion Method

This method is usually used in case of the wasting assets like mines, oil wells, quarries, etc.

Depreciation = \(\frac{Estimated Total Cost – Residual value}{Estimated total output (units)}\) x Actual output during the year (units)

Machine hour rate or Service hours Method

Under this method, the hourly rate of depreciation is calculated and thus, the actual depreciation depends on the working hours during the period. This method is suitable in case of textile and jute mills and also in the handloom industry.

Depreciation  = \(\frac{Cost of the Asset – Residual Value}{Life of asset in hours}\) x Actual hours used during the year

Production units Method

Under this method, we charge the depreciation on the asset on the basis of units produced during the year. This method is applied in Plant and Machinery as their wear and tear depending on how much they are used.

Depreciation = \(\frac{Estimated Total Cost – Residual value}{Estimated total output (units)}\) x Actual output during the year (units)

Sum of Years of Digits method

It is a variant of the diminishing balance method.

Depreciation = [Original cost – Residual Value] x \(\frac{No. of years of the remaining life of the asset (including the current year)}{Sum of the years’ digits of life of the asset}

Sum of years Digits = \(\frac{N(n+1)}{2}\)

Methods of recording Depreciation

There are two methods of recording depreciation:

1. Provision for depreciation A/c is not maintained

2. Provision for depreciation A/c is maintained

a. Asset Disposal A/c is not opened

b. Asset Disposal A/c is opened

Provision for depreciation A/c is not maintained

Under this method, we debit the amount of depreciation to the Depreciation A/c and credit it to Asset A/c. thus, this reduces the book value of the asset.

Journal Entries

Date Particulars Amount (Dr.) Amount (Cr.)
1. On purchase of asset including all expenses incurred to bring it into use Asset A/c Dr.
To Cash/ Bank A/c
(Being purchase of asset)
2. For depreciation Depreciation A/c Dr.
To Asset A/c
(Being depreciation charged on the asset)
3. For transfer of depreciation to Profit and Loss A/c Profit and Loss A/c Dr.
To Depreciation A/c
(Being transfer of depreciation)
4. On the sale of the asset Cash/ Bank A/c Dr.
To Asset A/c
(Being sale of the asset)
5. For a profit on the sale Asset A/c Dr.
To Profit and Loss A/c
(Being profit on the sale of the asset)
6. For loss on sale Profit and Loss A/c Dr.
To Asset A/c
(Being loss on sale of the asset)

how to calculate depreciation

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Provision for depreciation A/c is maintained

Under this method, we transfer the amount of annual depreciation to the Provision for Depreciation A/c. Thus, the asset appears at the original cost in the books.

a. Asset Disposal A/c is not opened

Journal Entries

Date Particulars Amount (Dr.) Amount (Cr.)
1. On purchase of asset including all expenses incurred to bring it into use Asset A/c Dr.
To Cash/ Bank A/c
(Being purchase of asset)
2. For depreciation Depreciation A/c Dr.
To Provision for depreciation A/c
(Being depreciation charged on the asset)
3. For transfer of depreciation to Profit and Loss A/c Profit and Loss A/c Dr.
To Depreciation A/c
(Being transfer of depreciation)
4. On the sale of the asset
a. For transfer of Provision for depreciation A/c Provision for depreciation A/c Dr.
To Asset A/c
(Being transfer of provision to asset A/c)
b.. On receipt of sale proceeds Cash/ Bank A/c Dr.
To Asset A/c

(Being sale of the asset)

c. For a profit on the sale Asset A/c Dr.
To Profit and Loss A/c
(Being profit on the sale of the asset)
d. For loss on sale Profit and Loss A/c Dr.
To Asset A/c
(Being loss on sale of the asset)

 b. Asset Disposal A/c is opened

Journal Entries

Date Particulars Amount (Dr.) Amount (Cr.)
1. On purchase of asset including all expenses incurred to bring it into use Asset A/c Dr.
To Cash/ Bank A/c
(Being purchase of asset)
2. For depreciation Depreciation A/c Dr.
To Provision for depreciation A/c
(Being depreciation charged on the asset)
3. For transfer of depreciation to Profit and Loss A/c Profit and Loss A/c Dr.
To Depreciation A/c
(Being transfer of depreciation)
4. On the sale of the asset
a. For transfer of asset to asset disposal Asset Disposal A/c Dr.
To Asset A/c
(Being transfer of asset to asset disposal A/c)
b. For transfer of Provision for depreciation A/c Provision for depreciation A/c Dr.
To Asset Disposal A/c
(Being transfer of provision to asset A/c)
b.. On receipt of sale proceeds Cash/ Bank A/c Dr.
To Asset Disposal A/c
(Being sale of the asset)
c. For profit on sale Asset Disposal A/c Dr.
To Profit and Loss A/c
(Being profit on the sale of the asset)
d. For loss on sale Profit and Loss A/c Dr.
To Asset Disposal A/c
(Being loss on sale of the asset)

Solved Example For You

X Ltd. purchased machinery on 1st April 2014 for ₹500000. It charges depreciation @10% p.a. on W.D.V. method. On 30th September 2018, it sells apart of machinery for ₹50000, it’s original cost being 70000. Calculate the profit or loss on the sale.

Ans.

Particulars Amount (₹) Amount (₹)
Original cost on 1st April 2014 70000
Less: depreciation- 2014-15 7000
2015-16 6300
2016-17 5670
2017-18 5103
2018-19 2296 (26369)
W.D.V. on 30th Sept. 2018 43631
Sale Price 50000
Profit 6369

 

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